Equity Indexed Annuities: Pros and Cons for a Safe Retirement

One of the biggest challenges faced by retirees, or people who have just entered retirement, is finding the best method for ensuring that the money they’ve worked so hard to save doesn’t run out, or isn’t lost to market declines.

The closer you are to retiring, the less time you have to work and earn additional money to invest and grow your retirement nest egg.

Therefore, it’s essential to understand the different options available to both maximize your retirement savings and shield that money from loss.

One such option that has grown significantly in popularity over the past decade is an insurance product called an equity indexed annuity. In some circles, it’s referred to as a fixed indexed annuity, or just an index annuity.

Index annuities function similarly to ordinary annuities, while also providing benefits akin to a traditional brokerage account. Of course, there are a number of exceptions related to the fact that it is, indeed, an insurance product and not a typical investment account.

Admittedly, index annuities — like any investment products, actually — are not for everybody, nor are these products suitable for the entirety of your retirement savings, but rather an appropriate portion based on your unique individual time horizon and risk tolerance.

Understanding how index annuities work is essential to making the best decision regarding your retirement investments, as well as playing a key fundamental role in securing the safety and security of your financial future.

This article reviews some of the key features of index annuities, as well as the pros and cons of these products.

The goal here is that, by providing you with a better understanding of how these insurance-related investments work, you will be better informed and educated if, or when, it comes time to decide if an index annuity is suitable for you.

Potential Challenges Faced by Retirees

There are a number of potential challenges faced by retirees, or those who will soon be entering retirement.

These challenges are not unique to any one individual investor, but rather shared by all regardless of status, occupation, demographic composition, geographic location, or financial capability.

One of the most common fears among retirees is the possibility that they will simply not have enough money.

An estimated 10,000 baby boomers will be retiring every day from now until the end of the next decade, and a significant percentage of those individuals possess inadequate savings to support their current lifestyles for the years following their retirement.

Going hand-in-hand with simply not having enough money to survive is the fear that retirees will outlive the money that they have saved.

According to LifeHealthPro, “people could routinely live past 100” in the foreseeable future. With advancements in modern medicine, living too long is indeed another legitimate and valid concern.

Additionally, looking back on the performance of the stock market over the past fifty or so years and considering the number of relatively notable market downturns, yet another valid concern from a large percentage of future retirees is a possibility that — even for those who have saved enough to support themselves — their money may still potentially be at risk from the next market decline.

Owning high quality dividend growth stocks and using metrics such as our Dividend Safety Scores can help minimize damage to your income stream, but there are never any guarantees in investing.

Equity Indexed Annuities Pros and Cons

A fixed annuity is a retirement investment product developed and maintained by life insurance companies. There are many different types of annuities, each with its own pros and cons, however all annuities share certain features.

Briefly, fixed annuities are most similar to traditional bank CD’s in that they offer investors a predetermined rate of return on deposits for a specific period of time.

Money held within fixed annuities is not subject to stock market volatility and is therefore in no danger of decreasing in value.

However, fixed annuities usually offer an interest rate dramatically lower than what could typically be earned in a conservative brokerage account containing investment-grade bonds, blue-chip dividend stocks, or similar income-producing securities.

Admittedly, there are a number of equity indexed annuities problems investors should be aware of. The main features and characteristics of fixed annuities that opponents tend to focus on are the fees within these products.

Annuity fees, in general, range from 0.5% to approaching 2%, depending on factors such as the various guarantees associated with that particular product, as well as the financial health and credit rating of the issuing insurance company.

The industry debate regarding the suitability of annuities versus other retirement investments has been ongoing for decades and won’t be ending any time soon.

However, that debate is beyond the scope of this particular educational article and it’s something that we will discuss separately. Read on to learn more about equity indexed annuities and how they work. 

What are Equity Indexed Annuities?

Equity indexed annuities are, technically, fixed annuity products. But, they operate more like variable annuities than traditional fixed annuities in that your account balance is tied to the performance of a stock market index, rather than a predetermined rate of return.

Although index annuity account balances are directly related to the stock market, your money is never actually at risk; your product value is only tied to the market, not actually invested in it.

In the simplest terms, when you first purchase an equity indexed annuity, the value of a chosen index — typically the S&P 500 — is notated and becomes the benchmark for future gains.

On your contract anniversary date, if the value of the index (again, in this case the S&P 500) is higher than it was when you first opened the annuity, your account will be credited with the relevant percentage increase.

