Annuities that provide Stock Returns Without Risk?

There’s a new top-seller among annuities. Buyers are flocking to the relatively new equity-indexed annuities.

The last time these annuities were hot was in 1996-1997. At the time many investors had a lot of doubts about the stock market and were looking for a way to capture possible future stock gains without much risk. Insurers said equity-indexed annuities would, like a variable annuity, deliver the potential of high returns if the stock market rose and, like a fixed annuity, guarantee a minimum yield if the market fell or was flat. Of course, all the earnings are tax-deferred.

But don’t rush out to buy an equity-indexed annuity right away. They carry some heavy costs and restrictions, and I believe they really are appropriate only for certain types of investors.

The return credited to your annuity account can indeed increase if stock market indexes rise. Under most of the annuities, however, your return is less than 100% of the stock market’s return for the year. Many equity-indexed equities also put a ceiling on your annual return, no matter how well the stock market does.

Some policies will be straightforward about the limited potential for growth. Others tend to hide the limit in the formula used to calculate the return that will be credited to your account. The return might not be based on the actual rise in a market index but on a computation such as “the average daily closing prices of the index during the year.”

Such formulas can reduce your return, since the market tends to move in brief bursts both up and down. When a daily average is used, the market’s long flat periods and periodic declines are likely to generate a return far lower than the simple percentage difference between the beginning and ending values for the year. Most of these annuities also allow the insurer to change the equity-linked return or index at any time.

After the formula is applied to the stock index returns, you still probably aren’t going to get that return credited to your account. Most annuities subtract an annuity fee and an asset management fee. Some insurers also put a cap on the return that can be credited to your account each year.

You can find equity-indexed annuities that let you participate 100% in the stock market index returns. The kicker on these annuities (and even on some of the others) is that there is a surrender fee or vesting schedule or both. For example, with a 10-year vesting period, you can get access only to 10% of the accumulated return for each year you owned the annuity. Only after 10 years is 100% of the return vested to the account and available for your withdrawal. Surrender the annuity early and you lose all the unvested gains.

In addition to the vesting schedule, there usually is the traditional surrender fee.

Today, you have an advantage over buyers of the original equity-indexed annuities. In 1996 there wasn’t a history for these annuities. Now there is a history at least at some insurers.

Before buying an equity-indexed annuity, ask to see the returns that were credited to holders of that type of annuity in the past. Compare that with the returns of stock index funds. You can get an idea of the spread of returns by going to www.annuity.com and visiting the Equity Index section. There you’ll find a page that gives the actual returns for all equity-indexed annuities issued since 1996 by Physicians’ Life, Life of the Southwest, and Conseco Annuity. For example in 1999, a good year for the stock market, the credited returns for all policies issued by the three companies were 7.32%, 8.87%, and 13%. In 2001, the interest credited at all three companies was 0%, according to the web site.

Annuity.com also has good educational materials, giving details on different definitions and features on equity-indexed annuities.

Taxes can be another disadvantage of equity-linked annuities. Stocks and mutual funds owned outside of a tax-deferred account generate tax-favored long-term capital gains if held for more than one year. But all distributions from an annuity are taxed as ordinary income. You convert capital gains into ordinary income with an annuity. In a taxable account, losses can be deducted against gains and other income.

Equity-indexed annuities are designed for risk-averse investors who realize they need some exposure to the stock market, not for investors looking to maximize returns. You are guaranteed a minimum return even in years when the stock market is having problems. The guaranteed return isn’t worth getting excited about. On most annuities it is 0% to 3%, compared to the 4% to 5% yield on bonds. You can get a better rate on traditional fixed annuities. In addition, the guarantee applies to only 90% of your investment.

These criticisms don’t mean equity-linked annuities are a bad product. They are appropriate for certain investors.

Equity-indexed annuities can be a good idea for investors who fear leaving the safety of certificates of deposit and money market funds but who need some money invested for growth and inflation protection. The annuities also require that investors be able to leave the money in the annuity for at least 10 years to get maximum benefit and avoid the penalties.

Before buying an equity-indexed annuity, also consider a balanced mutual fund. A good balanced fund will mix quality bonds with quality stocks. You won’t get the full return of stocks in a bull market, but when the stock market declines the bonds usually cushion the losses. You lose money only in rare years such as 1994 when both stocks and bonds decline or 2002 when stocks decline more than bonds appreciate. A balanced fund won’t get the tax deferral of an annuity, but most of the appreciation will qualify for long-term capital gains. My recommended balanced funds are Dodge & Cox Balanced, Vanguard Wellesley Income, and Vanguard Wellington. Each of these funds has declined about 10% so far in 2002 and was up about 14% in 2001.

Another option is to construct your own “balanced fund” annuity by putting part of your money in a regular fixed-rate annuity and part in a variable annuity. The variable annuity will give you the full stock market gains and losses (after deducting the annuity’s fees), and the fixed-rated annuity will give you a higher yield than the guarantee in an equity-index annuity. And both annuities will be tax deferred.

Consider an equity-indexed or variable annuity if you want tax deferral and already maximize contributions to IRAs, 401(k)s, and other retirement plans. Then choose your annuity carefully. Before buying, make sure you know exactly how much will be credited to your account after fees under different stock market scenarios.