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Indexed Annuities: The Latest Sales Pitch in Investing

  

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Would you be interested if I told you about an investment product that promises never to lose money while at the same time allowing you to participate in stock market gains when they occur?  The products are called indexed annuities, and judging by recent sales figures a lot of people are interested.  According to AnnuitySpecs.com, indexed annuities attracted a record $8.7 billion from U.S. investors in the third quarter of 2010, an increase of 16% from a year earlier. 

            Investors turned off by bank CD rates and perceived risks in the stock market may be led to view indexed annuities as an attractive alternative.  Insurance companies are aggressively marketing these products and some insurance agents here on the Central Coast are offering “free lunch” seminars in hopes of earning up-front commissions as high as 8% to 12% for each indexed annuity sale.   

Unfortunately, what marketers of these products frequently fail to thoroughly explain or disclose at all is the multitude of drawbacks that are tucked away in often lengthy contracts.  My guess is that if all investors were aware of all the drawbacks of indexed annuities prior to purchase only a small fraction of the sales occurring today would come to fruition.

Here’s how indexed annuities work:  an individual invests a large sum of money with an insurance company in a contractual arrangement and as part of the insurer’s obligations they promise the investor will never lose money on their balance from year to year no matter how poorly the stock market might perform, while at the same time offering a percentage of the stock market’s gains as a return.  Here’s an example:  An insurer may offer 100% of the stock market’s gains up to a maximum return of 8% per year as measured by a reading of the S&P 500 Index on January 1 of every year.  If the stock market returns 8% from January 1, 2011 to January 1, 2012, investors receive a gross return of 8% in 2012; if the S&P 500 returns 25%, then investors still only receive 8% because of the aforementioned cap; if the S&P 500 posts a negative return, then investors are guaranteed not to lose any of what the market lost.

While this may sound great on the surface, consider two major drawbacks.  First, most contracts permit insurance companies to reduce the stock market participation cap in future years.  In other words, the potentially attractive 8% gross return cap you’re offered could be reduced substantially at the sole discretion of the insurer.  Additionally, most indexed annuities have lock-in clauses that impose a penalty for withdrawing money in the first 5 to 15 years of the contract period.  This means investors who are unhappy with their investment returns could pay penalties of up to 15% of their account balance just to cancel the contract.  It doesn’t seem fair that consumers should be locked into these contracts while the insurance company has free reign to change the terms, but this is in fact how these products typically work.

The truth is that indexed annuities are extremely complex investments, and the majority of investors are not aware of many of the nuances at the time of sale.  Beyond the aforementioned flaws, these products present a litany of other potential drawbacks, such as potentially unfavorable tax consequences, a lack of FDIC protection and other prohibitive contractual provisions.  While these types of investments may be appropriate in limited situations, they are often inappropriately sold to seniors and other investors who don’t understand the many drawbacks.  While indexed annuities make for a terrific sales pitch, they generally offer much less substance than advertised.

Securities offered through LPL Financial, Member FINRA/SIPC