However, if the value of that index is less than it was a year earlier, your account balance will remain the same. Essentially, when the value of the index goes up so does your account balance, but if it goes down your account balance remains the same. “There is zero downside risk in negative stock market years,” so long as the company that sold you your annuity is still in business.

Investors who are not familiar with the concept of an index annuity often find it hard to believe that such a product exists and that you can participate in stock market increases while being shielded from decreases. How is this possible? How can insurance companies offer such a product?

As you may have suspected, it’s not as simple as I just made it sound. There are certain aspects of an index annuity that can limit or reduce gains, or even eliminate them entirely.

This is why it is paramount to the success of your retirement investments that you understand, specifically, how index annuities work; with the right knowledge, you can avoid unfavorable features and consider only those annuities that offer the best possibility of growth with the least number of restrictions.

One of the most common limitations on the potential gains of an index annuity is called a performance cap. Here, the insurance company institutes a maximum percentage rate that can be applied to your account in any given year.

On your contract anniversary date, if the increase in value of your chosen index is more than the cap, the amount above that cap is forfeited and kept by the insurance company. In most cases, the performance cap is typically high enough where most investors wouldn’t complain.

If the performance of the index is less than the cap, then that cap is essentially irrelevant. The only time the cap would be a hindrance to your annuity’s performance is if the value of the index was dramatically higher on several contract anniversaries.

Another common growth-limiting characteristic of many equity index annuities is a contract specification called a participation rate. This refers to how much of the increase in the index value is actually used to calculate the interest credited to your annuity for that particular year.

For example, if your annuity had a 70% participation rate and the actual increase in the index was 10%, only 7% would be credited as an increase to your account (70% x 10%).

A third, and perhaps the most controversial, aspect of all annuities (including equity index annuities) is the surrender charge.

Virtually every annuity contract contains provisions allowing the insurance company to keep a portion of your money if you decide to close your account within a certain number of years.

Typically, surrender fees range from 6%-8%, but can be higher depending on the insurance company and the specific annuity product you choose.

Surrender charges are not a permanent component to an annuity contract, though. These potential fees decrease over time, usually on an annual basis, until eventually disappearing entirely.

So, if you don’t plan on using the money in your annuity for at least a decade, surrender charges may be essentially irrelevant.

Are All Annuities and Equity Index Annuities the Same?

In a word, no. While the basic concept of an equity indexed annuity is the same across the board — linking your account value to a stock market index — no two EIAs are identical.

Each insurance company will have different performance caps, participation rates, surrender charges, and other product features. Your situation will determine which index annuity product is most suitable, given your unique goals and time horizon.

The multitude of features and options available with index annuities exists to meet the needs of the wide variety of consumers and retirement investors. So, it’s not necessary to settle for a product that’s less than perfect for you. There are countless insurance companies that offer these products, and many companies have several index annuities from which to choose.

Ideally, your index annuity should have low fees — in the least, a fee structure that’s in line with industry standards.

Keep in mind, though, that the more bells and whistles you add to an annuity contract (read, the more riders and guarantees), the higher the total fees. Those fees will reduce overall returns in your account.

So, depending on how much your annuity grows — which, in the case of an EIA, is dependent on the performance of a stock market index — the fees could end up totaling a rather significant amount.

As far as the interest crediting method, opinions vary, but one thing is certain: the “averaging” method most frequently leads to lower returns. It’s true that averaging the returns of a market index could alleviate the possibility of a zero return on your contract anniversary date. But, over the long term, the point-to-point method is much more likely to produce notable growth.

The Main Problems with Annuities

After initially publishing this article, one of our seasoned readers submitted his critique of these products. With his permission, I posted his comments about annuities below with hopes that they would provide everyone with greater knowledge about some of the risks annuities can pose. He is most concerned about how these products are bought and sold and the tactics that are used to try to take advantage of senior citizens:

