Indexed annuities’ performance may not be what you expect

At first glance, indexed annuities may sound quite similar to index mutual funds.

Their names suggest as much. Consumers can buy annuities that are linked to the Standard & Poor’s 500 index, like their mutual-fund counterparts. Plus, indexed annuities are marketed as having upside potential with no downside. So their investment returns must be similar, right?

Wrong.

“Our biggest issue with the industry is there still is a tendency to try and position this like an alternative to equities and get most of the upside without the downside. And it doesn’t work that way,” said Scott Stolz, senior vice president of private client group investment products at Raymond James & Associates Inc.

Indexed annuities are actually a type of fixed annuity and act more like fixed-income than equity investments, experts said. Sales have more than doubled over the past decade and posted their best year on record in 2016, at $60 billion.

An analysis performed by Cannex, a market research firm, found S&P 500-linked indexed annuities have an estimated average seven-year return of 3%, on par with competitive rates of 3% to 3.1% for multi-year-guarantee annuities over the same period.

(Cannex’s analysis is based on a forward-looking market simulation run through basic combinations of indexed-annuity formulas. It compared the products of five carriers that sell both indexed annuities and MYGAs, which guarantee a fixed rate over the life of the contract.)

“On average, you’re going to get the same type of return you’ll get on the MYGA product,” said Gary Baker, president of Cannex USA.

There are, of course, a few caveats to this argument. MYGAs lock in one rate of return, whereas indexed annuities provide the opportunity for a greater return. Some consumers may also use indexed annuities for income rather than accumulation.

But the broad point is: Advisers and clients should set a reasonable expectation for product performance.

Just why is the performance of the average indexed annuity so different from the broad stock market’s? The products don’t directly invest in equities at all. Insurers build the portfolios that underpin these annuities using roughly 95% bonds. The remaining 5% goes to derivatives, call options on a specific market index.

The bonds deliver downside protection, or the guarantee that an investor won’t receive less than 0% interest over a given period. The sleeve of derivatives provides upside, which is limited by product features such as caps, participation rates and spreads. Because consumers don’t invest directly in a market index, they don’t receive reinvested dividends, either.

“You’re not in the market, you’re on the sidelines watching the market,” Mr. Baker said.

(More: Complexity of new indexed annuities causing concern)

Sheryl Moore, president and CEO of market research firm Moore Market Intelligence, has a rule of thumb for judging how much juice advisers and clients can expect to get from an indexed annuity over its contract life: Take the average rate of all one-year fixed-rate annuities and add 1% to 2%.

The current rate on one-year fixed-rate annuities (which only guarantee an interest rate for the contract’s first year) is 2.7%. So indexed annuities will earn roughly 3.7% to 4.7% over the contract life, Ms. Moore said.

There are two primary scenarios in which it makes sense for an accumulation-focused consumer to buy an indexed annuity, said Mr. Stolz of Raymond James: as an alternative to a certificate of deposit, if the consumer doesn’t mind a longer holding period; or as a bond alternative, if the consumer is nervous about interest-rate risk.

“We always tell advisers it’s in the fixed-income sleeve” of an investment portfolio, Mr. Stolz said. “We don’t want people to think of it like an equity piece.”