Indexed annuities: Look before you leap - Fidelity Investments
Can you get principal protectionandinvestment growth? That’s what index annuities promise. But despite their popularity, this complex investment product doesn’t always deliver. So, it is important to know exactly what you are buying before taking the plunge—and to consider the alternatives.
What is an indexed annuity?
An indexed annuity is a contract issued and guaranteed1 by an insurance company. You invest an amount of money (premium) in return for protection against down markets; the potential for some investment growth, linked to an index (e.g., the S&P 500® Index); and, in some cases, a guaranteed level of lifetime income through optional riders.
How is the return calculated?
One element of indexed annuities that is often misunderstood is the calculation of the investment return. To determine how the insurance company calculates the return, it is important to understand how the index is tracked, as well as how much of the index return is credited to you.
Index tracking. The amount credited to your account depends, in part, on how much the index changes. Insurance companies use various methods to track changes in the index value. For example, they may use different time periods, such as a month, a year, or even longer periods of time. It is important to understand how the index is tracked, as it will have a direct impact on the return credited to you.
The amount an insurance company credits to you depends on a variety of factors (any of which can potentially be combined), such as:
- Cap, which is an upper limit put on the return over a certain time period. For example, if the index returned 10% but the annuity had a cap of 3%, you receive only a maximum 3% rate of return. Many indexed annuities put a cap on the return.
- Participation rate, which is the percentage of the index’s return the insurance company credits to the annuity. For example, if the market went up 8% and the annuity’s participation rate was 80%, a 6.4% return (80% of the gain) would be credited. Most indexed annuities that have a participation rate also have a cap, which in this example would limit the credited return to 3% instead of 6.4%.
- Spread/margin/asset fee, which is a percentage fee that may be subtracted from the gain in the index linked to the annuity. For example, if an index gained 12% and the spread fee was 4%, then the gain credited to the annuity would be 8%.
- Bonus, which is a percentage of the first-year premiums received that is added to the contract value. Typically, the bonus amount plus any earnings on the bonus are subject to a vesting schedule that may be longer than the surrender charge period schedule. Given the typical vesting schedule, the bonus may be entirely forfeited upon surrender in the first few contract years.
- Riders, which are extra features that can be added to the annuity for additional costs, further reducing the return.
“One challenge here is that insurance companies typically have the flexibility to lower the participation rate, increase the spread, or lower the cap, which lowers your potential returns,” says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company. “If this happens during the surrender charge period after you’ve invested in the annuity, you have very little recourse.”
In addition, an often overlooked point is that indexes exclude dividends, so your return from an indexed annuity will also exclude dividend income. This is important because history indicates that dividends have been a strong component of equity returns over the course of time. Since 1930, dividends have made up approximately 40% of the S&P 500's average annual total return.2
How does a cap impact potential returns?Over the 10 year period, the average annual return for the S&P 500 index was 7.31% including the dividends. With monthly crediting, the annuity had an average annual crediting rate (policy earnings) of 2.34%
Including the product's 8% initial bonus, the 10 year average annual crediting rate (policy earnings) for the annuity would be 3.14%
The chart uses a representative indexed annuity with a monthly cap on upside returns.
Over the 10 years ending Dec. 31, 2015, the S&P 500 average annual return was 7.31% (5.05% without dividends), while the indexed annuity returned only 3.14% annually—despite an 8% initial bonus and guaranteed annual floor of 0%. Indexed annuity returns are typically comparable to a conservative investment product's returns, and not to the stock market, a stock market index, or stock fund returns.
To better understand this, let’s take a look at another example, this time comparing an indexed annuity with a conservative investment strategy—a portfolio that has 90% invested in 10-year zero-coupon Treasuries3 and the other invested in stocks represented in the S&P 500 index.
In our example, both start with $100,000 invested. The assumptions for the indexed annuity include:
- In a given policy year, if the S&P 500 loses value, the policy will be credited 0%.
- If the S&P 500 returns more than 2.75%, the policy will be credited 2.75%.
- If the S&P 500 returns from 0% to 2.75% the policy will be credited the S&P 500 return.
- At the end of a 10-year period, the annuity account value will be 108% of the premium (based on an 8% bonus) plus 10 years of return credited to the investor, assuming no withdrawals.
Both the annuity and the conservative investment strategy are guaranteed to return at least $108,000 at the end of the 10-year period—the annuity thanks to the 8% bonus, and the conservative investment strategy thanks to the growth of the zero-coupon Treasury, given the interest rate and starting balance.
Both the indexed annuity and the conservative investment strategy have been simulated over 56 rolling 10-year periods, and, as you can see, the average ending balance of the conservative investment portfolio is about $10,000 higher.
