“If it doesn’t make sense, it’s usually not true.” Judge Judy Sheindlin
I hear all the time from diehard investors and salesmen of annuity products that “the stock market is nothing more than rolling the dice at Vegas!” To which I always respond, “Really? I didn’t realize we had that many compulsive gamblers in the world.”
My reply tends to get a very awkward look, because I force those investors and salespeople to logically assess their arguments. For their statement to be true, logic dictates that my response is true as well. Logic is the ultimate advisor weapon in the war on fear and misperceptions. In this and my next blog for ThinkAdvisor, I’ll apply logic to some issues that you and your clients face.
For example, let’s apply the concept of logic to “indexed annuities.” I personally believe they’re a sales gimmick, and really nothing more than a structured note or hedging strategy loaded with huge fees and surrender lockups which may, or may not, have some value within a portfolio. However, they’re often sold as the “Holy Grail” or “silver bullet” investment, with many salespeople recommending investors allocate far too large a portion of their assets into the investment.
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So what’s wrong with them? Better yet, what does logic say about index annuities?
Logical Response to Index Annuities No. 1
Most index annuities are tied to an index, such as the S&P 500. The sales idea is that if the stock market goes up, you get the upside return, but if the stock market goes down, you don’t lose anything. At least that’s how they’re marketed and sold. However, that’s not exactly true; logic and truth tells a different story.
An annuity, by definition, is a product or contract, created and sold by an insurance company, based on the agreed terms of the annuity contract. The investor is not actually investing in the S&P 500 directly or even indirectly. Logically, you can’t buy the S&P 500 and buy an annuity contract with the same dollars. Furthermore, most all indexed contracts limit the downside stops of not losing anything in bear markets by internally limiting how much upside percent of positive years the contract actually pays. Most limits range from 70% to 80% of the positive year returns.
Remember, with an indexed annuity, you’re not really investing. Rather you’re agreeing to a contract’s growth and return stipulations, which in this example is somewhat tied to the S&P 500 performance.
Logical Response to Index Annuities No. 2
An S&P 500 indexed annuity is indexed to the price-only index, which tracks the price change/ appreciation only, excluding all dividends from the 500 companies. Contrast that to the real S&P 500, which is a total return index, including all the reinvested dividends and price appreciation of all those companies.
So if you purchase an indexed annuity contract tied to the S&P 500, are you entitled to the dividends from all the companies included? The answer is no, because with an annuity contract, you don’t actually own any direct shares of those companies. In truth, the only thing you own is the right to the contract’s growth and return stipulations you agreed too.