In my experience, the only people who think equity-indexed annuities are a good idea are those who sell them, usually to unsophisticated seniors after a free steak dinner. Imagine my surprise to read, in an otherwise very good book, an opinion to the contrary.
Hank Parrott, ChFC, AEP, RFC, has a small section in his 7 Steps to Financial Freedom in Retirement about equity-indexed annuities. He had bad things to say about variable annuities (as expected) and good things to say about fixed annuities (again, as expected) and then launched into his section on equity-indexed annuities (which he also refers to as “fixed index annuities.”)
[These] are fixed annuities that have potential earnings linked to a stock or bond index such as the S&P 500…It is important to understand that you do not actually own the stocks, but that the returns are tied to the performance of the index. These unique investments offer the principal guarantees and built-in minimum rates of return of fixed annuities, while also providing the potential for higher returns based on a percentage of the gains in the index to which they are linked. You are thus able to reap some of the benefits of gains in the stock market, while protecting your principal against the risks of a catastrophic drop like we saw in 2008.Most of these annuities limit the amount of gains you receive through provisions such as a participation rate. So if your participation rate is 50 percent, and the S&P 500 is up 22 percent, your account would increase by 11 percent…While the potential gains may be less than you would get from investing directly in an index mutual fund, many of the clients I work with like the idea of protecting their principal and don't mind giving up some potential return for that protection. Indeed, there are times, usually in a bear or sideways market–that a fixed index annuity may outperform the market index to which they're linked. This is due to the fact that you are participating in the gains of the market without having to make up for the losses. Fixed index annuities have historically offered a rate of return in the 3 to 7 percent range over time, though it's important to meet with a trusted financial adviser who can help you find an annuity that offers the best rate and other features to best obtain your objectives…
Later, he discusses charges:
Oftentimes clients come into my office and ask about the charges associated with annuities. They mention how they've heard about annuities but their source…warned them about the costs associated with these products. It is important to know that charges and fees are only relevant to variable annuities. This is due to the fact that you are charged a fee no matter the performance of the index the annuity is linked to…rather than get caught up in trying to figure out what insurance companies' fees and expenses are relative to those attached to CDs by banks, you should instead consider what overall features and benefits within the respective products work best for you…The important point to understand here is that you are not expected to be able to understand, manage, and purchase annuity products on your own.
For the counterpoints, we'll take a look at Larry Swedroe's excellent The Only Guide to Alternative Investments You'll Ever Need, a book which divides alternative investments into The Good, The Flawed, The Bad, and the Ugly (which only has two categories, one of which is equity-indexed annuities):
An equity indexed annuity (EIA) is another one of those products described by the people selling them as providing “the best of both worlds”–the potential rewards of equity investing without the downside risks (because of the guaranteed minimum return.) The typical EIA offering has the following characteristics:
- A link to a portion of the positive changes in an index [which portion varies] between 50 and 100 percent
- Principal Protection
- A minimum rate-of-return guarantee, regardless of the performance of the index
- Tax-deferred growth potential
- Income options to meet investor's specific needs
- A death benefit guaranteeing beneficiaries 100 percent of the annuity's indexed value
Investors seem to find these characteristics irresistible, purchasing an estimated $25.1 billion worth of EIAs in 2007….tripling since 20001. Another explanation for the explosion in sales is that commissions on EIAs average 8.5 percent…hidden in the form of high internal expenses and surrender charges.
The typical EIA provides far less than 100% of the index's return…First…most EIAs have participation rates….between 70 and 90 percent, [second is] through the use of an annual cap–the maximum rate at which the annuity can be credited. For example, the S&P 500 rose almost 29 percent in 2003 [but] an EIA might have limited the gain to…perhaps 12 percent, less…expenses. [Third, dividends don't count toward payout, only the price change of the index. Fourth is] the use of a margin fee…For example, in the case of an annuity with a [margin fee] of 3 percent, if the S&P 500 gained 9 percent, the return credited to the annuity would be 6 percent. Fifth…[they use] simple interest instead of compound interest.
Swedroe also discusses several ways in which the “change in the index” can be calculated. Not surprisingly, all of the various ways benefit the insurance company at the expense of the investor. He also points out that the “minimum guaranteed return” isn't necessarily based on 100% of the value of the annuity, but often only 90%. He discusses early surrender charges, sometimes as high as 22%, as well as explaining how EIAs essentially convert what would tax-efficient capital gains into tax-inefficient regular income.
