“If you can’t explain it to a 6-year old, you don’t understand it yourself.” Albert Einstein
The majority of people who purchase equity-indexed annuities have no idea they could accomplish their goals in a much cheaper, simpler way. Equity-indexed annuities are sold with the promise of nirvana for investors; i.e., some or all of “market returns” without the the terrifying risk of losing one’s principal.
Like any any other promise that sounds too good to be true, this offer does not fail to disappoint. Insurance companies take your money and, by law, invest it in a bunch of very conservative bonds. They then take a small portion and purchase a derivative based on a market index, like the S&P 500.
While sales of variable annuities have experienced deep declines recently, companies like MetLife have seen a 45% year-on-year increase in its indexed annuity sales. Are investors on to something? I don’t think so.
This strategy has many drawbacks.For one, since investors do not own the index outright, they cannot receive dividends. Reinvested dividends have historically made up about 42% of the market’s’ historical returns.
Second, there are caps on the maximum equity returns investors will receive. For example if the market returns 10%, you may only participate in 4% of the total gains. Often, the insurance companies also have the ability to change this amount unilaterally.
Third, these products come with high fees and commissions. When all of the overhead is taken into account, investors end up with a return similar to a treasury bond or long-term C.D.
In addition, there are early withdrawal penalties that could be as high as 10% if investors unexpectedly need their money back.
I am a strong believer that the vast majority of investors have zero need for complicated and expensive annuities. They are often sold by conflict-ridden salespeople who are pressured into doing the unthinkable. I wrote about one such case where a salesperson sold a variable annuity to a stage 4 cancer patient.
My colleague, Ben Carlson recently wrote about someone named Phillip Cannella who hawks annuities on his weekend radio infomercial.
He takes the word ‘absurd’ to a whole other level by comparing himself to Martin Luther King when pushing this garbage.
“If I get picked off for doing something great nationally, I’m OK with that,” he said. “Isn’t that how Martin Luther King died? They all died for a cause, and the cause still survives … So, I’m not afraid to die.”
I will show great restraint and leave this comment be.
Ben also asked me if I could write something about how someone could create a low-cost, simple alternative to these complicated, conflict-ridden monstrosities.
Is there actually a way to participate in some of the markets gains while protecting your principal?
I believe there is.
Let’s say you had $100,000 to invest. To duplicate this strategy you would need to guarantee the return of your principal after, say, 10 years. Currently you could purchase a 10-year C.D. at a rate of about 2.40%. Based on this return, you would need to invest $78,886 in order to receive $100,000 in 10 years, based on a 2.40% interest rate.
You could then take the remaining $21,1143 and buy a low-cost total market index ETF, (with an expense ratio of as low as 0.05%). While no one can say what the return of this investment will be over 10 years, there is a pretty decent probability it will be positive. Since 2001, the U.S. total stock market index has returned, on average, 6.32% per year. This is despite the fact that during this cycle, the S&P 500 lost half its value during two separate periods.
This strategy is superior to an expensive, and indecipherable equity-indexed annuity. First I would much rather have the backing of the Federal Government through F.D.I.C. insurance on my C.D. than any guarantee by a private insurer.
Second, low-cost indices/ETFs can be purchased through many discount brokers, commission free. Since your C.D. should have no penalties if you hold it to term, your total, all-in cost will be 0.05%, annually.
Third, you will have much more liquidity. For instance let’s say you buy the index and, by its third year it has returned 30%. You could sell it at no cost and walk away with these profits while still holding your C.D. (knowing full well you will collect $100,000 at the end of its term). In other words there is no cap placed on your equity return, unlike the annuity product; and, you get the added bonus of keeping all the dividends.
Finally, you could do this in a very tax-efficient manner; by placing the C.D. in a tax-deferred account, you can maximize its interest payout. You could place the indexc in a taxable account and take advantage of favorable long-term capital gains and dividend income rates.
No strategy is perfect. I am sure many people can make an argument against purchasing a 10-year C.D. The point is this is a much cheaper and transparent strategy than purchasing a complicated and enormously expensive equity-indexed annuity from a conflicted salesperson looking to win a trip to Bora-Bora.
While nothing is guaranteed in investing, I believe there is a high probability that this simple strategy would produce a higher return than the annuity product. It’s simple math; when your expenses are reduced from 3.0% -4% to a mere 0.05%, wonderful things can happen.
As an added bonus, you just might be able to explain this strategy to your 6-year old grandchild.