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Rekenthaler Report

What to Know: Indexed Annuities

Lower risk has a high price.

Reader Request

A reader writes: “I would like your take on a trendy financial product that has received relatively low attention from Morningstar authors. What do you think about indexed annuities?” Your wish, my command.

Also known as fixed-index annuities, equity-indexed annuities, and registered index-linked annuities, these are insurance contracts that combine features of both bonds and equities. As with bonds, indexed annuities pay interest; as with equities, their payments increase as the stock market rises.

Although the returns of indexed annuities are linked to the stock market, they are constrained. For example, an indexed annuity with a 10-year life might guarantee that, for each year in the contract, the investor will not lose more than 5% of principal no matter how poorly stocks perform. However, in exchange for that protection, the issuer limits the investor’s gains. The annuity’s performance therefore moves in a narrower band than does the stock market.

Not so Simple

The concept is straightforward, but the execution is not. In practice, indexed annuities carry a wide variety of features. For example, the SEC’s Investor Bulletin on the topic mentions:

  1. Participation rate.--The percentage of annual stock-market appreciation that the annuity receives. (Regrettably, participation rates are typically computed on the index’s price return, which means that unlike standard total-return calculations, they do not include the effect of dividends.)
  2. Rate cap.--The annuity’s maximum annual payout. For example, if the annuity’s rate cap is 7% and its participation rate is 70%, then all stock-market appreciation above 10% would accrue to the insurer, not the policy owner.
  3. Margin fee.-- An additional charge that lowers the effective participation rate. (Not all indexed annuities carry margin fees.)
  4. Floor.--The largest permissible annual loss. In the case of strongly protected contracts, this figure can be zero.
  5. Buffer.--An alternative form of protection, where the policy owner’s losses are not capped, but where instead the insurance company absorbs a certain percentage of stock-market decline, for example, the first 10%.

The bulletin then discusses the difference between point-to-point and averaging calculations, withdrawal provisions, surrender charges, and tax penalties.

Practical Difficulties

Indexed annuities differ sharply from index mutual funds. If you have seen one index mutual fund, you have seen them all. Every index fund is similarly structured. In contrast, if you have seen one indexed annuity, you have seen … one indexed annuity. Even if two annuities are based on the same benchmark, their features--and therefore their returns--may be markedly different.

Unfortunately, investors cannot research indexed annuities to determine which are the best values. Indexed annuities lack expense ratios, because their costs are implicit, consisting of the spread between the expected return on the stock index and what the investor will receive. Nor can one compare their provisions, as such information is not publicly available. (Most indexed annuities are unaccompanied by prospectuses.) Ultimately, the investment must be made on faith.

In that respect, as well as several others, indexed annuities resemble their cousins, structured notes. Indexed annuities are contracts created by insurers that offer partial stock-market participation while reducing investment risk. Structured notes are securities created by banks that offer partial stock-market participation while reducing investment risk. (There are other varieties of structured notes, but that is the most popular flavor.) Peas in a pod.

With both investments, buyers concede several benefits that are routinely enjoyed by fund shareholders. Besides the ability to conduct meaningful investment research, they forgo liquidity, transparency, and custodial protection. Neither indexed annuities nor structured notes can readily be traded before their expiration dates; they divulge neither their investment tactics nor their expense ratios; and their scheduled payments consist solely of promises.

To address the latter point: While mutual funds (and exchange-traded funds) possess assets that are held in custody by outside parties, so that if the fund sponsor goes bankrupt the fund itself is unaffected, indexed annuities and structured notes are legal fictions. Their buyers own not securities, but instead guarantees that the investment will fulfil its obligations. The strength of those guarantees, of course, depends entirely on the creditworthiness of the issuer.

This list of drawbacks is depressingly long. Indexed annuities are complex investments that cannot be comparison shopped, and that might be quite pricey, were it possible to ascertain their costs. Nor can they be liquidated after they have been purchased, except by paying a surrender charge. Finally, as with all insured products, they rely on the issuer’s word. Why would anybody buy such investments?

Possible Justifications

I can think of two reasons, besides the obvious answer that if an investment carries a high sales commission, as indexed annuities do (reportedly, 6%-8% on a 10-year contract, which is above what any mutual fund pays), then buyers inevitably will be found.

First, self-insurance only goes so far. In extraordinary circumstances, even a portfolio that holds only 20% in equities can sustain painful losses, if its ballast also declines when stock prices crash. Those who seek the comfort of knowing absolutely that the value of their investment will not drop below a guaranteed floor (assuming, that is, the continued health of the insurer) cannot accomplish that on their own, at least not without trading derivatives.

Second, sometimes insurers underprice their offerings. For example, during the 2000s, long-term healthcare policies were sold at less than their cost of future service. Effectively, buyers received more than what they purchased. It could be, in their eagerness to attract investors during this low-yielding era, that insurers are now making offers that properly speaking should not be refused.

However, in the absence of third-party models that can evaluate each policy’s features, to arrive at an estimate of its true cost (which would be negative for underpriced contract), those who would invest in indexed annuities must rely on trust without verification. Ronald Reagan would not have approved.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.