Variable Annuities Part 3 of 4: Indexed and Fixed Annuities

How much do you value safety when it comes to investing? That’s what the choice between a traditional variable annuity and the next two competing products in our educational series boils down to.

They’re called indexed and fixed annuities, and like with the other options I covered in Parts One and Two of this series, they come with their own quirks, benefits, and drawbacks.

Indexed Annuities

At first glance, indexed annuities (also called equity indexed annuities) appear to provide investors with the best of all worlds. These investments are designed to appreciate at the same rate as a stock index — usually the S&P 500 — over the term of your policy. That gives you the upside potential of investing in equities. But if the stock market takes a header during your policy term, you still earn at least a minimum, guaranteed annual return. The most common figure is 3%.

Sound too good to be true? Well, in most instances, it is. Here’s why:

First, your returns on an indexed annuity will never equal the returns you would get from owning an S&P 500 index mutual fund. Reason: Although an indexed annuity provides you with a return equal to the S&P 500’s price appreciation (historically averaging about 7.5% per year), it does NOT include the index’s dividend-driven returns (which have averaged about 3%). So rather than earn the 10.5% on average you’d get from an S&P 500 mutual fund, you’d earn only around 7.5% with the indexed annuity.

The frequency with which your interest is credited is another potential pitfall. Indexed annuities that only credit your earnings at the end of the policy term are at a serious disadvantage. Why? Even if the stock market has a couple of great years in the early part of your policy term, those returns could be completely wiped out in the latter years of this type of policy, leaving you to rely on the 3% guaranteed minimum return for nominal investment appreciation.

In other words, most policies do not give you a minimum return based on the greater of 3% or the performance of the S&P 500 each year. Instead, you receive a return based on the greater of 3% compounded annually or the long-term performance of the S&P 500. This leaves you very vulnerable to an untimely cyclical stock market downturn.

Another problem? The guaranteed minimum return is not paid on your full investment. Regulators instead require that the guaranteed minimum rate be paid on either 87.5% or 90% (depending on the state the annuity is sold in) of the original principal.

So, on an initial investment of $100,000, a 3% guaranteed minimum return is actually paid on either $87,500 or $90,000. That translates into $2,625 or $2,700 in returns, respectively, rather than the $3,000 you might otherwise expect.

Next, your investment safety with an indexed annuity is far more dependent on the financial stability of the underwriting insurance company. Unlike with a variable annuity, your indexed annuity funds are pooled with the assets of the insurer. If the insurance company should fail during the term of your policy, your funds could therefore be subject to a moratorium on withdrawals.

One last thing: Your insurance company isn’t typically investing in an S&P 500 index fund with your money. In reality, an insurer will typically invest about 70% of your money in bonds and 20% in call options on the S&P 500 index. The balance goes toward acquisition costs, administrative costs, and insurance company profits.

If interest rates drop and the stock market stagnates or declines, the insurance company will be saddled with a loss. So, unless it has a solid capital cushion or good revenues from other sources, it could be hard-pressed to pay you what it promised.

Advantages vs. Variable Annuities

The most obvious advantage is the guaranteed minimum annual return. This safety net is one that many people find attractive. In recent years, companies have started offering guaranteed minimum accumulation benefit riders on their variable annuity policies. Those guarantee that the contract value will be at least equal to a certain minimum percentage (usually 100%) of the amount invested after a specified number of years — regardless of the underlying investment performance.

Disadvantages vs. Variable Annuities

 Disadvantage #1. Your returns will always be lower than a comparable investment through a variable annuity because you miss out on the dividends.

 Disadvantage #2. An indexed annuity effectively limits your choice of mutual funds to one: A stock index fund. Therefore, you can’t diversify your investment and make changes to your asset allocation like you can with a variable annuity.

 Disadvantage #3. The value of your investment in an indexed annuity is subject to the financial health of the issuing insurance company. If the insurer goes bankrupt, you could experience a loss.

Let’s compare the net effect of Sheila Turner’s $20,000 one-time investment in an indexed annuity to that of a variable annuity that’s fully invested in an S&P 500 index fund. Assume the term of her investment is 30 years, and that she is lucky enough to see average annual price appreciation of 7.5% for the S&P 500 during that time – plus dividends enhancing that return by an additional 3% per year.As you can see, the additional 3% dividend yield available through the variable annuity S&P 500 index mutual fund provides Ms. Turner with an extra $224,752 at the end of 30 years. Moreover, if the market starts to tumble during this period, Ms. Turner has the flexibility to shift her fund allocations, thereby potentially increasing this difference even further.

