Think Twice About an Indexed Annuity

We all enjoy playing a game we can’t lose, but investing in the stock market is not one of them. However, the promise of “guaranteed returns” led shell-shocked investors to pour nearly $30 billion into index annuities in 2009, even as they pulled $9 billion out of U.S. stock funds.

Index annuities are a close cousin of a traditional deferred fixed annuity, an investment vehicle in which an insurance company invests your money in bonds during an "accumulation period" of seven years and then converts your account into a steady stream of guaranteed income payments. An index annuity has the additional twist of tying those guaranteed payments to the performance of a stock market index, such as the S&P 500.

Guarantees are tempting in the wake of the Great Recession and continued market turbulence, but dangers lurk in the indexed annuity’s structure and fine print. In my view, the top three stumbling blocks are:

• High commissions, up to 9 percent in some cases, that can tempt the selling agents to act against your best interests.
• Steep surrender fees, as high as 20 percent, that can be imposed if you cash out before 10 years.
• Product complexity that makes it tough to know what you are buying.

Beyond those concerns, according to William Reichenstein, an investment management professor at Baylor University, over the long term a very conservative portfolio easily beats an index annuity. Why do indexed annuities almost always underperform? The issuing insurance company caps your return and can adjust the cap each year. A common cap for an annuity tied to the S&P 500 is 4.5 percent. And, according to the research firm Advantage Compendium, for the five years ended in September, the average index annuity paid an annualized 3.89 percent, just slightly better than the 3.81% you would have earned in a five-year CD and less than the 5.1 percent from taxable bond funds.

Finally, please be aware that fixed annuities are often marketed at “informational lunches” that are really over aggressive, high pressure sales pitches. Remember, the old adage “There is no such thing as a free lunch” applies to the market as well.