This Famously Tricky Investment Product Just Got Easier to Sell. Here's What to Watch Out For

Tony D’Amico noticed something new on television this summer: a surge in commercials for annuities, complex insurance products that offer certain guarantees for investors, often at a high price.

He watched them warily, hoping that would-be buyers actively weighed the pros and cons rather than simply succumbing to the sales pitch.

The timing was no coincidence. In June, an appellate court vacated the so-called fiduciary rule, effectively killing an Obama-era regulation designed to protect retirement savers from conflicted advice. The regulation, which many Wall Street firms opposed, had created uncertainty for sellers of fixed indexed annuities in particular, by challenging their distribution model.

When the regulatory cloud lifted, “It was like the dam broke,” says D’Amico, a certified financial planner at Fidato Wealth in Middleburg Heights, Ohio.

Sales of fixed indexed annuities hit a record $17.6 billion in the second quarter of this year, 17% higher than second quarter 2016 and 21% higher than first quarter sales results, according to LIMRA Secure Retirement Institute, an industry group.

Annuities come in several flavors, but all involve guarantees from insurance companies: a contract will ensure, for example, that you receive guaranteed income for life, or that your principal will never decline even when the stock market does. Unlike their more complex cousin, the variable annuity, fixed indexed annuities do not contain underlying mutual fund investments. Instead, your principal rises or falls according to a formula that’s based on an underlying index, such as the Standard & Poor’s 500.

Today’s market environment has also boosted annuities’ appeal. Annuity payouts and other features fluctuate with interest rates, which have risen this year. What’s more, the bull market has entered its ninth year, and many investors, particularly those on the cusp of retirement, may be drawn to the promise of holding onto their nest eggs no matter what happens in the market.

“Equity markets have been running for so long, clients are concerned about a downturn and looking for protection,” says Rob Santillo, executive vice president of product management and research at PNC Investments.

Still not all financial advisors are pleased. Many worry that fixed indexed annuities' high fees and tepid returns mean that in the long run, few fixed indexed annuity investors end up better off than they would have been in a globally diversified portfolio of stocks and bonds.

How Annuities Work

Annuities may be most popularly understood as vehicles that provide guaranteed income for life by turning a lump sum into a stream of monthly payments. While single premium immediate annuities do just that, fixed indexed annuities are generally not bought for that purpose. Just $1.5 billion is annuitized annually, representing less than ½ of 1 percent of the roughly $400 billion in assets under contract, according to LIMRA.

Instead, fixed indexed annuity buyers purchase the product for a number of goals, one of the main being principal protection. With fixed indexed annuities, your money will drop only within a fixed range even if the stock market tanks. Some contracts stipulate a floor of 0%, effectively ensuring that your principal won’t decline as long as the insurance company remains in business. (Advisors generally recommend that you look for a company with a A.M. Best financial strength rating of A-minus or higher.)

You pay for this protection in the form of limited gains when the market goes on a a tear. If a contract has a cap of 9%, for example, then that’s what you’ll earn even if the market returns a blockbuster 49%. Legacy products can have ceilings as low as just 2.5%, says Bob Morrison, a certified financial planner at Downing Street Wealth Management in Denver.

Over the long run, the caps can take a big bite out of your expected investment returns. For instance, if you invest $100,000 today in a fixed indexed annuity with a 0% floor and a 9% ceiling, then after 30 years, you'd have a portfolio worth $209,728, according to one market simulation run by David Blanchett, head of retirement research at Morningstar. This is compared to $253,325 if you'd invested in a balanced portfolio of 50% stocks and 50% bonds and cash, or $415,863 if you'd invested 100% in stocks.

Some fixed indexed annuities come with an income feature that makes them function similar to a bond in your portfolio. For example, a $100,000 fixed indexed annuity could come with an income of 2.5% distributed annually and a cap rate of 6.5% based on the Standard & Poor’s 500 index.

Lastly, high earners, can be drawn to annuities for their tax-deferred growth. You pay no taxes on the gains until you (or your heirs) withdraw the money, when gains are taxed at ordinary income tax rates. That makes annuities attractive to some consumers who know they will be in a lower tax bracket in retirement.

Look for Low Fees

Despite their drawbacks, annuities can have a place in certain portfolios. If market gyrations truly keep you up at night and a guarantee would help you sleep better, then they could be worth considering. Ditto if you haven't saved enough for retirement. Someone with, say, $300,000 in retirement savings might consider plunking a portion of that into a fixed index or other annuity, whereas someone with $1.5 million is better off in a globally diversified portfolio, D'Amico says.

If you fall into one of the above categories, make sure you consider the newer fixed index annuities on the market today. They're geared to registered investment advisors that already act as fiduciaries and have to put clients' interest first (they are regulated differently than the brokers who were the main target of the fiduciary rule). As such, they charge outright fees instead of commissions that are baked into the product and thus largely invisible to consumers, even as they act as a drag on returns.

These newer annuity policies have lower surrender periods and lower surrender fees. The surrender period is the number of years during which you’re penalized if you decide to exit the annuity early.

Despite the improvements, there are still problems. For one, it’s hard for the lay investor to tell the difference between the legacy, commission-based products that still represent the bulk of the market and the newer, fee-based annuities, Morrison says.

Five years is considered a reasonable surrender period in the new annuities, whereas legacy products can go out more than double that length. “Some marriages don’t even last 12 years,” Morrison says. “How can you get out of this if it’s not performing well?”

Fees during the surrender period can reach as high as 10% of the account balance in commission-based products, whereas some newer products have fees as low as 2%, Morrison says.

He encourages consumers to ask their advisor how he or she is compensated. “If they say, ‘it’s included in the product,’ I’d be persistent,” he says.