Many people with no pension to count on and only a modest expected income from Social Security know they need to make smart decisions about their retirement savings and investments. Thus, when a salesperson pushes them toward indexed annuities, they're quickly convinced, and sign up. That's not good news, though, because indexed annuities can be problematic.
According to the latest Wink's Sales and Market Report, which covers the industry, sales of indexed annuities in the fourth quarter of 2014 were up 3.5% over year-ago levels, with 2014 marking the sixth-consecutive year of record-breaking levels, and an overall increase of 21% from the year before.
Nuts and bolts
In a nutshell, an indexed annuity -- which is sometimes called a fixed-indexed annuity, or an equity-index annuity, or a variation on one of those -- is an investment you can make to help yourself save money for retirement. You shell out a significant sum of money to buy it, and then it pays you a certain sum at a certain time for a certain length of time.
Its key distinguishing feature is that it's linked to the performance of an index, such as the S&P 500, which is an effective measure of the overall U.S. stock market -- measured by market capitalization, the S&P 500 represents about 80% of publicly traded stocks. You could invest in the S&P 500 easily via an inexpensive index mutual fund such as the Vanguard Index 500, or via an exchange-traded fund, such as the SPDR S&P 500 ETF, which offer returns that closely track the index.
But if the S&P 500 dips or plunges, so will your investment -- though, over long periods, it has always recovered and gone on to new heights. That volatility scares some people, so they're happy to hear about indexed annuities, which often promise them no chance of losing money, or a guaranteed minimum return.
How they work
So what's wrong with all that? Well, if you read the fine print on indexed annuities, as you should always do before investing in one, you'll see that, while your downside is limited, so is your upside.
Your gains are constrained in a variety of ways. For starters, there's the "participation rate," which measures what portion of the underlying index's return you might receive in your investment's return. Imagine that the S&P 500 was the benchmark, for instance, and it gained 10% in a year. If your participation rate was 100%, the participation component of your investment's return would be 10%. If it were 80%, you'd be credited with 8%.
That might seem pretty good, considering that you're promised little or no losses in the investment. But wait! There's more. There's a cap. The cap is a strict limit on how much you can earn. If the cap is, say, 7%, then even in a year when the S&P 500 surges 20% or 30%, you'll earn no more than 7%.
It gets worse, too. There are annual fees, often subtracted from the return, and they can make quite a difference.
The folks at Fidelity crunched some numbers to show how performance limiting indexed annuities can be. They point out, for example, that in 2013, the S&P 500 surged by 32% (including dividends), while a representative indexed annuity delivered just 10%. They also looked back at the decade ending in 2013, and found that the overall S&P 500 averaged an annual gain of about 7.4%, while the annuity averaged 3.2%. (In many years, the annuity returned 0%.)
That's a meaningful difference. A $10,000 investment that grows for a decade at 7.4% will become $20,400, while growing at 3.2%, it will only become $13,700.
More problems with indexed annuities
There are other issues to consider, too. For starters, if you change your mind and want out of the investment, there can be sizable surrender fees.
Meanwhile, indexed annuities are sold by insurance companies and are regulated by state insurance authorities. But they're not regulated by the Securities and Exchange Commission or by the Financial Industry Regulatory Authority.
Another problem is that these instruments are often pushed hard by salespeople who don't have their audience's best interests in mind. As they stand to collect a sales commission, they're at best dealing with a serious conflict of interest.
They can be convincing, too, pushing features such as a first-year "bonus," which is a guaranteed (and generous) return in the first year. However, you often have to remain in the investment for a number of years before you fully vest, and you might lose it entirely if you choose to get out of the annuity early.
What to do
So what should you do? Well, go ahead and consider these investments if you must; but simply avoiding them is a reasonable choice, too. Know that there are other kinds of investments out there. Variable annuities are another option, but also a problematic one, historically featuring high fees and some unfavorable terms for investors. A much more appealing annuity is the immediate annuity, which is very upfront in what kind of income you're promised.
Another fine option, though one with no promises, is simply investing in dividend-paying stocks. If an annuity is going to average 3% or 4% or maybe 5%, then you can earn that much and more in some dividend payers -- and you can enjoy stock-price appreciation on top of that.
When it comes to deciding where to park your precious, hard-earned dollars, think any possible move through closely. Consider consulting an advisor or two, as well -- just not one who sells these annuities.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.