It is not often that I have a chance to review an equity-indexed annuity (EIA) and even more rare that one comes across my desk that has been in existence for 15 years. Most investors who are potential clients for EIAs—those looking for no volatility while believing they can benefit from good years in the stock market and avoid losses—likely are not going to value a long-term relationship with a fee-only advisor.
I recently began working with a client with three of these annuities, all closing in on their 15-year surrender period end date. What I found in analyzing the returns is that the story that these annuities lock in gains, allowing investors to benefit from the positive years of the market while avoiding down years, is not likely to be the case. In fact, the real story behind actual returns makes it hard to see how these investors benefit at all from the EIA. Even the formulas within the contract provide some interesting insights that betray the sales pitch. (For more, see: An Overview of Annuities.)
- The annuities began around the start of 2002.
- Each of the annuities is invested in a mix of equity formulas tied to the S&P 500 and Dow Jones, and each includes a portion to the fixed portfolio (two at ~31%, one at ~10%).
- Each had a 5% premium bonus.
If there were a period that EIAs would have been ideal for investment, one would think of missing the down markets of 2002 and 2008, while benefiting from some of the large market bounce-backs. This was not the case in these annuities. The average annual returns of all three were between 3.76%–3.93% for the period ending December 31, 2015.
Especially of interest was that the two annuities with the higher allocation to the fixed account had a higher average annual return (3.93%) than the annuity with the lower allocation (3.76%). The stock formulas were clearly a drag. (For more, see: Are Equity-Indexed Annuities Right for You?)
Given that interest rates are near all-time lows and that the annuity in 2014 had a guaranteed rate on the fixed account of 3%, it is likely that the fixed account average was at least as profitable, if not more so than the stock formula returns.
If this is the case, one would not only have been better off in the fixed account in the EIA, but they would have been better off with more liquidity in just about any other higher quality option. In looking at various bond indices, most intermediate-term bonds during this period returned ~4.5–5.5%, while long-term government and corporate bonds exceeded 7%.
In looking at a few blended portfolios* one could have avoided negative returns for 13 of the 14 years of this period with a 20% allocation to a diverse mix of equities and 80% in bonds, while increasing average annual returns to above 4%. A 40% allocation to equities had four negative years but a 5.7% average return, providing a chance at positive inflation-adjusted returns after taxes.
During a time of ideal stock volatility and increase, one would think these products avoided losses in down years (2002, 2008), and captured the gains during the positive years, but investors didn’t even beat the fixed account. This client deferred capital gains in one annuity while spending years in the 15% tax bracket where long-term gains could have been taxed at 0%. Now, they will be taxed at 15-25% on an after-tax basis, making the annuity after-tax return even worse.
And, in addition to all of the above, another downside is the massive uncompensated illiquidity. Generally speaking, investors should benefit from locking up their money for 15 years. I know of no other investment that has such long lockup periods. Meanwhile, investors would have been better off in a simple, liquid mix of government bonds and cash or CDs.
In summary, investors in these annuities locked up their investment for over a decade and had to rely on returns based upon the formula changes and needs of the insurer, all for a return somewhere between cash and intermediate-term, high-quality bonds before taxes. While we had two of the worst market years in history, investors would have been better off with just about any investment than the one designed to save you from a negative market. The facts simply don’t prove the sales pitch that annuities capture stock returns with no downside compared to just about any sounder alternative. (For more, see: How Good a Deal is an Indexed Annuity?)
*The blended portfolios listed about are based upon the following mix of indices from 2002-2015: S&P 500 (4% for the 20% stock portfolio, 8% for the 40% portfolio), Dimensional US Large Cap Value Index (4%/8%), Dimensional US Small Cap Index (2%/4%), Dimensional US Small Cap Value Index (2%/4%), Dow Joes US Select REIT Index (2%/4%), Dimensional International Value Index (2%/4%), Dimensional International Small Cap Index (1%/2%), Dimensional International Small Cap Value Index (1%/2%), Dimensional Emerging Markets Index (0.6%/1.2%), Dimensional Emerging Markets Value Index (0.6%/1.2%), Dimensional Emerging Markets Small Cap Index (0.8%/1.6%), BofA Merrill Lynch One-Year US Treasury Note Index (20%/15%), Citigroup World Government Bond Index 1-3 Years Hedged (20%/15%), Barclays Treasury Bond Index 1-5 Years (20%/15%), and Citigroup World Government Bond Index 1-5 Years Hedged (20%/15%).