False Expectations of Annuities
Here is some truth about annuity returns. Working with fixed index annuities (FIA) since their inception in 1994, I think I can tell you many annuity owners have false expectations of what their actual returns are going to be. I saw this happen in the late 90’s when the stock market was ripping and roaring. I was doing a live workshop, and somebody approached me toward the end of the workshop with a question. He said, well John, he said, I bought one of these. He said, “John, I’ve been listening to you, and you talked about putting the minimum amount of money into these insurance products, which allows you to keep the majority of your money in growth type equities.” And he said, “Why would you do that? I just bought one of these a couple of years ago.”
And he knew that 2017, which was a banner year in the stock market. The S&P500 went up close to 20%. And he said, “Why wouldn’t you want to put all of your money in there?” You can have that kind of return without any market risk. Unfortunately, he believed he was going to get a statement toward the end of January that confirmed the index annuity he had not only tracked but delivered that S&P500 return to his account. So, I responded, “I don’t want to ruin your day, but do you remember when you bought that policy? And did they say something about a cap?” Well, he says “yes, I remember that he said the cap was about 5%. And I don’t understand what that means.” I had to explain to him that his return was not going to be what the S&P500 did in the calendar year 2017, but it was going to be the cap rate of 5%.
Caps and Participation Rate
Caps and participation rates limit your upside but remember you have no downside. Let’s talk about how they work, so you don’t have any false expectations.
Cap
Upon issuing annually every year, the company will present you a choice of different index options. Many companies have anywhere from 4 to 8 different index options that you get to choose each year. Now, they will tell you what your cap was for the last year, and what your cap’s going to be for the next year. (Oh, by the way, in my experience, normally these caps seem to run anywhere from 3-7 %.) For example, if you sign up to put 100% of your money into the S&P500, which has a cap of 5%, so that’s all you are going to get.
Participation Rate
The second popular calculation rate, instead of a cap, is something called a participation rate. And it works just like this. Let’s say that you have a one-year participation rate of 60% into the S&P500. What that means is if the S&P500 goes up 10%, you’re going to get 60% or 6%.
It’s the Annuity Orphans
Most FIA’s are sold by insurance agents who have no basic investment training. Indeed, they have not even bothered to pass the basis securities license, which I believe proves a level of competency in understanding how investments work. These insurance contracts are not investments, but they’re tracking the investment indexes. So, to choose among these sophisticated markets, I believe that you ought to have some basic securities license.
So, normally, every year, the client is sitting there, staring at something that they hated in high school and college, and that’s algebra. So, the problem is in many cases, if they can find their agent, a lot of times the agents already left the business. The agent will say just leave it alone. I coined the phrase “annuity orphan” years ago. We would have people call and tell me, “my agent, who I haven’t been able to find for a couple of years now, put all my money in these contracts. And at the same time every year, I get these options. I have no idea what these formulas mean, but what I do know is I don’t seem to be doing as well as I thought I was. To make matters even worse, every year they change the participation rate and the cap rate.” Fixed Indexed annuities have become more sophisticated, and I believe you should have a trained investment advisor helping you make these credit interest strategy decisions.
Does It Make a Difference?
If you’re going to maximize your earnings potential in these kinds of contracts, the selection is the key. There will be some years when it’s better just to use the cap rates. There’ll be some years it’s better to use the interest rates. And then there will be some years when it’s better to use the foreign markets. Furthermore, there are some years where you can make a tremendous difference by using the participation rate.
Here’s a short example: We talked earlier about the year 2017 being this great year in the market. Let’s say you had two options; you had a 5% cap or a 60% participation rate. Which would you rather have? Well, let’s think. If the market went up 20%, which it did, the cap rate would give you a maximum of 5% and the 60% participation rate would give you 12%. Pretty big difference between 5% and 12%, huh?
So, if you’re an annuity orphan and you are getting no help, or somebody has put the bulk of your money in there, and you just know there’s something wrong. Or your returns have not been higher than low single digits, and you don’t understand what’s happening, just give me a call or shoot me an email. It’s not a big deal to me to talk to you on the phone for a few minutes. Maybe I can help you at least steer you in the right direction.
John Romano, CERTIFIED FINANCIAL PLANNER™, has over 30 years’ experience in the financial field. John is a Registered Representative with Securities America, Inc. (member of the FINRA and SIPC), and an Investment Advisor Representative with Securities America Advisors. He has prepared hundreds of reports for retirees to assist in their retirement income planning needs. He is dedicated to providing portfolio analysis, dividend and income information, and investment management services to retirees (and those preparing to retire) in The Villages, Florida, and throughout the United States.
The S&P 500 Index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. An investor cannot invest directly in an index. Past performance does not guarantee future results.
Fixed index annuities are intended for retirement or other long-term needs. It is intended for a person who has sufficient cash or other liquid assets for living expenses and other unexpected emergencies, such as medical expenses. Fixed Index Annuities are insurance contracts and should be considered complex products. Fixed Index Annuities are not stock market investments. You are never invested in the index itself. Fixed index annuities are subject to possible surrender charges and a 10% IRA early withdrawal penalty prior to age 50 ½. Early withdrawal charges and Market Value Adjustments (MVA) may apply. Withdrawals may reduce any optional guaranteed amounts in an amount more than the amount of the withdrawal. Taxable distributions are subject to ordinary income taxes.
Current minimum return, principal value and prior earnings guarantees by the issuing insurance company, subject to their claims paying ability, and contract provisions.
Indexed interest is calculated and credited (if applicable) at the end of an annual interest term based on the strategy selected and will be adjusted for any caps, spreads, performance triggers or participation rates, all which can limit or reduce the interest credited. Outcomes may differ based upon the interest crediting strategy selected and assume compliance with the product’s benefit rules. Not all strategies are available in all states and firms. Amounts withdrawn from the indexed account before the end of an interest term will not receive indexed interest for that term. Interest credited to the indexed accounts is affected by the value of outside indexes and the annuity will not experience returns identical to the index’s performance. Values based on the performance of any index are not guaranteed. The contract does not directly participate in any outside investment.
Indexed interest caps, fixed account interest rates and margin rates may be reset at the end of each interest term. Interest Rates, indexed interest caps and margin rates are subject to change without notice.
Tax qualified contracts such as IRAs, 401(k)s, etc. are tax deferred regardless of whether or not they are funded with an annuity. If you are considering funding a tax-qualified retirement plan with an annuity, you should know that an annuity does not provide any additional taxdeferred treatment of earnings beyond the tax-qualified plan or program itself. However, annuities do provide other features and benefits such as death benefits and income payment options.
Annuity contracts have terms and limitations for keeping them in force. Although Fixed Index Annuities guarantee no loss of premium due to market downturns, deductions from your Accumulation Value for additional optional benefit riders could under certain scenarios exceed interest credited to your Accumulation Value, which would result in loss of premium. They may not be appropriate for all. Please contact your financial professional or insurance producer for complete details.