THE CASE FOR Indexed Annuities
Kiplinger's Personal Finance|April 2021
These products may offer better returns than traditional fixed-income investments. But there are trade-offs.
SANDRA BLOCK

One of the many drawbacks of record-low interest rates is that they have made creating an income stream in retirement significantly more complicated. Retirees and near-retirees can no longer rely on certificates of deposit and U.S. Treasuries to provide reliable, risk-free income. Interest rates are so low that these investments no longer keep up with inflation, which means investors effectively lose money over time. Likewise, the traditional 60-40 portfolio—60% stocks and mutual funds and 40% government bonds—has fallen out of favor with some analysts because of the abysmal returns from the bond portion. // That creates a conundrum for older investors who are reluctant to increase their exposure to an uncertain and volatile stock market. But the financial services industry—specifically, the insurance industry—has an antidote: annuities that provide higher returns than you’ll earn from CDs or government bonds, with limits on how much you can lose in a market downturn.

Annuities have a checkered reputation. Insurers have created a seemingly endless variety, with a seemingly endless list of bells and whistles, and the products are often poorly understood (see the glossary on page 60 for a list of the main types). And annuities are sometimes loaded with high upfront commissions that can motivate some insurance brokers to sell them to investors who don’t understand the terms and restrictions. Worse, the commissions limit investors’ returns because insurance companies adjust caps and other features to recoup the cost of the commissions.

In recent years, though, companies such as DPL Financial Partners, which distributes annuities and life insurance to financial planners, have developed commission-free indexed annuities. The lack of commission allows certified financial planners to offer the annuities without running afoul of the fiduciary rule, which requires CFPs to put their clients’ interests above their own.

An increasing number of fee-only planners are recommending indexed annuities to clients who are near or in retirement and want the security of guaranteed income that will last the rest of their life. An annuity can also reduce your portfolio’s overall risk and provide peace of mind, especially when the markets play havoc with stocks and stock funds. But annuities aren’t appropriate for everyone—plus, some planners, insurance agents and brokers are still pushing expensive, high-commission products.

THE INDEXED ANNUITY MENU

Indexed annuities come in different flavors, with different degrees of complexity and cost. The most basic is a multi-year guaranteed annuity, which provides a fixed rate of return over a specific period of time (typically three to seven years). They’re similar to certificates of deposit but usually offer higher yields. Currently, fiveyear fixed-rate annuities have yields that range from 2% to 2.75%, compared with an average of 0.35% for a five-year CD.

If a five-year yield of less than 3% leaves you underwhelmed, your financial planner may suggest a fixed-index annuity. With these annuities, you are protected from losses, and your returns are linked to a specific index, such as the S&P 500. Instead of investing your money directly in stocks, though, insurance companies invest most of it in fixed-income investments and use options to provide the potential for higher returns.

In exchange for protection against losses, fixed-index annuities limit how much you earn, even when the market is going gangbusters. For example, if your contract has a cap of 6% over a specific period of time, you’ll earn a maximum 6% rate of return, even if the S&P 500 index rises 25% during that same period (see the box on the facing page for details on how your returns are calculated).

For somewhat bolder investors who still want some protection from the ravages of a bear market, the insurance industry offers buffered annuities, also known as registered index-linked annuities, or RILAs. Buffered annuities more closely resemble equity investments in that you can lose money in a down market, says David Lau, founder and CEO of DPL Financial Partners. But the annuities have a floor, or buffer, limiting how much you can lose. For example, if the annuity has a buffer of 10% and the index it’s linked to falls 4%, you lose nothing. If the index falls 30%, though, you’ll lose 20%—not quite as terrible, but still a loss.

In exchange for taking on this higher level of risk, buffer annuities offer the potential for you to earn higher returns on the upside—for example, up to 15%, instead of 6% for a fixed-index annuity, Lau says.

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