Should Annuities Be Part of Your Retirement Plan? Part 3

In the final part of this three-part series, managing partner and CERTIFIED FINANCIAL PLANNER™ Allen Stocker takes on the fixed index annuity — one of the most heavily marketed and least understood retirement products. He walks through how it works, the terms you must understand, what regulators and researchers have said, and the costs that don’t appear on the statement.

Video transcript

Hi, my name is Allen Stocker, certified financial planner and managing partner here at Patriot Asset Advisors. Over the past couple of videos, we’ve done a series on annuities and whether they should be part of your retirement plan. This time we’re covering the fixed index annuity. Several years ago these were called equity indexed annuities, but the name has since changed. I’d like to cover how they work, the important terms, a couple of articles that address the topic, and some of the fees involved.

What a fixed index annuity is

Fixed index annuities are a subset of the fixed contract — a kind of hybrid between a fixed annuity and a variable annuity. To start with, these are extremely complex investments. Most people have a hard time grasping how the insurance company actually calculates what you earn, so you want to do a lot of homework before putting any money in. In fact, back in 2019 FINRA — the Financial Industry Regulatory Authority — put out an investor bulletin noting how complex these are and warning against going into them without really understanding the terms and conditions. They’re often pitched, at least in a broad sense, as giving you market participation without downside risk. So you’re probably asking: what could go wrong with that?

Terms to understand before you buy

There are a lot of different ways the insurance company calculates your market participation, so there are several terms you’ll want to understand: the participation rate, interest rate caps, the spread (if there is one), bonuses and riders and how they impact the contract, and how point-to-point compensation is calculated. Back in 2012, FINRA published a piece called “Equity Indexed Annuities: A Complex Choice.” They cautioned that the rules can be changed — the insurance company may change the participation rate, the cap rate, and/or the spread on an annual basis, and those changes can be detrimental to your returns. I equate this to Lucy and the football in the old Charlie Brown cartoons: your money is tied up in a contract that may last seven, eight, ten, even fifteen years, but the rules of the game can change midstream.

What the research says

Fidelity had a piece in 2019 called “Indexed Annuities: Look Before You Leap.” Quoting them: in reality, indexed annuity returns are typically comparable to conservative investment products, not the stock market indexes or stock mutual funds. In other words, their returns are more correlated with CDs and money markets than with the stock market. Investors often mistakenly think they’re investing in the market directly, and are surprised to find their returns aren’t measuring up.

The hidden cost: fees and opportunity cost

One area where fixed index contracts have a problem, in my mind, is that they’re often sold as having no fees. It may be true that you don’t see explicit fees in the paperwork, but the opportunity cost is the real issue. As Fidelity notes, indexed annuities typically don’t have upfront sales charges, but there are often significant surrender charges — fees you pay if you need access to your money before the surrender period ends — and other hidden costs. While they’re sold as no-fee products, investors still incur costs by giving up higher returns in exchange for guarantees. Surrender charges for the top-ten selling annuities average 9% in the first year, which is rather high, and indexed annuities have significant opportunity costs passed on to consumers by limiting potential returns through the participation rate, cap rate, or spread. That’s why it’s important to ask your agent explicitly to define how the product works, so you know up front any factors that could drag on your return. In my opinion, index annuities are among the highest-commission products in the investment business, and having been in this business for over 30 years, I’ve seen that returns are reduced by paying higher compensation to the reps who market them. So look before you leap. If you have any questions, we’re happy to help you read through any annuity contracts and statements you own.