Index-Linked Annuities Offer A Clever Sleight of Hand
The magician smiles as he removes his hat. He tips it to the audience so they can see inside. Then a dove flies out. Two seconds later, he winks, nods, then pulls out a rabbit. We know it’s a trick. But we’re often less certain when offered magical investment options.
In 2012, a financial advisor pitched a seemingly magical product to Lucy Smith (I’ve changed her name to protect her privacy). Lucy saw her investments crash in 2008/2009, so in 2012 she sought something stable. Her advisor convinced her to buy an Allianz Endurance Plus Annuity. It’s an index-linked annuity.
Here’s how he might have pitched it:
Lucy, here’s an investment/insurance product that’s guaranteed not to lose money. You can earn the return of a stock market index and a 20 percent bonus.
Unfortunately, index-linked annuities are hungry wolves dressed like granny.
Heads, We Win Tails, We Almost Certainly Win
The guarantee is the first part that baits risk-averse investors. The prospectus might as well blend Latin and Swahili. I’ll quote it first, before translating into English.
“Minimum guarantee: 87.5% of premium with no bonus, less any withdrawals, accumulated daily at an interest rate that, when compounded, results in an annual effective rate of no less than 1.35% per year for the first 10 years, then 1% thereafter.”
Here’s the translation, along with information that comes later in the product’s description:
If you invest for at least 10 years, you cannot lose more than 12.5 percent for the decade. That’s what it means when they guarantee, “87.5% of premium with no bonus.”
If you remain invested for at least 10 years, and if you stay with them for an extra 10 years (making it 20 years in total) they promise you a minimum return of 1.35 percent per year on the money you invested during the first 10 years. That includes the bonus they offer.
If investors don’t remain invested for at least 10 years, they pay a penalty. If you’re wondering about the insurance company’s upside, well… it’s huge.
Moana Whipple is a Financial Associate with Natural Bridges Financial Advisors. She says, “One of the reasons we hate these annuities is because you can’t calculate the fees up front, and they do a great job obfuscating the true cost of buying into the annuity versus simply investing directly.”
Consider Lucy Smith’s Allianz Endurance Plus Annuity. It gave Lucy the choice to invest in either the S&P 500 index, the Nasdaq-100, the FTSE 100 or a balanced index comprising 35 percent in bonds and 65 percent in stocks. And if the markets crashed, the insurance provider guaranteed she would earn at least 1.35 percent for her first ten years (but only if she kept the money with them for 20 years).
Pulling The Rabbit From The Hat
If that isn’t bad enough, the insurance company limits how much Lucy can make each year. Moana Whipple says, “Each year, they can change that cap to whatever they want.”
For example, according to annuitywatchrate.com, in April 2017 Allianz capped the amount investors could earn in the S&P 500 to 4.5 percent over the following 12 months. This decision made a windfall for the insurance company. But investors like Lucy paid the price. From April 2017 to April 2018, the S&P 500 gained 13.10 percent. If someone had selected the S&P 500, Allianz would have kept 8.6 percent of the client’s money that year. That’s equal to an annual fee of 8.6 percent.
In 2012, Lucy Smith selected an index-linked balanced investment portfolio. Here’s the allocation:
35% Barclay’s Capital U.S. Aggregate Bond Index
35% Dow Jones Industrials Index
20% FTSE 100
10% Russell 2000 (small cap stocks)
“My initial investment was capped at 3.5 percent,” she says. If that cap remained at 3.5 percent, Lucy would have turned $10,000 into $11,450 between January 2012 and June 30, 2020. *
But if $10,000 were invested directly in the above index funds, it would have averaged a compound annual return of 7.99 percent. That would have turned $10,000 into $19,227. That’s 68 percent more money over after just 8.5 years. Here’s how Lucy’s index-linked annuity would look, compared to a direct investment in the above index funds.
What About The 20 Percent Bonus?
Sometimes, index-linked annuities lure investors with the promise of a bonus. But these are usually tiny Band-Aids put over gaping gashes. If Lucy’s growth were capped at 3.5 percent per year, she would already be 68 percent behind someone who directly invested in the same portfolio.
And to receive her 20 percent bonus, she must remain with the index-linked annuity for at least 2 more years and roll the proceeds into a fixed-income annuity that must be held for at least 10 more years. If she doesn’t do that, she won’t get the 20 percent bonus, which is based on the value of her account after the first ten years. Sadly, as I’ve written before, most fixed income annuities are also a really bad deal. But let’s circle back to that initial guarantee: no less than an annual average of 1.35 percent for the first 10 years and 1 percent per year after that.
Insurance companies tend to be savvier than their clients. They know the odds of a balanced portfolio not earning at least 1.35 percent per year over a 10-year period are lower than a lizard’s belly.
There were 39 rolling 10-year periods between 1972 and 2020. Some of these periods dealt with horrific market crashes. For example, from January 1973 to October 1974, U.S. stocks fell about 46 percent. On October 22, 1987, they cratered 22 percent in a single day. From March 10, 2000 to October 4, 2002, the tech-heavy Nasdaq composite index cratered 76.81 percent. And in 2008, the S&P 500 dropped about 37 percent.
By offering a guarantee averaging at least 1.35 percent over a 10-year period, insurance companies know they’ve stacked the odds in their favor. Over the 39 rolling 10-year periods between 1972 and 2020, a balanced portfolio of indexes would have exceeded a compound annual return of 1.35 percent every single time. Even during the 10 years ending June 2020 (which included the COVID-19 crash) the balanced portfolio would have averaged 9.77 percent per year.
The worst 10-year period (1999-2008) saw two massive market crashes. Stocks fell hard from 2000-2002 and again during the financial crash in 2008. Consequently, a balanced portfolio of index funds would have averaged a compound annual return of just 2.66 percent. That would have turned $10,000 into $13,002, for a total 10-year gain of 30.02 percent.
But even this return thrashed the insurance company’s guarantee. If they offered a minimum guarantee of at least 1.35 percent per year (that includes the bonus!) it would have turned $10,000 into just $11,435. That’s a total 10-year return of just 14.35 percent…but only if the investor rolled the money into a fixed-income annuity for another ten years.
With two years left on her 10-year index-linked annuity contract, Lucy Smith has a choice. She could continue to benefit the insurance company, or she could sell and invest her proceeds more effectively.
If she sells now, she would be canceling her policy two years before her first 10-year term. According to her contract, that would cost her a 3.75 percent penalty.
Nobody can see the future. But the magician (or more correctly, the sorcerer) knows more than Lucy. Even if Lucy’s annual profits were capped at 4 percent per year, she would still be about 64 percent behind a diversified portfolio of index funds after just 8.5 years. And if she wants her 20 percent bonus, she must remain with the index-linked annuity for at least 2 more years and then roll the proceeds into a fixed-income annuity that must be held for at least 10 more years.
If she remains to collect her bonus, she’ll likely prolong and enhance the long-term bleeding.
Several similar products are on the market now. They pay large commissions to advisors. But they’re a bad deal for investors. If the names and terms sound confusing, this might help: Avoid all products that blend investments with insurance. This should help you avoid a sorcerer’s trap.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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