Annuities are contracts issued by an insurance company with promised payments at pre-determined times, often after retirement. Annuities have become increasingly popular over the years for reasons including their tax-deferred status and because financial advisors increasingly licensed to offer these insurance products. Since less than half of workers have access to an employer-sponsored retirement plan, index annuities seem like a way to play catch-up when saving for retirement.* Some annuities are even endorsed by AARP. Annuities seemingly solve two problems 1-income yield in a low interest rate environment and 2-payments for extended life expectancies. But annuities may have more risk than you anticipate depending on the type of annuity it is and the company who’s insuring the annuity. Indexed annuities are the most popular type but indexed annuity risks are being gravely understated by many investors.
Indexed Annuity Risks
Indexed annuities provide returns that correspond to some underlying index, such as the S&P 500. Over $25 billion went into indexed annuities in 2015. This is worrisome for a few reasons:
1-Very high fees. Not only are there sometimes high up-front commissions on indexed annuities, but there are lucrative renewal fees for the broker. This creates a conflict of interest with these products. Many indexed annuities are pitched as an alternative to workers without an employer-sponsored retirement plan like a 401(k). If these annuities are held in a tax-deferred retirement account such as an IRA, Fidelity concluded there is no additional tax benefit to owning the annuity since the account is already tax-deferred. Essentially, you’re paying higher fees for the tax-advantaged status you already have. If you want the variability of stock movement buying a low-cost indexed mutual fund or ETF is a much cheaper way to accomplish the same thing.
2- Limited Upside Participation. Some indexed annuities have performance caps that limit the upside participation (returns) an owner can enjoy. Further, if the annuities tracks an index which doesn’t include dividends, that is additional returns the annuity holder foregoes. For example, Fidelity reveals that in 2013 while the S&P gained 32% including dividends, a typical representative indexed annuity returned just 10% because of the caps.**
3- Credit Risk. An annuity is only as good as its issuer. There is some safety in annuities in that the portion that goes to mutual fund companies or other asset managers is custodied there. If a broker sold you an indexed annuity, does he know realize that this is further allocation to equities and possibly leading to overconcentration.
How to Hedge Indexed Annuities
1-The one good thing about indexed annuities is that they can be hedged since almost all major indices offer inverse ETF counterparts. If you have an brokerage account or even an IRA, you may be able to purchase an inverse ETF on the annuity’s benchmark index as a hedge. Most indexed annuities are benchmarked to the S&P 500 so the S&P 500 inverse ETF, SH is a logical hedging instrument, although maybe not in the retirement account itself. There are also inverse index ETFs for the Dow Jones Industrial Average, DIA, the NASDAQ 100, PSQ and the Russell 2000, RWM.
2- You can sell the annuity. There may be considerations such as surrender charges, etc but if you need the cash in a crunch, it might be worth it. A bird in hand…
3- You can switch into another type of indexed variable annuity with downside protection. There is a catch-you give up some upside since there is a cap or maximum you can receive. Your upside in the accumulation phase is capped but there is a floor under losses. There are some with 10% floors meaning you’re loss is limited to 10% on the downside but nothing further. That is assuming the solvency of the insurer, but at least it offers more protection than the traditional upside only products. You could always buy the downside protected index variable annuity and buy a put option on the insurer if you’re worried about individual risk or hedge against downside with an inverse financial ETF or a broader market fund like SH.
Understanding Risks in Guaranteed Investment Contracts
Guaranteed Investment Contracts (GICs)
Another popular insurance product over the last few years has been Guaranteed Investment Contracts (GICs) which are offered in many defined contribution plans like 401(k)s. The low interest rate environment has again allowed more of these type of products to seep into retirement plans under the guise of safety because of the word “guaranteed” in them. There is nothing guaranteed about them. Most GICs are issued by a single insurer and are subject to credit risk by that insurance company. Let’s not forget that insurance companies have enormous amounts of risky corporate debt in their investment portfolios and there is no telling what affect a rising interest rate environment will have on them. They are not backed by the Federal government or through SIPC insurance but they may be back-stopped by a state insurance fund.
Another risk to GICs is illiquidity risk, which should be a major concern in a retirement account. Surely, these products have been marketed to match (an exaggerated) longevity risk in your retirement plan. The problem arises if you need to sell these products. You’ll probably incur some type of penalty or gate fee. Given this illiquidity, in an oscillating or downward trending market, there will be no way to properly rebalance your portfolio, robbing you of the actual diversification benefit you were told the investment provided! This will not allow you to maintain either a 1- constant risk profile or 2- an accurate risk profile. This could also be construed as an unsuitable investment strategy since you can not ascertain a target asset allocation.
Stable Value Funds
You’ve probably heard the term stable value funds or maybe own one in a retirement account. Despite the conservative name, stable value funds are essentially portfolios of GICs. Like the collateralized debt obligations of the mortgage crisis a few years ago, just because these risks are packaged together and ‘securitized’ into a structured product, does not make them much safer. Just be wary.