Indexed annuities are often presented as the perfect middle ground between the potential for stock market growth and the prospect of avoiding losses if the market falls. That’s a desirable proposition, but in practice they often offer little upside, use complicated crediting formulas, and impose restrictions the investor may not fully understand.

You Don’t Receive the Full Market Return

Indexed annuities link the interest credits to an index (typically the S&P 500). You don’t own the stocks under the index so you won’t be getting any dividends. The insurer will have a number of mechanisms to cap the return.

• Participation rates: you get only a percentage of the index return.
• Return caps: your maximum credited return is capped (i.e., no matter how high the market goes, you can’t get a return in excess of the cap).
• Spreads: a percentage will be deducted from the index return prior to interest being credited.

For instance, if the S&P500 goes up 20% but your annuity only has an 8% annual cap, then your credited return is only going to be 8%. You’re going to miss a lot of the market upside.

The Illusion of No Risk

Many fixed indexed annuities will guarantee that the account won’t lose value in the event of negative index performance. They are by no means risk-free, though. Inflation will erode purchasing power, withdrawals can result in surrender charges, and any optional riders will add cost. All of this is of course subject to the financial strength and claims-paying ability of the insurance company issuing the product.

Your Money May Be Locked Up

Indexed annuities typically have surrender periods of several years. If you withdraw more than the permitted amount during that period, you’ll face substantial penalties. Some contracts will also have market value adjustments which will reduce your proceeds.

For retirees who need access to their savings, these restrictions can be a real disadvantage.

The Hidden Cost of Protection

Even if the indexed annuity has no stated annual management fee, the protection it provides is by no means free. The insurer will limit your return via caps, participation rates and spreads. The economic cost of that limitation is difficult to quantify.

A More Transparent Alternative

A broad range of low-cost ETFs, bonds and other liquid assets provides transparency, flexibility and control. Hedged equity strategies and options overlays may be used to manage downside risk whilst still allowing you to own the underlying investments (though with their own risks and no guarantee of protection against loss).

The Bottom Line

Indexed annuities aren’t in themselves a bad product but they are very frequently oversold. The promise of market linked growth with no market loss is a very attractive one and it can cause investors to overlook the inherent limitations, restrictions and opportunity costs of the contract.

Before you buy an indexed annuity ask yourself a very simple question: what return are you giving up in exchange for the protection you’re getting?

For a lot of investors a transparent, well diversified portfolio is probably the better long term solution.