 Who Should Consider Indexed Annuities?

You should only consider investing through an indexed annuity if you want the potential of stock market returns but are afraid of a market decline and lack the time or ability to actively manage your investment.

Bear in mind that you will not experience the full returns of other investors who are using S&P 500 index mutual funds, though you will be guaranteed at least a small return on your investment regardless of what the stock market does. Be sure you stick with an insurer that has a strong Weiss Safety Rating to reduce the risk of insolvency or loss, too.

Fixed Annuities

The oldest and most conservative type of annuity is the fixed annuity. Under this type of investment, you contribute your after-tax dollars to the pooled accounts of an insurance company. The insurer invests the money primarily in bonds, guaranteeing you a minimum annual return on your investment.

In their sales pitches, most insurance companies will show you illustrations assuming annual returns of 7% to 10%. But the reality is they have historically averaged a mediocre 3% to 6% after expenses.

Just like with variable annuities, fixed annuities provide the opportunity for tax-deferred investment growth. Taxes are due on the earnings portion of your investment once you convert it into an immediate annuity.

Unlike variable annuities, however, your investment dollars are not held in separate sub-accounts, segregated from the rest of the insurance company’s assets. So, if you do buy a fixed annuity, keep a watchful eye on the financial health of the insurance company by periodically monitoring its Weiss Safety Rating.

Fixed immediate annuities provide you with a fixed payout, one which stays the same until you die or the annuity’s term ends, depending on the payout option you choose. On the other hand, the payout from a variable immediate annuity will fluctuate depending on the growth you experience in your underlying mutual fund investments.

This means that the purchasing power of your monthly income from a fixed annuity will decline over the years due to inflation. The prospect of higher returns in a variable annuity has the potential to help you maintain your purchasing power — if you’re willing to accept the added risk.

Advantages vs. Variable Annuities

Fixed annuities are an extremely low risk option because you aren’t directly affected by market fluctuations, unlike with variable annuities. Their guaranteed minimum annual returns also give you peace of mind. You know that, provided you’re dealing with a strong insurer, your deferred investment is going to grow year-in and year-out. And if you do not have an interest in actively managing your own investments, fixed annuities have a definite advantage.

Disadvantages vs. Variable Annuities

 Disadvantage #1. Your annual returns are extremely limited. Historically speaking, fixed annuities have typically yielded about 3% to 6% annually, compared to around 11% for stock mutual funds.

 Disadvantage #2. The safety of your investment is ultimately dependent on the financial health of your insurance company.

The only real difference that can be illustrated by comparing a fixed annuity to a variable annuity is the difference in growth based on the expected performance of one versus the other. Aside from this, the tax implications are exactly the same for either type of investment.

Let’s assume that Bill Reilly invests $20,000 under two scenarios: One using a fixed annuity returning 2%, and the other a variable annuity returning 4%.As you can see, the 2% yield differential between the two investments would provide Mr. Reilly with an extra $28,641 at the end of 30 years. And if you rework the example based on an 11% annual return — which more closely approximates the stock market’s long-term historical performance — this differential widens to a whopping $421,619 at the end of 30 years.

Keep in mind that the assumptions in this analysis are based on historical results, which may not necessarily be indicative of future performance. The drastic decline in the stock market during 2008 and early 2009 demonstrates the possibility of wide fluctuations in annual results. In a year such as 2008 when the S&P 500 Index was down 37%, the guaranteed rate of a fixed annuity would’ve looked pretty good!

 Who Should Consider Fixed Annuities?

Fixed annuities are most appropriate for people who have very little investment experience and who don’t want to assume responsibility for managing their investments. A deferred fixed annuity is a good means of steadily building a tax-deferred nest egg with very little risk (other than the risk of an insurance company failure). And an immediate fixed annuity can provide a good deal of comfort during retirement, knowing that you will receive a fixed amount every month, guaranteed for the rest of your life.

As always, be sure to check an insurer’s safety rating on the Weiss Ratings website. And don’t forget to check out Part Four of our annuity series next week.

Think Safety,

Gavin Magor