My Annuity Will Give me 100% of the
Market's Growth and None of the Downside
Q. Who said in that classic movie of yesteryear, "There's no Place Like
Home, There's No Place Like Home...?"
A. Why, Dorothy, of course, in "The Wizard of Oz", as
she clicked her heels together and dreamed happy
If Prudence be a Virtue, then it might be
virtuous to looker deeper into an oft heard salesmans pitch that the
equity indexed annuity will give you 100% of the upside of the stock market and
0% of the downside. Although various crediting strategies provide a "market
upside" to the standard indexed annuity contract, it is helpful to recognize the
specific math that be at play in order to set expectations properly. Otherwise, simply "clicking your heels" and expecting double digit annual growth every year in your annuity contract might lead to disappointment.
The Indexed Annuity was initially designed by Insurance Companies to compete for the same consumers that keep their monies in the banking system, ie, conservative investors. Since Insurance companies have always been in the business of managing risk, it only made sense that their financial products would also be marketed primarily to safety conscious investors.
Annuities, however, typically have terms longer than bank products, and in order to make the annuity more attractive, in 1995 actuaries designed indexing methodologies (also known as indexing strategies) based on various stock indices, that were designed to capture some of the growth in the market.
This has been, of course, the eternal challenge for any investor; to manage risk in such a way that yields are steady while losses are few.
The indexing strategies used by insurance
companies are based on call options purchased
by the insurance company that allow the owner
of the option (the insurer) to capitalize on rising
stock prices for a predetermined price. It is
important to note that the insurance company
is not actually participating in the market,
only obtaining the right to buy stock at (hopefully)
a lower price than what it is valued.
The mechanics of call options can be a tricky discussion, so for the purposes of this article, let's just focus on a few of the options that the insurer can purchase and credit gains to the policy holder from.
These call options are represented by the same crediting strategies that the annuity policy owner can choose from in the annuity brochure at the point of sale - such as in the following examples:
S and P Growth Only (not the loss) measured on the first day to the last day of a 365 day year, subject to a limit (cap)
80% of the S and P Growth Only (not the loss) measured on the first day of a 2 year term to the last day of a 2 year term, subject to an annual fee of 1.25%
S and P Growth measured from the first day of the month to the last day of the month (subject to a cap as well) and tabulated annually.
The strategies mentioned can be applied to the Dow, or the Nasdaq, or the European Stock Market as well. (There are actually a multitude of indexing options that an insurer may offer).
This multiplicity of choices can create confusion for the consumer,
and very often these options are not fully 'unpacked"
by the insurance agent. Often agents will simply
say "all the upside with none of the downside".
Well that is scientifically a half truth, as there
will be no downside in an indexed annuity
and that part is the full truth.
But the upside is always limited by either a cap,
or an annual fee, or a participation rate
(as in the 80% of the S and P example above).
So you should know this in advance.
If it sounds too good to be true, then of
course you are likely hearing a half truth.
After all, the insurance company is living in the same world as the
stock market. It would be impossible for an insurer to offer 100%
of the markets growth and protect principal 100% of the time as well.
So, instead, they must manage risk by limiting the growth in the upside for those times when the market does fall.
IN all of the above strategies, the policy owner will never see a decline in their accumulated principal.
In bad times, the worst an owner can earn is nothing. And in good times, there are some serious gains to be had.
But in order for the reader to understand how much of the markets actual growth
is available in an indexed annuity, one must read the details in the crediting
methodology. Remember, as someone said, God (or the devil)
is in the details. If an agent says that his annuity will provide
100% of the stock markets growth, that agent is simply not
confident enough in his annuity to recognize the virtue that
the contractual minimum guarantees are really the strongest
selling feature of an indexed annuity in the first place !
An indexed annuity owner should expect some of the markets
upside and none of the downside.
How much of the markets upside will depend upon the details in the crediting strategy.
Only by having this nuanced level of expectation will certain satisfaction be plausible. Anything beyond this is an improperly informed client.
One additional note, since indexing options offered by insurance companies do not actually participate in stock ownership, dividends are not possible with indexed annuities. In many cases this may make a difference, so it should be taken into consideration.