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You’ve probably heard the saying, “No pain, no gain.” It’s true in life, in work, and in exercise. It’s also true in investing.
This is not to suggest that you have to suffer big losses in order to reap big gains. But if you are investing with the hope of achieving significant upside, you’ll probably have to assume at least some downside risk.
You can’t earn interest if your money’s under your mattress. Likewise, it’s hard to totally protect your money if you invest it. Investments often carry costs – and risks.
Recently I wrote about the concerns of investing in annuities, which sound like a sure thing but may carry downside risk. These concerns are especially relevant with equity-indexed annuities.
The name equity-indexed annuity makes these investment tools sound like they are stock investments tucked safely away in your mattress, enabling you to preserve your principal while taking part in any stock gains. But that’s not entirely true. In reality, while these annuities may be loosely indexed to the S&P 500 or another major stock index, they typically don’t grow at the same pace as a bull market. That’s because these equity-indexed annuities usually cap potential gains.
Participation Rates
Many equity-indexed annuities come with fine print that details a “participation rate,” which effectively limits any gains you’ll see. If the participation rate is 80% and the market grows 10%, your investment will grow 8%.
And if that seems like a nominal difference, keep in mind that markets often grow far less than 10%. An 80% participation rate in a market that’s growing at 5% means that your investment grows at 4%. In years of tepid stock market growth, these imposed caps can reduce your gains to the realm of CDs or interest-bearing checking accounts. They may also exclude dividend gains from the upside calculation.
This all may be fine if you are a conservative investor, except that the penalties for early withdrawal are often so steep that they effectively present downside risk.
Surrender Periods and Fees
It’s not unusual for an equity-indexed annuity to come with a surrender period of 10 years or more. If you take your money out before the surrender period elapses you’ll typically pay a hefty penalty in addition to taxes. And keep in mind that 10 years is a long time to lock up your money, particularly for older investors, who are so often the ones buying annuities.
Because indexed annuities often come with steep commissions, the additional costs associated with early withdrawal can potentially erase all your earnings. Some of these annuities impose “spread fees,” which can further cut into any upside. For example, if the stock index gained 10% and the annuity imposed a 4% spread fee, that would take your realized growth down to 6%.
If you are a conservative investor primarily interested in preserving your principal, you might not be too concerned about limited growth prospects. But given the limited upside, you may do just as well with other low-risk investments such as bonds or CDs.
Annuities Are Complex
If you’re interested in buying an equity-indexed annuity, it behooves you to read the fine print and take the time to understand how they work. One of the key factors to take note of are “riders” – add-ons of sorts –which may offer many guaranteed benefits. Riders include a cost of living adjustment to your annuity income, an increase to cover the cost of long-term care, guaranteed minimum income, and various survivors benefits.
Riders may make sense for some investors, and may be just the tool to help your annuity work for you. But all come with a cost. Understanding the costs, together with various caps on earnings, may help you decide whether equity-indexed annuities are right for you – or if you’re better off with a simpler, more conservative investment.
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