  1. These products are not investment products – If you buy one of these products you give your money away…so there is no rate of return. It takes years just to recapture your principal and you are paid in cheaper dollars. I have done various tests and I have found that a typical internal rate of return amounts to about 2.2%.
  2. The fees can be enormous – You mentioned between 0.5 to 2%…I have never seen 0.5%…and I have seen in excess of 2% if the annuitant purchases the various options. Of course these products are very lucrative for the agent who sells them, typically up to 10% of the amount invested…so $10,000 on a $100,000 annuity.
  3. The company can change the actual interest rate credited to the account once per year – Read the fine print and you will see the company has a right to do this once per year. So it really doesn’t matter about the performance of the index…that to me is the red herring. You see it advertised on the TV all of the time….”if the market goes up, your portfolio goes up…if the market goes down your portfolio stays the same”. This is a “true” statement, but IMHO it’s totally misleading. The truthful statement should be, “If the market goes up your actual interest credited to your account will not go up as much as the market because of two reasons: One is that the annuitant chose (paid) the specific participation rate, and two the company selected the actual interest rate in the beginning of the current year. Since this is a CD instrument of course you will never lose any of your principal”.
  4. Products are often purchased within a tax-deferred account – Think about the pitch is about how the account grows tax free…well if it’s a tax deferred account it already grows tax free. The other issue to consider is that these instruments are often referred as a way of reducing your RMDs. This is not accurate…the RMDs are delayed until you start taking your RMDs…then they are accelerated when the annuitant can least afford to have that happen. The only reason the are placed into a tax deferred account is because that’s where most people have their investment monies. There is no other valid financial reason to purchase them in a tax-deferred account.
  5. Free Dinner – Just look at some of the tactics that are used. A nice local restaurant is chosen and the senior citizens (usually) are offered a free dinner…we all know there is no such thing as a free dinner. There the sales people use heavy handed tactics to scare the audience about the market collapsing…and they happen to have a product that could save them. Keep in mind this is NOT an investment, the actual growth is less than the rate of inflation so your annuity stream is paid in cheaper dollars. Also, there is credit risk involved (the insurer)…and that is never mentioned. Jut look at the current companies who seem these products….they are NOT all rated A+ by A. M. Best (anything less is more risky), and some of the largest sellers are controlled by hedge funds. Hedge Funds…yikes!
  6. Are there alternatives? Check any ten year rolling period since the 1920s and you will see there is better than an 85% probability any individual will realize an average rate of return of 7% by investing in an S&P fund that costs around .03%….you could conservatively draw 5% per year and still have your principal grow.

Are There Any Alternatives That Could Potentially Produce the Same Results?

To reiterate, index annuities are not for everybody, nor are they necessarily suitable for the entirety of your retirement investments. But, the right product from the right company can be an integral component to a larger portfolio, depending on the investor.

Perhaps the most advantageous of the viable alternatives to consider for the remainder of your retirement investment composition is dividend stocks.

A collection of reliable high-yield securities with a longstanding history of solid dividend growth can serve as a powerful source of stable income.

If kept within the portfolio as cash, over time those dividend payouts will create a (relatively) liquid cash component that is both conservative and full of potential.

Alternatively, most brokerage accounts offer a dividend reinvestment option, wherein the dividends received from the securities in your portfolio are automatically used to purchase additional dividend stock shares.

Is It Important to Enlist the Services of a Professional Advisor?

With so much risk, and so many fears and potential disaster situations laying on their minds, it’s no surprise that Baby Boomers and young people alike flock to professional financial advisors for assistance.

The financial advisor’s goal is, obviously, to help retirees arrange their savings in such a way as to alleviate — or at least minimize — all of these fears.

A number of techniques, investment products, and account types exist to address these specific issues. However, knowing which product or account type will yield the best results is impossible for anyone to determine.

All that an advisor of any type can do is present suitable options and educate retirees on the pros and cons of each type in an effort to assist with making the most advantageous decision.

CheatSheet.com hit the nail on the head here:

“A lack of understanding creates an abundance of uncertainty and stress, which helps explain why 60% of employees report feeling somewhat or very stressed about their financial situations, or why 62% of millennials want a financial advisor to walk them through every step of the retirement planning process.”

So, the bottom line is that there is no sure-fire way to know which retirement product or investment will yield the biggest returns. Therefore, familiarizing yourself with the different features and characteristics of available retirement investment options is a wise idea.

While you do have to be very selective with whom you trust and the fees you pay, the assistance of a qualified, properly trained, and experienced financial advisor can be a big help. Decisions shouldn’t be made on whim, nor without adequate information and insight.

Retirement planning is serious business, which is why it can make the most sense for many folks to get help from someone who has highly specialized training and years of relevant industry experience.

This is particularly true when you’re considering investments as complex as index annuities. The right advisor could mean the difference between retiring in the lifestyle you want versus not being able to retire at all.

Trusted by thousands of dividend investors.

Track your portfolio now

Our tools and Dividend Safety Scores™ at your fingertips.

More in World of Dividends