He concludes:
While there may not be a perfect correlation, the following is a good rule of thumb to remember about all financial products: The larger the commission, the worse the investment. The reason is that the worse the investment, the higher the commission that must be offered to entice the salesperson to devote time and energy to selling the product. The bottom line is that large commissions explain both why the products are heavily sold, and why these products are meant to be sold, but never bought…In 2006, Dengpan Luo and Craig McCann coauthored a paper on EIAs. They found that an astounding 15 to 20 percent of the premium paid by investors purchasing EIAs represented a transfer of wealth from unsophisticated investors to insurance companies and their sales forces. They concluded, “Insurance companies add trivial insurance benefits, disadvantageous tax treatment, and exorbitant costs to mutual funds and sell them as equity-indexed annuities.” Our conclusion is that EIAs are the “poster children” for products that are too good to be true….An EIA represents a good reason why investors should avoid products that are inherently complex.
I find Swedroe's arguments compelling. In my experience, complexity always favors the issuer of a financial product. I'm disappointed to see Mr. Parrott arguing for these flawed products (or at least not outright proclaiming their wickedness). An EIA is a great idea, but the execution is flawed and the devil is in the details. All it takes to see through these things is a bit of common sense. How can an insurance company give you most of the upside of investing in stocks without any of the downside? They don't have a magic box for their investments. They have to invest just like anybody else PLUS they need to make a profit PLUS they have to pay these huge commissions to their sales forces. The bottom line is that the money for the profits and the commissions comes out of your pocket, and what you get in return is of far less value. The guarantees that seem so attractive to the purchaser, while valuable, are simply sold at far too high a price. Avoid complex financial products and don't take investment advice from commissioned salespeople.
Your comments on no magical investments sort of sums up equity indexed products. Since there are no magical investments, there is no mechanism for insurance companies to be able to guarantee principal but produce anything even remotely similar to equities long term. What these companies typically do is purchase high quality bonds with most of the money and options with a small subset of the cash. The good news is that the product typically remains fairly safe that you wont lose money (not including inflation or opportunity costs) but the bad is that its just not going to ever give near market performance especially when you consider the high commissions they pain to sell these things. One should look at these as fixed products with a different credit method. They will produce very similar to other fixed products. They may perform slightly better or slightly worse but over time very very similar to other fixed. The marketing on these is ridiculous. The idea that the returns could be anything similar to equities is misleading at best.
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As ADVANCED MARKET & SOPHISTICATED life insurance agents; we are suppose to help show people, how to Make, Protect and Move their money from UNSAFE places, such as (401k’s, 403b’s, TSP’s, Pensions, Stocks, Mutual Funds, Cd’s, IRA’s, Social Security, etc..) Which are all exposed to the volatility risks of the stock market, inflation and Taxes. 😬
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LIFE INSURANCE = SAVINGS ACCOUNT?! .
With banks giving (1%) interest back and inflation being at (3.5%) plus, taxes at (1.5%) = a total of (5%) against your $ By Default, your losing (4%) of your money every year just by having it in the bank!
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HOW MUCH LIFE INSURANCE DO WE NEED?! 🤔😀
(EXAMPLE): (apply the D.I.M.E. Method in order to help calculate, exactly how much Insurance is needed.)
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Debts (all debts, Credit cards, etc..)
Income x(10) or x(20) years
Mortgage
Education x(# of children) $60k per child
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Add up the total and that’s your Life Insurance necessity.
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THINK 2008 WAS BAD; WAIT UNTIL, YOU SEE WHATS COMING?!
THE EVERYTHING BUBBLE?!!😶
If these crashes / collapses / Market corrections, happen so often; this means, we may be facing another one here in the near future, right?!
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If you think you can still retire with a pension plan; then, you may just be in for a rude awakening. 👀
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Most Americans are now concerned; that company pension plans & Social Security, will not be adequate in providing them with enough income in their retirement years. Their concerns are warranted; and rightfully, so!
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According to an article on barrons.com; Social Security benefits, will start to exceed the programs cost in 2020, & the program will deplete it’s $2.9 Trillion reserve fund in 2035.
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The reserves will run out a little later than what the trustees of Social Security & Medicare projected last year; however, the bottom line is still the same. The programs deficits appear vast; making it clear, that the public should expect smaller benefits, higher taxes or more than likely, “both!” 😲
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Over the past 40 years, Congress has approved increasingly beneficial retirement options, designed to encourage Americans to save on their own, for their golden years.
