With most fixed income investments, there is a high price to be paid for the “security” of fixed income in an investment. Government issued bonds, for example, carry a perception of security—albeit not altogether true—and the price to be paid is low or even negative returns on your investment.
Although a relative newcomer on to the scene of investment products, it would appear that equity index annuities also fit into that category: perceived security, yet very low returns and a requirement to tie up capital for long periods of time in order to achieve anything positive in returns.
Equity indexed annuities are insurance products. Their returns are tied to the performance of stock indexes such as the S&P 500 stock index. The advantage is touted to be that, regardless of the performance of the index, the principal balance of their investment will not decline. It is said that if the stock market performs well, the investor shares in some of the gain. If it doesn’t, the investor doesn’t lose. Sounds like you get to have your cake and eat it, too.
But that protection comes at a price. First, there are surrender charges and other penalties if an investor withdraws early, so changing your mind is really not an option unless you want to lose money. And how to get MORE than a pittance of a return even when you do hold out for the long term? That presents a dilemma as well, since indexed annuities have pre-set caps that limit their gains. If, for example, you believe the stock market will provide 10% returns, the investor in an index annuity gives up much of those gains. On the other hand, if you believe the market will drop by 10%, you will be protected from the decline. So it’s really what happens over the long-haul that matters.
It’s obvious that many investors have taken the bait. In 2008 alone, more than $25 billion was plunged by investors into equity index annuities.
Insurance companies, of course, keep much of the gains when the market is up.
Much of the risk by the insurance companies, for example, is hedged by regularly-changing “participation rates”, which reference how much of the return the index provides can be kept by the investor. As you can imagine, the insurance company gets to change those limits from year to year, usually based on “market performance”.
In my opinion, the biggest negative to this type of investment is rooted in the fact that it is an insurance product. Like most insurance policies, just like in a casino, the rules are somewhat complicated and always changing in an effort to make sure the “house” wins over the long haul. Doesn’t mean there’s never a mutual benefit, but it probably means the benefit will be mutual only if the market does better than average.
And if you feel like you have a handle on whether a market will do better than average, why not just invest in that market, and give yourself the ability to opt in or out, instead of relinquish control of your funds long-term to an insurance company who gives you a “guarantee” you won’t lose in order to keep much of the gain?
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