It seems the hottest topic in financial advice these days is Fixed Indexed Annuities. The pitch promises asset protection on the downside, some stock market participation on the upside, and an eventual lifetime income stream – if you choose to attach a costly income rider.

Insurance salespeople are aggressively selling these enticing products, often glossing over the costs, restrictions, and potential hazards. They benefit from the huge unseen commissions and ongoing fees buried in these products.

The concept of a fixed income annuity is designed to appeal to your fear of stock market losses, your hope for gains — and your desire for an attractive interest rate.   It looks simple, but the moving pieces are tricky. Here are some of the catches in fixed index annuities:

• You get only a portion of the market “index” gains – and you do not get the dividends, which have historically made up about 40 percent of the return on the S&P 500 index. The overall investment return will have a cap, typically 5 percent.
• The index might not be the broad-based S&P 500 stock index, but instead a group of stocks created by the insurance company in a so-called “proprietary index.” There are over 40 index “types” currently being offered in the industry. And the insurer can change the components of the index at any time.
• In most policies, the “investment return” might be computed only on a specific date, such as the “anniversary” of your purchase of the policy. So if the stock market tumbles on that date, and then recovers, (as it has lately), you’re out a good portion of the annual return.
• You’re likely “locked in” to this product for at least 5 years –and sometimes as long as 14 years – or else you face a significant penalty (surrender charges) for early withdrawal of your principal. That’s how the insurance industry compensates the agent for bringing money to them
• It’s the “rider” that offers that attractive “interest rate” of 7 to 10 percent (simple interest). That rate is not credited to the actual cash value of the investment account. It is credited annually to the “withdrawal base”. Your annual income stream will depend on the value of that income base and the age at which you start withdrawals.

With most of these fixed index annuities, the withdrawal base, which grows based on the promised interest rate, is likely to be far larger than the gains in the investment portion of the account, which is tied to the index. But you cannot simply take out the withdrawal base in a lump sum.  You can only take out regular withdrawals, that are guaranteed for your lifetime (or lifetime of you and your spouse).   Those withdrawals are guaranteed – even if they completely deplete the investment account.

If you’ve purchased the fixed index annuity hoping for future income – which is the right reason to buy this annuity – then you will want to opt for the fixed annual withdrawals, not a cash withdrawal from the (likely) smaller investment account. So, the stock returns won’t matter.  Remember, these products are structured so it’s likely the withdrawal base will be the larger account by the time you can start your income stream.

I know you’re disappointed, because you thought you could get everything in one product: safety, market upside, high rates, and income-for-life.   But did you think the insurance company was just going to give that away?  They have to “hedge” their bets – and you’re paying for that hedge, as well as the commissions to the agent.

It is imperative that you compare these deals – not only the promised interest rate on the rider, but the surrender charges that lock you in during a period while rates could move higher (and the stock index moves lower), not to mention comparing the cost and terms of the rider (and how they impact the growth of the withdrawal base). You’ll also want to understand the underlying index, the guarantees, the caps, and the way the earnings are credited to the investment account.

Since the variables are too complex for a simple online comparison tool, you’re at the mercy of your financial “advisor” whose motivation might not be your best interest, but his or her commission check.

There are some good uses for annuities:  for immediate lifetime income, and for tax-deferred growth of money outside of an IRA.  Next week, we’ll look at an alternative use of annuities to build tax-deferred income – the Multi-Year Guaranteed Annuity. It doesn’t have a stock market upside, but it can create secure, laddered liquidity, much like CDs, on a tax-deferred basis.  And future columns will deal with the pros and cons of immediate annuities and deferred annuities.  But none of those products carry the “free lunch” sales pitches of fixed indexed annuities, with their huge built-in commissions.

So, be skeptical of fixed indexed annuity sales pitches. Some are just too good to be true.  That’s the Savage Truth.