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Meanwhile; no congressmen, will dare utter the fact that with mine blowing numbers of TRILLIONS & TRILLIONS of unfunded obligations; such as, Social Security & Medicare, which have now become described by many as a Ponzi scheme, that can never be fixed.
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Congress has covered itself w/ retirement legislation. So, much so, that sometime in the near future; 10 to 20 years from now, when the government system inevitably breaks; congress, The institution will be able to shake it’s finger at the American people, and point the finger back to 401(k)s, IRAs, Roth IRA‘s, & the similar in between of products they have created.
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The message will be, that the benevolent Congress gave the masses a way to save for their own retirement, years ago! 😯😶
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What will not be addressed, is why did the government continue to take 15.3% in PAYROLL TAXES from workers & businesses for a failed system; However, that will be an issue between you & the ballot box.
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The point here is; that to provide for your own retirement is prudent, as it is in all facets of life, to rely on yourself & not the government.
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I hope I was able to help.. Much Love ❤💪
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Remember; He who forgets the past, is bound to repeat it!” 😳
Sounds like a lot of salesy life insurance agent speak to me.
Your DIME method fails to account for how much someone spends rather than how much they earn and how much they already have. Under that method someone making $5M a year with a net worth of $100M would somehow “need” $50M in life insurance, which is obviously ridiculous.
i have invested in fixed income annuies for the last 5 yeart. i must be a super schmuck this is a poor investment smart people makestupid choices
If you’re investing instead of spending, I hardly think you’re a schmuck making stupid choices. That doesn’t mean there isn’t room to improve your investing returns. It’s pretty rare to find someone who has never made a mistake investing. This site is all about minimizing those mistakes.
Is the commission on a $100,000 equity-indexed annuity more or less than the management fees on $100,000 of managed money for 20 years?
Depends on how much you’re paying for each. It also depends on whether you apply a fair time value of money rate to the commission, which most salesman making that argument fail to do. Obviously if you’re paying some ridiculous fee like 3% a year, it’s not going to take very long to eclipse the original commission. A bigger issue is finding someone willing to manage just $100K at a fair rate.
I ran some numbers. Please let me know if they are accurate. A $100,000 annuity would have a $6,000 commission and would grow to $265,330 at 5% growth over 20 years. $100,000 under management with just a 1% management fee would have $31,104 paid out to the manager and would grow to $217,015 at 5% growth over 20 years.
So the advisor who sells the annuity only receives $6,000 in compensation, while the advisor who manages the money receives $31,104. And the client with the annuity ends up with $48,315 more than the client with money under management (assuming 5% growth for 20 years).
Shall we apply Swedroe’s advice of “The larger the commission, the worse the investment” to my numbers above? And if you think the commissions paid on annuities are “huge commissions,” then what do you call 1% in management fees?
I call 1% in management fees huge. I certainly wouldn’t pay that much when there are perfectly good managers available for 1/3 that. Your analysis also doesn’t account for the time value of money of that original 6% commission. We ought to let that grow at 5% too, no? After 20 years, that $6K is the equivalent of $15,919. Another error your analysis makes is that annuities tend to be lousy investments. Not to mention the sleight of hand of not accounting for the commission. So let’s run the annuity at 5% and perhaps the other asset at 8%. Combine all those factors (0.3% management cost, time value of the commissions/fees, and the difference in returns, and it doesn’t look good for the annuity.
Take your $100K. Now pay $6K as a commission. You now have $94K. I’ll humor you and go with the 5% growth rate for 20 years. That comes out to $249,410. Now, let’s take the money managed by an advisor (although personally, I’d just do it myself and save that fee.) Since it’s invested in better investments, we’ll go with 8%. Minus 0.3% a year, we’ll use 7.7%. But you get to invest the whole $100K. So after 20 years, you have $440,874, 77% more than if you were suckered into buying an annuity. Plus, you probably get the benefit of having a financial advisor for 20 years and aren’t locked into a single investing product to boot.
It was a damn good steak dinner, but now we’re in a zone of confusion after meeting with the “chef”.
He wants to take 300K out of an IRA and another 100K out of a CD and small annuity and get a 400K index annuity with survivor benefits, blah blah blah.
I’m a finance dummy (although I read Michael Lewis religiously). Do I fish or cut the line and run?
Are you kidding me? Who do you think is paying for the steak?