Should You Invest in an Equity-Indexed Annuity?
April 17, 2017Should you consider investing in an annuity linked to stock market returns but with less risk than the stock market? I recently had a coaching session with an employee who had invested a lump sum distribution from a retirement account into an equity-indexed annuity. Did she make the right decision, she wondered, and should she add more to the annuity or diversify into something else?
Remind Me What an Annuity Is, Please!
An annuity is a contract between you and an insurance company in which the insurance company agrees to make periodic payments to you, starting immediately or at some future time, in return for payment from you, either in a lump sum now or over flexible installments over time. With a “fixed annuity,” the insurance company agrees to a fixed return and a fixed payment. With a “variable annuity,” the rate of return and the payment vary depending on the investment choices within the contract.
So What is an Equity-Indexed Annuity?
An equity indexed annuity is the lovechild of a fixed and a variable annuity. With an equity-indexed annuity (EIA), the insurance company will pay an interest rate linked to a stock market index if the market index is up, with a guaranteed minimum rate if the market is down. In the case of the employee I spoke with, she would earn an annual rate of return linked to the performance of the S&P 500 during the accumulation phase of the annuity, capped at 6%. If the S&P 500 index went down, her return would be 0% for that year.
Who is a Good Candidate for an Equity-Indexed Annuity?
The primary financial planning purpose of an annuity is to turn a sum of money into a stream of income you cannot outlive. An equity-indexed annuity makes the most sense for an investor who is a) looking to create a future fixed income in retirement and b) who is not comfortable with direct stock market risk but would like to participate partially in potential stock market returns. In the case of this employee, she was willing to accept a cap on returns of 6% in return for no loss of her investment if the market declined.
She was also within 10 years of retirement and much more concerned about maintaining the value of her savings than she was in generating out-sized returns. It’s important to have both fixed and flexible sources of income in retirement so ideally an investor would refrain from putting all their retirement savings into an annuity. I encouraged this employee to keep some of her retirement funds in her 401(k) and IRA so she would have a source of income to meet flexible expenses in retirement such as a big vacation, dental work or an unexpected home repair.
Who is Not a Good Candidate for an Equity-Indexed Annuity?
A more aggressive investor would not be comfortable capping returns at 6% – especially in a year when the S&P 500 index went up 20%. Plus annuities generally have high fees which can eat into investment performance. EIAs typically have high surrender charges during the first 8-10 years of the contract so once purchased, you’ve got a strong incentive to stay put.
The moderately aggressive to aggressive investor could consider accumulating savings in a diversified portfolio of low fee index funds. That investor could potentially build a larger nest egg and then purchase an immediate annuity at retirement with some of those savings if interested in turning them into a stream of income. Because of the higher fees, younger investors are also generally not good candidates for equity indexed annuities. Finally, an investor who doesn’t ever plan to turn their savings into retirement income is not a good candidate for an annuity.
Was it a Fit for Her?
Was an equity-indexed annuity a good fit for this employee? After weighing the pros and cons, her conclusion was “yes.” She was willing to trade upside potential in order to eliminate the risk of losing money.
She was planning to annuitize within ten years – turning her annuity into a stream of payments in retirement. Moreover, she had chosen a reputable insurance company with an A+ rating from A.M.Best. Although she was excited about the annuity return/risk profile, she decided it would be best to continue to keep some of her retirement money in her employer plan so she’d have some flexible sources of income to meet unexpected retirement expenses.
Do Your Homework
Annuities are very complex investments. Before signing on the dotted line, make sure you’ve read and understand all the provisions in the contract. If you are considering an equity-indexed annuity, start with this fact sheet from FINRA. Check out the financial strength of the issuing insurance company and make sure it has a high rating for its financial position. If possible, get an unbiased second opinion from a financial planner in your workplace financial wellness program or a fee-only CFP® professional.
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