Indexed Annuities vs S&P 500

Sales of indexed annuity products have soared since the beginning of the 2000 decade which was marred by the tech stock implosion and period of volatility in the stock market. Sales again spiked following the 2008 market crash topping out at $31 billion for the year ending in 2010 (2001 sales were $6.5 billion).  The primary source of funds fueling this growth has been investor money fleeing the stock market as well as cash deposits from savings accounts and CDs that have been yielding next to nothing.  The rising popularity of indexed annuities is indisputable which has drawn the ire and the scrutiny of financial advisors and brokers, as well as the obvious comparison of their performance with that of the S & P 500 index to which many indexed annuities are linked.

As Different as Apples and Oranges

Indexed annuity critics are quick to draw comparisons with the performance of the S & P 500 index, however, there is actually very little that can be compared apples-to-apples as the only aspect they share in common in the term “index”.  If a comparison is made between an equity indexed annuity linked to the S & P 500 index, and an S & P 500 exchange-traded fund (ETF), it is done so between two very different types of investments that address very distinct investment objectives.

An ETF invested in equities is a growth investment while an indexed annuity is a principal preservation investment.  The ETF offers unlimited upside growth potential, with commensurate downside risk, and the indexed annuity offers fixed rate returns tied to stock index gains, with no downside risk. The ETF is appropriate for investors willing to assume market risk, while the indexed annuity is suitable for risk-adverse investors seeking higher fixed yields.  So, what is there to compare?

Index Annuity Returns can Outperform the S&P 500

The first problem with performance comparisons is that there are so many variables when considering stock market data, and the variables in the yield crediting methods of indexed annuities are far ranging which doesn’t allow for straight forward comparisons. It’s fairly easy to data mine historical data to skew the results in favor of one type of investment over another.  And, trying to use past performance as a predictor of future performance has never found any validity. Stock market investment models almost never account for major “Black Swan” events such as the huge natural disaster in Japan, or the financial meltdown of 2008 which can result in significant market declines. Conversely, there is no real reason to account for unexpected market calamities with indexed annuities because of their mechanism for locking in positive gains while providing minimum investment returns in down markets.

The data on indexed annuity performance only goes back to 1996, the year they were first introduced, while historical stock market data goes back many decades. So, the direct comparison would only encompass less than two decades which many would consider too short a period of comparison. Plus, the stock market encountered two major events in that period that led to major market declines in which investors lost significant value in their portfolios.  But, isn’t that the point of the comparison? Don’t we want to see how an indexed annuity treats investor returns versus the way the stock market does? Take, for example, the period between 2001 and 2011, which was a period of tremendous stock market volatility. The S & P 500 finished 4.74% down in that period. An indexed annuity with annual resets that locked in positive gains, and in which down years were treated as zero return (although most indexed annuities credit a minimum return), would have achieved a 132% gain.  Indexed annuity advocates won’t argue the fact that their upside return potential is limited. Investors don’t buy them for the upside potential. They buy them to protect their principal during times of market and interest rate volatility.

What about Liquidity Risk

With no clear advantage in annual returns to point to, indexed annuity critics then turn to the issues of liquidity risk and expenses to extend the comparisons. The main argument made against annuities is that they are not liquid and they have large surrender charges.  But, when compared to the liquidity risk of owning stocks or an ETF, annuities may still hold an advantage.  Annuities do allow for annual withdrawals of 10% of the account value without incurring a surrender fee.  Setting aside the fact that the surrender fee declines over time so that, within a five to ten year period they vanish all together, annuities may be more liquid than a stock or mutual fund portfolio.  If you are a retiree who needs to withdraw funds from your mutual fund account that has lost value, you might consider not taking it in order to allow them to recover their value.  If you do withdraw the funds at a loss, you will never regain the value.  So, there is liquidity risk with equity investments, perhaps more so than with indexed annuities.

Yeah but, What about those Expenses?

Most indexed annuities don’t charge a sales load, or management fees, or 12b-1 marketing fees. The same cannot be said for mutual funds.  ETFs tend to have lower expenses than mutual funds, but there still is the inherent expense associated with market loss when it occurs. And, if you are withdrawing funds during periods of market loss, that becomes a permanent expense.  The expenses for indexed annuities are recovered by the carriers through their yield crediting method which consists of a participation rate and a cap rate. This, essentially, allows them to create a spread between what they earn on their portfolio and what they actually credit to the account. They cover their expenses through that spread.  More competitively priced annuities will have a smaller spread allowing the investors to earn a higher yield.

What it Really Comes Down to

What any comparison of indexed annuities and the S & P 500 index fail to consider is that investors who buy indexed annuities have some degree of risk intolerance. For these investors, an 8% return achieved with no risk, may be more superior to them than a 20% return that came with the possibility that it could have been a 20% loss. The bottom line is that indexed annuities were not created to compete with index investing. Indexed annuities are of a completely different asset class than equity investments – they are principal protection investments, not growth investments.