“Investors often mistakenly think they are investing in the market directly with an indexed annuity and are surprised when their actual return does not measure up,” says Tim Gannon, a vice president of product management at
Fidelity Investments Life Insurance Company.
|Compare average ending balances.|
|Representative Indexed |
|Conservative Portfolio: 90% in Zero-Coupon Treasuries, |
10% indexed to the S&P 500
|Average Ending Balance after 10 years4||$130,031||$140,090|
Another way to look at this is to see how this representative indexed annuity would have performed in the past compared with the index that it would have tracked. The chart below shows rolling 10-year periods going all the way back to 1926, with each point on the lines representing an annualized return for the 10-year period beginning in that month. Note that the S&P 500 Index returns are significantly higher in the majority of periods, while the Indexed Annuity stays within a narrow range.
Note: S&P 500 Index returns include reinvested dividends.
How much do they cost?
Indexed annuities typically do not have an up-front sales charge, but there are often significant surrender fees—fees you pay if you need access to your money before the surrender period ends—and other hidden costs. “While index annuities are often sold as ‘no-fee’ products, investors still incur a cost to own these products,” explains Gannon. In fact, surrender fees for the 10 top-selling indexed annuities averaged 11.25% in the first year.5
“In addition, indexed annuities have significant opportunity costs that are passed on to customers by the insurance company, by limiting potential returns through a participation rate, cap, or spread,” notes Gannon. "That’s why, it is important to ask your agent to explicitly define how the product works, so you will know up front about any factors that could put a drag on your potential return.”
Can you lose money?
The answer, in some cases, is “yes.” If the market index linked to your annuity goes down and you receive no or minimal index-linked return, you could lose money on your initial investment if you withdraw assets before the surrender period is up.
“Your principal is protected only if you hold the annuity through the surrender period, which could be 10 years or longer,” says Ewanich. “Unfortunately, many investors believe that, regardless of what happens in the market, they get all their money back with these products. But this is not always true.”
So what is the minimum amount you might get back? Index annuities may guarantee a minimum of only 1% to 3% interest each year on 87.5% of the premiums you invest,6 as defined in state insurance laws. So, if you invested $100,000, you might be guaranteed from 1% to 3% a year on $87,500.
What’s more, in an effort to attract more customers, these products are offering certain riders for an additional cost. For example, many companies offer a guaranteed living withdrawal benefit at an average cost of nearly 1% that promises a guaranteed withdrawal amount7 for life with upside potential. Because of the indexed annuities’ participation rates, spreads, and caps, however, upside potential is generally limited. Be sure to determine whether the benefits outweigh the extra cost.
Does it fit your needs?
“Indexed annuities can be a challenge to understand, so be sure to do your homework,” advises Gannon. Depending on what you are looking to address, it may be in your best interest to consider a different type of annuity or a combination of investment products.
For example, for principal protection and market participation, you may benefit from a strategy that invests a portion of your assets in a conservative investment, such as bonds, and the remaining portion of your assets in the stock market, for upside potential.
“A financial representative can help you build a comprehensive plan that takes into account your specific needs and objectives,” says Gannon.
Before investing, consider the investment objectives, risks, charges, and expenses of the variable annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus or, if available, a summary prospectus containing this information. Read it carefully.
1. Guarantees are subject to the claims-paying ability of the issuing insurance company.
2. Source: Morningstar® EnCorr®; FMRCo, as of 12/31/2015.
3. The analysis is based on prevailing interest rates in February 2016. The 10-year zero-coupon Treasury yield of 1.93% at that time implies an initial investment of approximately $0.89 in order to provide $1.08 with certainty after ten years. Note that this rate and the assumptions based on it are applied over the entire historical range, even though very different rates applied at various times.
4. The ending balances of the two strategies are calculated based on the 56 rolling 10-year periods beginning with 1951–1960 and ending with 2006–2015, so the first 10-year period is 1951–1960. The 56 results for each strategy were used to calculate the average ending balances shown in this hypothetical example. Both investments are within a qualified account.
5. AnnuitySpecs, Beacon Research and Fidelity Life Insurance Company, as of Q3 2015.
6. “Equity-Indexed Annuities: A Complex Choice,” FINRA Investor Education Series, 2012.
7. According to WINKS Q3 '15 Indexed Product Sales and Market Report, 37 companies offered a guaranteed lifetime withdrawal benefit (GLWB) rider in Q3 2015 for an average cost of 91 basis points.
Past performance is no guarantee of future results.
The S&P 500 Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500 is a registered service mark of Standard & Poor's Financial Services LLC.
Indexes are unmanaged. It is not possible to invest directly in an index.
The conservative portfolio can lose money, and the total balance could be less than the indexed annuity total balance.
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