All annuities aren’t created equal. Some are simple and straightforward, others complex. Although they can offer retirees an income stream, the devil is in the details.
The annuity landscape is also changing, with a Department of Labor rule that aims to put investors’ best interests first, potentially depressing sales of complicated financial products, such as indexed annuities. The rule, which went into partial effect this month and won’t be implemented fully until January, requires advisors working with retirement account money to be held to a fiduciary standard.
The conversation about annuities just became more complex because advisors now must make sure their clients fully understand the products they’re buying, says Craig Simms, senior vice president at Vantis Life Insurance Company in Windsor, Connecticut.
Indexed annuities guarantee a minimum interest rate, as well as one that fluctuates because it’s linked to an index, such as the S&P 500. Essentially, indexed annuities are a hybrid of fixed annuities, which guarantee a rate of return and payout unaffected by market fluctuations, and variable annuities, in which the rate of return changes with the value of underlying investments.
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
The Limra Secure Retirement Institute projects sales of indexed annuities to fall 5 to 10 percent this year and 15 to 20 percent in 2018, but the products will still be sold. In the short term, Simms believes fixed annuities, the most conservative annuity products, will become more popular. As advisors become acclimated to the nuances of the fiduciary rule and banks provide software tools that make it easier to understand a client’s risk tolerance, sales of indexed and variable annuities may rebound, he says.
Investors who are aware of the potential pitfalls of indexed annuities are in a better position to determine whether other annuities might be a better fit.
Expensive Drawbacks. By tying returns partially to an index, indexed annuities attempt to give investors stock market exposure without the risk, and they can guarantee principal, says John Kageleiry, owner of Verium Planning and Asset Management in Dover, New Hampshire.
What investors don’t always realize, however, is that indexed annuities come “with a lot of strings attached,” says Eric Aanes, president of Titus Wealth Management in Larkspur, California. Those strings can restrict returns in myriad ways.
For instance, most indexed annuities don’t include dividends but instead calculate gains based only on the price moves of stocks in an index, according to the Financial Industry Regulatory Authority (FINRA).
“This is important because history indicates that dividends have been a strong component of equity returns” over time, according to Fidelity Investments. “Since 1930, dividends have made up approximately 40 percent of the S&P 500’s average annual total return.”
[Read: How to Invest in Annuities.]
And that’s not the only way these annuities can limit an investor’s earnings. The annuities may have participation rates that are below 100 percent, which means investors don’t get the full amount the index earns.
Instead of a participation rate, or perhaps in addition to it, some insurance companies may charge a spread, margin or asset fee, which will also reduce gains.
Some indexed annuities also cap rates so that the return can’t exceed a certain percentage no matter how well the index does.
What’s more, commissions for indexed annuities can be higher than for other annuity products.
Better alternatives. Given all the drawbacks of indexed annuities, their declining sales are a good thing for investors, Kageleiry says.
As an alternative, he recommends zero-coupon bonds, which can be bought at a discount to their face value but don’t pay interest. When the bond matures, investors can redeem them at full face value.
Investors can then put the difference between the face value and the discounted price to work in the stock market, Kageleiry says. This strategy offers the potential for decent returns with the guarantee of getting at least a certain amount at the maturity date, he notes. Another perk: Investors who need the money early aren’t subject to surrender fees, which annuities can charge to take money out early, he says.
[See: The 25 Best Blue-Chip Stocks to Buy for 2017.]
Fixed or variable annuities can also be good options, Kageleiry says. Although fixed annuities provide simplicity and safety, they are not high-earning products, he says. Variable annuities offer the potential for higher earnings but also come with more market risk.
Variable annuities can be good investments for higher-earning investors who have already maxed out other avenues for retirement savings and who can afford to sock the money away for a long time, Kageleiry says. Nevertheless, he cautions, these annuities can be expensive.
For those who want more return, a mix of variable annuities and blue-chip, dividend-paying stocks could be the ticket, Simms says.
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Indexed Annuities Under Pressure From Fiduciary Rule originally appeared on usnews.com
