Don’t buy index annuities

By Felix Salmon
January 18, 2011
Lisa Gibbs has a great article on index annuities in Money magazine (HT: TFF). The short version: don't buy them, and don't let your parents buy them.

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Lisa Gibbs has a great article on index annuities in Money magazine (HT: TFF). The short version: don’t buy them, and don’t let your parents buy them.

There are at least three scandalous aspects to the index annuity racket. First up is the commissions, of as much as 9%. Incentives matter, of course, and when financial products carry these enormous commissions, the people selling them will never have their clients’ best interest at heart.

That problem is exacerbated by the fact that not only don’t the salespeople have any fiduciary duty to their clients, they don’t even have to have securities licenses. Index annuities are technically an insurance product, which means that you can sell them with nothing but an insurance license — even if FINRA has torn up your securities license. That’s no mere theoretical problem: more than a third of all brokers of insurance annuities in Florida and Massachusetts have had their securities licenses revoked.

Gibbs explains how this egregious loophole survived Dodd-Frank. It’s exactly what you thought:

When details of last year’s massive financial reform bill were being hammered out, Democratic Sen. Tom Harkin slipped in an amendment affirming that index annuities are not securities — and therefore are out of the SEC’s reach. Harkin is from Iowa, home of five big index annuity sellers.

Gibbs singles out one company, Pinnacle Investment Advisers, which persuaded elderly investors to surrender old annuities, paying $208,000 in surrender fees in the process, and for its troubles earned both $126,000 in commissions and a lawsuit from Illinois’s securities division. But it turns out that the only reason that the securities division has standing to bring the suit is because Pinnacle was a registered investment adviser. If it was just an insurance broker, it would be out of their reach.

And on top of all that, index annuities are very bad at their main job, which is being annuities. To back up a bit: in old-fashioned defined-benefit pension plans, there was always a significant insurance component. The pensioners who needed the most money — the ones who lived the longest — would receive the most money. Meanwhile, those who didn’t need as much — people who died relatively young — would effectively subsidize the longer-lived. That’s a great idea: living people need money much more than dead people do.

Nowadays, however, with the move to defined-contribution pensions, all that has gone out the window. You have a certain amount of money, and it needs to last you the rest of your life, but you have no idea how long that life will actually be.

Annuities are the obvious way of solving this problem. You hand over a lump sum, and an insurance company promises to pay you an income so long as you’re alive. If you die early, you lose out (but don’t need the money any more); if you live long, you win, and do need the money.

The problem is that many annuities, and pretty much all index annuities, are sold as investment products:

Insurers say that index annuities are meant to be held over the long term. However, in the wake of complaints like Passanisi’s, they have added provisions to most new index annuities that allow you to take out up to 100% of your money penalty-free if you are diagnosed with a terminal illness or enter a nursing home.

This, of course, does a great job of undercutting the main reason why annuities ever make sense. The reason for me to buy an annuity is that I want to be subsidized by the short-lived if I turn out to be one of the long-lived. What I don’t want is for the short-lived to be able to get their money back in full, because then my subsidy goes away, and there’s no point in buying an annuity at all.

At the end of her piece, Gibbs manages to replicate an index annuity at much lower cost and with much more upside. Put 85% of your money into FDIC-insured bank CDs, and 15% into a low-cost S&P 500 index fund. Then, when you retire and are ready to start getting that lifelong income, buy a plain-vanilla immediate annuity designed to cover all or most of your basic living expenses; the rest should be kept invested according to your risk appetite.

What Gibbs doesn’t do is raise any hope that the Consumer Financial Protection Bureau or anybody else will start regulating and cracking down on the index annuity racket. Insurance regulators are reasonably good at regulating the sale of genuine insurance products. But index annuities are not insurance products, they’re financial investments. And they should be regulated as such, by a federal regulator.


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The traditional advantage of a variable annuity — is this more or less that? — over a fixed annuity is inflation protection. (Though it’s not particularly well-suited to it, it’s better suited than a fixed annuity.) There are inflation-adjusted fixed annuities, but they’re fairly uncommon. They should be more common — perhaps a more robust TIPS market in which to hedge risks would help promote that.

Posted by dWj | Report as abusive

@dwj No, indexed annuities are not the same as variable annuities. VAs are composed of “subaccounts” which are generally based on actively managed mutual funds. So your account value can go up or down, with no floor or ceiling. An indexed annuity’s growth is based on the performance of an index, but with a floor and a ceiling, usually 0 or 1% and somewhere between 9 and 15%. Said floor and ceiling being before fees, of course.

Posted by CavelCap | Report as abusive

Thanks, Felix, for the lengthy comments and insight!

I’m still struggling with the rationale for a payout annuity of any sort, though I guess it depends on your personal situation. A $1M joint life annuity at the age of 60 promises a little over $50k annually, just a 5% draw rate. Index that for inflation and another third is lopped off.

