Many conservative investors buy these products to provide downside protection in years when the index goes down in exchange for limited upside potential in years when the index goes up. This article provides examples of how conservative investors who may be attracted to indexed annuities can use index mutual funds to commonly replicate the risk-reward characteristics of indexed annuities. I will explain. We then compare the historical performance of both strategies based on figures we recently received for indexed annuity products that are popular among brokers.
Hypothetical Performance of Indexed Annuities, 1993-2020
The screenshot below is from a US indexed annuity provider. While many indexed annuities are complex and difficult for consumers to understand, this one is straightforward and does not include other features such as income riders that are often added to the contract at an additional cost. The insurer offers a floor of 0% for him in years when the index is negative, and a current ceiling of 4.4% for years when the index increases more than his 4.4%. In years when the index return is between 0% and 4.4%, the interest credited to the contract equals the index return. This simple floor and ceiling methodology makes it easy to explain how $100,000 has grown over the last 28 years.
$100,000 grows to $231,479 for an average return of 3.06% and a compound return of 3.04%. That’s less than a third of the index’s average return. A common way to replicate the performance of a real index is to own an index fund, such as the Vanguard S&P 500 Index Fund. Many people who are anti-index annuities point to this huge performance difference, which is undoubtedly true, but most people ignore the reason they buy these annuity contracts which is principal protection. A conservative portfolio of index funds with similar risk/reward characteristics is therefore a better comparison.
Conservative Index Fund Portfolios and Indexed Annuities, 1993-2020
Life insurers typically take contract deposits received by purchasers and purchase derivative contracts such as index call options paired with bonds to create floor and cap combinations that support the underlying guarantees of the contract. To do. This same process can be implemented by individual investors, but it is too complicated for most people. A simpler approach is to combine equity index funds, such as the Vanguard 500 Fund, with short- and medium-term high-quality bond funds. In the example below, the exact portfolio used is shown below and you can find a direct link to the performance data. hereRebalancing is assumed to be based on the 5%/25% rebalancing band. A total of 12 rebalancing transactions were required over the last 28 years.
Conservative portfolios of index funds have been clear winners over the past 28 years. Negative years are highlighted in red. The floor of his index annuity is 0%, but the floor is almost worthless compared to a conservative index fund portfolio with just 15% equity exposure. This was also the case in his 2008, when the index dropped his 38.49%. The final net worth is more than double his in index fund portfolios, and investors will also retain full liquidity. In non-qualified accounts, index annuities have the advantage of tax deferred growth (a feature of all annuities in US tax law), but with the trade-off that all withdrawals of profits are taxed as ordinary income. The after-tax return is the same for eligible accounts such as Traditional or Roth IRA.
Downward protection in fixed insurance products can appeal to conservative investors. This can be compared to a conservative allocation of index funds, where individuals are willing to accept the possibility of a small loss. A separate product from the one described in this article, annuities with lifetime income guarantees, can add an additional element to returns known as death credits that cannot be replicated by investments alone. For this reason, academic research usually favors income pensions in retirement planning. Next time you get a postcard from your local pension salesman offering a free dinner, maintain a healthy level of skepticism if you decide to go. If you currently own or are considering an index annuity and would like a second opinion, please feel free to contact us at [email protected]
Jesse Blom is a licensed investment advisor and Lorintin Capital, LPHe provides investment advice to clients across the United States and around the world. Jesse has been in financial services since 2008, Certified Financial Planner™ professional. Working with a CFP® expert represents the highest standard of financial planning advice. Jesse Oral He holds a Bachelor of Science degree in Finance from Roberts University.