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Integrated Wealth Management

Indexed Annuities: A Free Lunch?

Recently we've had a number of clients & acquaintances who were approached by salesmen selling what appeared to be a very appealing annuity product that offered not only the upside potential of the stock market but also guaranteed at least a 1% return in a downturn. This sounds like investment nirvana! Who wouldn't want that? But as the saying goes, "if it sounds too good to be true, it probably is" and that is certainly the case with indexed annuities. Let's take a closer look.

Fuzzy Math

Like other fixed annuities, indexed annuities offer a guaranteed minimum rate of return; the contract we examined promised a 1% guarantee. So far so good, but the catch is how the upside returns are indexed to the stock market. The bottom line is that due to participation rates and cap rates, you will never be credited with full upside participation of the stock market.

Participation rates determine what percentage of the stock market's increase will be credited to an indexed annuity's equity-related returns. The cap rate is the maximum rate the indexed annuity can earn regardless of how high stock market returns are. For example, if the participation rate is 85%, the cap rate 9%, and the stock market is up 12%, you will only earn 9% because 85% of 12% is 10.2% which is higher than the 9% cap rate.

To add to the complexity of the interest rate calculation, the insurance company can calculate the rate using annual point-to-point, daily average, or monthly point-to-point methods. Furthermore, the insurance company reserves the right to change the cap rate anytime WITHOUT informing policy holders! If you are confused at this point, join the crowd.

The bottom line is that stock returns never come equally, and very high returns in some years typically make up for poor and negative returns in other years. By using cap rates, insurance companies guarantee you will never have any big positive years to make up for the bad years.

Hefty Fees & Commissions

Most indexed annuities are sold by life insurance salesmen who earn up to a 10% commission on their sale. It has been our experience that often even the salesman does not truly understand how the participation rates and cap rates described above are actually calculated. In addition, indexed annuities also have significant internal fees which serve to further lower expected rates of return.

Bonus Points?

Indexed annuities may also entice prospective buyers with an immediate "8% bonus credit" at purchase, but there are rules you must follow to keep this bonus. An example might be that you have to annuitize (start life payments) with the issuer in order to receive the signing bonus.

Lack of Liquidity

Indexed annuity contracts often charge a hefty surrender fee of up to 18% if you surrender the contract for any reason in the first 14 years, thus severely limiting your financial flexibility. A sound financial plan presented by any clear-headed advisor should consider liquidity of your assets in case of emergency.

Investor Alert from Financial Industry Regulatory Authority (FINRA)

FINRA issued an alert on equity-indexed annuities that warns investors about the complex nature of the product. See the article here-"Protect Yourself: Equity Index Annuity- A Complex Choice".


While low cost traditional annuities have their place in some client's financial planning, we feel strongly that most people should steer clear of complicated, over-sold and over-hyped indexed annuities.