After the turmoil of the 2008 stock market, who could resist the offer of capturing the upside of a market with no downside risk? Sound too good to be true? That’s basically how equity indexed annuities are being positioned by some issuers. They promise that you will never lose money when the stock market declines and that you will still be able to participate when the market goes up. What’s not to like? Let’s look at the facts.
Although the name says equity index, you don’t actually invest your money in the stock market. Your return is based on a market index like the S&P 500, but you don’t earn any of the dividends. Dividends are an important part of the stock market return. The 20 year average for the S&P 500 Index for the period ending April 30, 2011 was 8.86%. However, if you take out the dividends the return drops to 6.66%. By giving up dividends you gave up nearly 25% of the total return of the market.
Another important limitation is the capping of returns. Many equity indexed annuities allow you to participate in the return of the index up to a point. Some contracts cap the return at 7 or 8%. Others reduce your return by offering you a participation rate. This rate is quoted as a percentage of the index return (without dividends) and is typically 70% to 80% of the index. Not only do you miss out on dividends which could be 25% of the return, you take another 20-30% cut through the participation rate.
Finally, the equity indexed annuities I’ve reviewed all had large penalties for early surrender and 7-10 year or more holding periods until you can cash out. This is a fairly hefty price to pay for peace of mind, especially when you can accomplish the same thing without subjecting your money to early withdrawal penalties.
Consider this example: If you had $100,000 to invest, you could buy a 10-year treasury note to guarantee your principal. As of mid-May 2011 the note was yielding 3 ½% so you would need to invest $70,892 in the note so it will grow to $100,000 in 10 years. The balance of $29,108 can be invested in an index fund. Using the 20 year average index return of 8.86%, the $29,108 grows to $68,000 in 10 years and the bond grows to $100,000 for a total return of $168,000. That works out to an average annual return of 5.32% .Assuming the same 20 year average return, if your equity indexed annuity gave you 70% of the index return without dividends for the same 10 years, it would have produced an annual yield of 4.66%.
There’s more. While the earnings on your annuity would have been tax-deferred for the entire time, it would all be taxed as ordinary income when it comes out. If it were in a mutual fund, the growth would be taxed as dividends and long-term capital gains so a taxpayer in the 15% bracket would be taxed at zero on these earnings. Taxpayers in higher brackets would be taxed at a maximum of 15% tax on those earnings versus a maximum of 35% on ordinary income.
The tax difference is an important consideration, and as you can see, this is complicated. There is no free lunch. Insurance companies need to be paid for taking risk. It’s up to you to determine if the guarantees are worth the price.