Indexed Annuities: The Good, The Bad and The Truth

Goldfish with shark's fin swimming underwater
••• John Lund / Getty Images

Annuities, an investment product offered by insurance companies, can provide you with a stream of income-replacing payments once you retire, with no risk of outliving them. With many companies no longer providing pensions, annuities can become an important substitute to round out your financial plan. The only challenge is wading through the various types and figuring out which suits your particular scenario.

The Good

Indexed annuities are fixed annuities. The story shouldn’t be any fancier than that. That’s a good thing because your principal is fully protected from downside market volatility, which more and more retirees and baby boomers have started to require. 

Indexed-annuity returns are based on a call option on an index like the S&P 500. A call option is a no-risk bet that the markets are going up, and if they do, you will benefit from that growth. If the markets take a big dive like they did in 2008, then the call option expires worthless and you don’t lose any money.

The upside is limited, but the gains are permanently locked in on the contract anniversary date. That’s the simplistic value proposition for indexed annuities.

If you are comfortable with CD-type returns, then indexed annuities could work well in the principal protected part of your portfolio. To be clear, it is a contractual fact that an indexed annuity is not a market-growth product even though it seems like every agent on the planet pitches it that way. The strategy was designed to perform on the accumulation value side of the ledger. Click here to read more in-depth information about Fixed Index Annuities.

The Bad

indexed annuities might go down in financial history as the most over-hyped and mis-sold product ever. Unless the annuity industry and carrier stop this ongoing sales pitch, indexed annuities may become a case study at business schools everywhere on how a good product was run into the ground by an unregulated sales force.

The typical agent pitch is “market upside with no downside.” Only half of that statement is true. True there is no downside because it is a fixed annuity. If the sales pitch statement was actually true, then Janet Yellen’s job at the Federal Reserve would be solved. Nobody can promise market upsides. Based on the reality of stock market fluctuations, the statement can NOT be true.

If you listen to local radio, watch cable TV ads, or troll the internet, you are going to run into the unregulated sales message that permeates the Indexed annuity world. Anything can be said, claimed, or promised to get the sale. It’s a disturbing trend that continues to grow because there are no repercussions for the wild west sales atmosphere.

Be aware that indexed annuities are not a security, and classified only as a life insurance product, so they are supposed to be regulated at the state level, which doesn't actually take place in many cases.

 The Truth

In 1995, indexed annuities were first developed and designed to compete head-to-head with Certificates of Deposit (CD) returns, not the stock market. Most annuity agents don’t even know this fact, but it's a contractual reality if you ever purchase an Indexed annuity contract.

Indexed annuities are also an efficient delivery system for attached income-rider benefits for future income guarantees. In fact, this may be the best way to use indexed annuities. Don’t even look at the accumulation part (i.e. index option) of the policy in most cases. The majority of the time, you can only look at the income rider guarantee for “income later” needs. The reasoning is that you should always own annuities for what they will do for you, rather than might do. Contractual guarantees deliver.

You could also use short-term indexed annuities in combination with fixed rate annuities (aka MYGAs) for laddering strategies. Some call this a “mixed fixed ladder” because it’s a combination of fixed rate and indexed annuities. Click here to read further about Laddering Annuities

The bottom line is that indexed annuities are not too good to be true, but they can be pretty good if you keep your expectations in-line with the contractual realities.