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Q: I’m 67 and am not confident the stock market will provide me good returns through my retirement. An index annuity has been recommended to me, but I see lots of negativity about annuities. Are indexed annuities a good substitute for stocks?
A.: Sam, I do not view Equity Indexed Annuities (EIAs) or other “indexed-linked” products as a good substitute for stocks.
EIAs are regulated as fixed insurance products and not considered an investment in the securities markets. By law, the insurance company must be conservative with the funds. The insurance company will buy bonds to cover the guaranteed rate in the contract. The guaranteed rate will be lower than what you can get from a good bond portfolio because the insurance company starts with a good bond portfolio itself and from that must cover its costs, make a profit, and have something left to buy derivatives that tie to a stock market index.
As a result, only a small portion of your purchase goes to anything that relates to the stock market. This makes it highly unlikely to produce returns competitive with stocks over a long period of time.
Now, over short time frames, when the stock market drops, an EIA will produce better results than stocks because it is a fixed product and not really an investment in stocks. EIAs can limit the downside but your returns during bad market times will likely be less than what you would receive from a good bond portfolio because you would not incur the aforementioned costs the insurance company must cover.
Index-linked products are often sold as a way to alter the fundamental link between risk and return but that link is as solid as ever. If stocks do well, the most likely result of being in an EIA is a return that is less than what you could have obtained by investing a small portion of your funds in a simple index fund.
If stocks do poorly, the most likely result of being in an EIA is a return that is less than what you could have obtained by being investing in a good bond portfolio. EIAs are tough to model because the insurer will change various factors like participation and cap rates as stock and bond markets conditions change. You really don’t know what you will get but you can be confident that any adjustments are made to maintain profitability for the insurer not boost your results.
A much simpler approach is to build a good bond or bond fund portfolio and if you want to try to get more return, invest a little in stocks. For instance, a simple 20/80 ratio of the S&P500 and 5 year Treasury bonds rebalanced annually has never lost money over a 5 year period (1926-present). EIAs typically tie up your funds much longer than that.
With lower tax rates on capital gains, a step-up in basis at death, and the wide availability of low-cost ETFs and mutual funds, anyone can implement a similar strategy with far less complication, cost, restriction, and taxation over the life of the investment. Earnings removed from an annuity are taxed as ordinary income and do not receive a step up in basis.
If you can’t handle any of the volatility of stocks, you may be better off adjusting your goals than trying to sever the relationship between risk and reward.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.