I once attended an investing seminar at which the presenter asked for a volunteer with a five-dollar bill. A gentleman came forward and the presenter said, “Now I will toss a coin. Call it in the air and if you are correct I will double your money. Otherwise, I will give you your $5 back.” The coin was tossed and the man called it correctly and walked away, having doubled his money. The presenter then said, “Ladies and gentleman, you have just seen how an Equity Indexed Annuity(EIA) works.”
The presentation was impressive, but also highly misleading. Who wouldn’t want such a product, with the ability to double your money with no risk? But things are rarely as rosy as salesmen present them, and so it often is with indexed annuities. He was correct that the product guarantees you won’t lose principal (based on the claims paying ability of the issuing company) but he had greatly misrepresented, and overly simplified, the potential upside.
He failed to explain that, though gains are usually tied to a stock market index like the S&P 500, there are caps in place to limit the upside. There are also complex calculation methods that could result in the product making no money at all in some years, even ones when the market index is up. Nor do these annuities include the dividends paid by companies that make up the index. In my mind, worst of all, he did not mention that the insurance company was free to adjust caps on each anniversary, and the client has no recourse if they do. Imagine locking yourself in to a 10-year product where the company can unilaterally lower your rates each year. How much do you trust the insurance company to maintain favorable cap rates?
Though EIAs track a stock market index, their ability to earn money is largely connected to current interest rates, due to the way they function internally. Thus, when interest rates are low, cap rates tend to be lower as well. Investors looking to the safety EIAs might offer should be aware that current cap rates, which are near historic lows, will limit any potential upside.
There are large national organizations that teach agents how to sell indexed annuities using free dinner seminars. I advise investors to be very cautious anytime a salesman has to pay a lot of money to get them to attend their seminar. The financial pressure on the salesman can be high after paying an expensive restaurant bill.
This is not to say you should not consider an indexed annuity. Just be aware that the upside can be very limited and the cap rates may be adjusted each year by the issuer. These annuities can involve long term contracts with high surrender penalties. And finally, the salesman has a significant financial incentive to make the sale.
Indexed annuities may have a place in your portfolio once you understand the costs and limitations, but they are not as simple as flipping a coin, despite what some clever salesmen may infer.
*The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard and Poor’s. All indices are unmanaged and are not available for direct investment by the public.
Ten years ago a man walked in my Vegas office, age 83, with his bride who had just celebrated her 30th birthday. He asked if I could help him find an annuity with guaranteed lifetime income, and wanted one in the multi-million-dollar range. As I questioned the rationale for someone his age wanting a life insurance product, he responded with a clarity of understanding about annuities I have rarely experienced. I was so amazed by what followed that I wrote it down. He said, "I will not live much longer, and over the course of my life I have accumulated a great degree of wealth." Though sitting next to his clearly bored wife, he proceeded with amazing bluntness. "When I die, my money will be inherited by my young wife here, who, as you can see, is not prepared to receive it. I realize annuities have fees and can restrict growth, but to insure she doesn’t just waste it all when I am gone, I would like to create an income stream for her that will last her entire life.”
It was obvious this man understood what the annuity he was searching for could do. It could be used to guarantee a lifetime stream of income to his young wife. He also realized those guarantees would cost him money and possibly lost opportunity, but both were worth it to him. I have actually heard annuity salespeople publicly claim that the client does not have to pay any fees for certain annuities, and that commissions are born by the insurance company, not the purchaser. That they could make such claims with a straight face, and that some people actually believe them, is beyond belief. The last time I checked, there aren't a lot of insurance companies that operate as non-profit charities.
In this unique situation, and with a good understanding of the product, this man made the decision that an annuity suited his needs.
As I have mentioned before, I do not dislike annuities, I just dislike the fog of confusion under which many are sold. I say “sold” because there is an industry saying that “Annuities are sold, not bought.” Few people, unlike my client mentioned above, wake up in the morning and say, "Gee, I would sure love to buy an annuity today."
These complex and confusing products are sold in great quantities to people who often do not know what they are buying, by salespeople who can have significant financial incentives to keep pushing them. This has sometimes created an unfair cloud over the products because, used correctly in the right situation, they can have significant benefits. Unfortunately, if a person is sold an annuity that is not right for them, the results are often long years of frustration and bad feelings.
Since Annuities are sold so freely, over the next couple of weeks I will share a few more examples of situations where annuities may, or may not be, appropriate in a portfolio.
It was difficult for me to learn how to land an airplane. I kept trying to over-control the process, but landing requires patience. Landing, is what the plane does, when it is no longer able to fly. The magical moment in time when this occurs is not under the control of the pilot. It changes with each landing based on aircraft weight, balance, atmospheric pressure, and many other factors. A pilot’s job is to put the aircraft in a position to land, and then patiently wait for it to happen. Trying to over-control the landing usually just makes things worse.
Last month my daughter arrived via commercial flight into Saint George and reported that it was the worst landing of her life and questioned the skills of the professional pilot. I asked if anyone was hurt and she said that all seemed fine. I told her that pilots, knowing the many variables involved in landing, define a good landing as one that everyone can walk away from, and a great landing is one where the plane can be used again. Based on that measurement, I suggested she should have complimented the pilot after the flight.
All pilots know the most successful landings begin miles from the airport with a well-planned stable approach. Retirement investment planning is not unlike landing an airplane. It requires planning long before the event, and then, in many instances, being patient with the little bumps and gusts of wind that occur.Trying to over-control investing, or making sudden changes, usually just makes things worse.
Though perfection in landing and investing may be the goal, it is not required. Remember, any retirement plan that gets you to your destination intact, is a good one, and if there is a little something left over for your heirs, then it was a great one.
My instructor taught me about smooth landings, and safe landings. Safe landings, according to him, are within our control, and our only goal. A smooth landing is nothing more than a safe landing, combined with a little luck, leaving your passengers thinking you are the greatest pilot on earth.
Retirees should focus more on safe landings, meaning a retirement portfolio that gets them to the end of life’s runway intact. If there are bumps and gusts of wind along the way, don’t stress it so much. Likewise, when things run smoothly, resist the temptation to pat yourself on the back prematurely. Stay focused on the outcome.
I have attended the funerals of many clients. In every single case I have returned to the office the next day to find their retirement account still sitting there. It has had a profound effect on me to see repeatedly that the biggest fear of retirees, running out of money, with good planning will rarely happen. Like a landing, their investment lives were rarely perfect, with so many things out of anyone’s control, but the planning and stabilized approach led to a good financial ending to their lives, and that is what really matters.
Hi, I'm Dan. I'm a CFP® Professional.
Securities and advisory services offered through Commonwealth Financial Network®.
Member www.finra.org / www.sipc.org , a Registered Investment Advisor. Wyson Financial, 375 E Riverside Dr, St. George, UT 84790
This communication is strictly intended for individuals residing in the states of AZ,CA,CO,DC,FL,ID,IL,KS,KY,MA,MI,MN,MO,MT,NE,NM,NV,OH,OR,PA,SD,TN,TX,UT,VA,WA,WY. No offers may be made or accepted from any resident outside these states due to various state regulations and registration requirements regarding investment products and services.