How is this superior to a 3.5% dividend portfolio built from high-quality stocks? I guess the annuity is a LITTLE more certain to actually produce that income, but if we hit an economic crash severe enough to cause JNJ, KO, and PG to slash their dividends, I can’t see many insurance companies surviving. And when you annuitize, you lose all control over the principal — especially the right to change plans if your circumstances (or health) changes.

I could see an annuity making sense for a single individual with good health and “just enough” to make ends meet. But for a couple retiring in their early 60s, there is a good chance that SOMEBODY will need the income for a very long time. And the principal amortization under those assumptions is sufficiently low that it gets entirely eaten up by the fees. Which leaves just investment returns to support the annuity payments. Investment returns from a highly conservative portfolio that can be easily duplicated WITHOUT the high fees.

Am I missing something or are annuities the biggest sell job around?

Posted by TFF | Report as abusive

“What Gibbs doesn’t do is raise any hope that the Consumer Financial Protection Bureau or anybody else will start regulating and cracking down on the index annuity racket. Insurance regulators are reasonably good at regulating the sale of genuine insurance products. But index annuities are not insurance products, they’re financial investments. And they should be regulated as such, by a federal regulator.”

Great article felix! The Consumer Financial Protection Bureau SHOULD be able to umbrella anything that is NOT covered by the SEC that falls under its heading… Consumer Financial Protection …

Posted by hsvkitty | Report as abusive

First, let me say that Index Annuities are excellent products. I too am angered by how these products are sold to individuals without first educating them on what the products can and can’t do and without providing proper disclosures. It makes my job more difficult when I have to overcome what my so called ‘peers’ are doing. It is doubly difficult when flawed and biased articles as these abound.

When used appropriately, index annuities offer a viable alternative in the marketplace and my clients have been satisfied with the safety and results. I think it is a slanted and uneducated view to condemn the entire industry based on a few crooks. Whether it is the SEC or insurance regulators, we’ve seen failures and ‘Bernies’ on both sides.

These are not securities products as anyone who understands the mechanics of an annuity would quickly see. This is clearly not the case of this contributor. The SEC failed to regulate these products as securities as it desired due to the fact that they are not securities. 151-A was overturned for a reason and I recommend thorough understanding before condemnation or in the case of my so called ‘peers’ misselling.

Posted by Acceleratekc | Report as abusive

I am surprised nobody has really challenged the facts about this article. This is simply another hit-piece on Annuities that is a disgrace to all investors who are attempting to educate themselves of their financial options via online articles.

I would like to undercut this article in one swoop, so here goes: “If you die early, you lose out (but don’t need the money any more)”

You are simply talking about a SPIA, which, if you had any knowledge of annuities (which are only manufactured by Insurance Companies who actually back every dollar in reserves) you would know that carriers rarely sell these anymore… You do not mention the all important Income Rider, which never stops paying. If you die, your beneficiary receives the remaining funds. However, you can purchase a death benefit rider and receive your full premium in return.

The simple fact is… this author spends a lot of time writing about one or two sketchy investment firms who have nothing to do with working directly with carriers (as I am an agent and work directly for carriers) and instead of leaving you with a positive impression of Annuities – as they are probably the safest and most profitable investment you can make, especially if you are over 50 – he leaves you with no knowledge of how this investment actually works… and leaves out all the ample amounts of research and proof that experts say is the best investment you can make. Warren Buffet and Ben Bernanke own Indexed Annuities.

Hmm, but you probably didn’t know that because you don’t know anything about Indexed Annuities, do you? That’s a rhetorical question. I already know you have your own agenda :)

Posted by film9944 | Report as abusive

I read this article which is linked in when you click on LISA GIBBS hyperlink name at the beginning of the article. Funny how she has comments disabled so that no one can call her out for being a registered securities advisor who has a vested interest in keeping your money under management. Of course she will have nothing but negative things to say about Index Annuities. Lisa and Felix… millions of Americans are tired of being told to keep their money invested in the stock market, only to lose it during a financial collapse like we saw in 2001 and 2007. Lives have been devastated and security advisors like Lisa have been hiding products like the Index Annuity which is the ONLY product that allows the investor to still earn money based on the performance of the stock market, while at the same time guaranteeing they will not lose a penny due to the negative performance of the stock market. People are tired of being told that the market will bounce back, or spend less money… we are not sure when your money will come back, but everyone lost money during 01′ and 07′. There is nothing wrong with diversifying someones portfolio using Index Annuity and stock market investment products together, but you sound ignorant saying that everyone should stay away from Index Annuities. Why aren’t they regulated by FNRA? Hmmm, could it be because it guarantees that they WON’T LOSE A PENNY TO MARKET PERFORMANCE? All you make an investor do with market investments is sign a piece of paper saying that they could possibly lose all of their money. Whelp, I guess you are covered then. When my mother lost half of her life savings in 2007 her advisor told her… “well you knew the risk, you just need to spend less money for now until you earn it back, and you are going to have to post pone your retirement.” Give me a break. Crooks. She should have moved her money to an Index Annuity a decade ago.

Posted by DailyAdvisor | Report as abusive