We should note right off that we’ve written plenty about the pitfalls of annuities, especially variable and equity-indexed annuities. We’ll keep doing so, unapologetically, and this article is no exception. But before exploring some of the drawbacks and potential pitfalls of these types of annuities, let’s consider what motivates many to choose these investments in the first place. In our experience, investors often buy variable and equity-indexed annuities because these products seem to promise risk-free growth.

Risk-free growth is certainly alluring, but it’s an impossible dream that can lead investors down a dangerous path. When it comes to investing, the risk-reward tradeoff is unavoidable. You must accept some risk in order to reap the rewards of returns in excess of the rate of inflation. Most strategies for minimizing risk will also mean correspondingly lower long-term returns.

While stocks are more volatile in the short term, strategies for minimizing that short-term volatility risk open you up to other, sometimes more profound, risks. For example, investments that are less volatile in the short term, such as bonds, typically offer lower long-term returns. Lower long-term returns could result in one or more of the following: Your portfolio does not grow enough to meet your goals, your investments fail to keep pace with inflation or even that you eventually run out of money. When investors think about risk, they often tend to focus on the risk of losing money in the short term, but these other risks are just as real and pressing.

In our experience, many investors who purchase variable and equity-indexed annuities do so out of a desire to limit short-term volatility and potential losses, while still achieving strong long-term returns. From our perspective, there are two related problems with these sorts of annuities. First, as mentioned previously, this strategy to minimize volatility risk also tends to drastically curtail the potential for long-term growth. Second, these sorts of annuities are usually complex, with multiple fees and other contractual stipulations which can also cut into long-term returns.

Variable Annuities: Market-like Returns Without the Risk?

Variable annuities are often pitched as a safe way to get market-like growth minus the risk, but in reality there is no such thing as a free lunch. These products tend to be complicated, illiquid and come with multiple layers of fees that can eat into your long-term returns and jeopardize your ability to achieve your investment goals. Variable annuities typically let you invest in stocks, bonds and other assets through mutual funds held in subaccounts within your annuity. Importantly, these annuities do not guarantee a rate of return you can withdraw as cash. Instead they only promise you will get your principal back. While they may offer tax-deferred growth, an IRA or 401(k) offers the same. Also, annuity withdrawals are usually considered income and taxed at your ordinary income rate, which is often higher than the capital gains tax rate you would incur investing in stocks in a taxable brokerage account.

The biggest problem with variable annuities, however, is all the fees that often accompany them. Variable annuity fees typically include a base contract fee known as mortality and expense risk, which averages 1.21% annually, in addition to a usually smaller administrative fee. Many variable annuities are invested in mutual funds, with fees that can vary widely, but on average charge annual fees of around 0.63%. [i] Some annuities include the option to purchase a guaranteed lifetime withdrawal benefit rider that may let you withdraw up to a certain amount each year regardless of market performance. You would likely pay an annual fee ranging from 0.35% to 1.6% for this option. [ii] All told, these various fees could add up to around 2.19% to 3.44% that you would pay each and every year. And if you wish to make early withdrawals, you’d pay surrender fees as well. These fees can greatly impact your annuity’s long-term returns. Once you take inflation into account, you may find yourself with minimal or no long-term growth—likely not your goal!

Equity-Indexed Annuities: Market Growth and Downside Protection?

Similarly, equity-indexed annuities are often marketed as offering downside protection during a bear market, while allowing you to participate in some of the market’s gains. For example, an equity-indexed annuity may guarantee a 3% minimum annual return, but cap your annual returns at 10%. While that sounds pretty great, a little more scrutiny reveals the opportunity cost involved. Historically the US stock market has averaged 10% annual returns, but individual years vary greatly. In particular, big positive years are quite common. As the exhibit below shows, since 1926 the S&P 500 Index has posted greater than 10% annual returns 59% of the time. If you owned an equity-indexed annuity you would miss out on a great deal of the market’s returns in those years, making it very difficult for you to achieve the 10% historical annual return of stocks.

Exhibit 1: S&P 500 Annual Returns, 1926 – 2018

Source: Global Financial Data, as of 1/9/2019; S&P 500 Total Return Index from 12/31/1925 to 12/31/2018.Values may not sum to 100% due to rounding.

Further, some equity-indexed annuities also have a participation rate. If your participation rate was 80% and the index returned 10%, your total return would only be 8%. And equity-indexed annuities, like variable annuities, often have layers of fees that can further erode your long-term returns.

Make Sure You Understand the Fine Print and Your Long-Term Goals

Before buying a variable or equity-indexed annuity, make sure you understand all of the contract’s fine print. If you don’t understand the contract, seek out help or consider another investment.

Equally important is carefully considering your investment goals. For most long-term investors planning for retirement, their most important goal is not to minimize the possibility of short-term losses, but rather to grow their portfolio and ensure they will have enough money to cover their future expenses. Annuity investors focused on minimizing short-term volatility risk can open themselves up to other, perhaps more dangerous long-term risks, such as failing to keep pace with inflation and not achieving the growth needed to meet their goals.

If you’re considering buying an annuity for the life insurance benefit, there’s likely a better and cheaper way to do this—namely by buying a level-term life insurance policy. If you’re buying an annuity to limit volatility risk, remember that you’re also likely limiting your returns. And depending on the fees and fine print of your particular annuity, it may significantly reduce or completely eliminate your potential for long-term growth.

While the stock market has historically rewarded patient investors with higher long-term returns, it is simply not possible to avoid short-term volatility and achieve market-like returns. The risk-reward tradeoff is unavoidable. Believing risk-free growth is possible, as variable and equity-indexed annuities may seem to promise, leaves you open to other long-term risks and disappointment. We believe you deserve better.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

[i] Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102, 114. [ii] Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102, 114.

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