In the wake of broad stock market declines and uncertainty, it is only natural that investors are attracted by products with promises of downside protection, a minimal guaranteed return, and a slice of any increase of the stock market. Equity-indexed annuities are marketed by insurance companies as having those attributes, but they carry downsides and are risks that are not well-understood. The net result is that you can achieve the same benefits pretty simply and without the negatives associated with equity-indexed annuities, according to Jason Zweig in his Wall Street Journal column, “Downside Protection Has Its Downsides.”
Among other things, the downsides of equity-indexed annuities include commissions as high as 8%, a surrender charge of up to 12% if you need to cash out in the first year (the percentage usually declines by 1% per year), and a little trick called a cap reset. The “slice” of market returns is subject to a cap, but the cap can be adjusted downward each year by the insurance company. As an example, Zweig points out that the cap on the Allianz MasterDex X annuity starts out at 5.25% but it can go as low as 1% at Allianz’s discretion. Zweig writes: “If interest rates fall further, caps could drop again, constricting your gain if stocks do well ? as they often do when rates decline. Your return from stocks could go down even as their performance goes up.” Stated differently, it’s all set up to benefit the House, and you are not the House.
Zweig cites a financial planner for the following alternative proposal: Instead of investing a sum in an equity-indexed annuity, create your own by investing about 70% in a 10-year certificate of deposit paying 3.25% and 30% in the Vanguard Total Stock Market Index Fund. According to the article, this planner says that if interest rates rise, you pay a penalty for early withdrawal and still come out ahead by investing at a higher rate. Also, gains on the index fund, which are not capped, are likely to be taxed as capital gains rather than as ordinary income, as withdrawals from equity-indexed annuities are.
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