In our August 21st post titled “Avoid Complex Investments”, we noted that “when investments are more complex, they often contain hidden fees or in some cases, carry higher risk.”

While we believe low-cost fixed annuities can be very beneficial, we have never been big fans of variable annuities or more recent annuity products called “indexed annuities”.

Indexed annuities come in many different flavors. In general, however, they guarantee a minimum rate of return and the possibility of returns tied to the stock market if stocks return more. Investors who are very risk averse are attracted to indexed annuities as a means of avoiding losses. In times such as we have experienced the last couple of years, products that guarantee a return can be quite attractive.

In our opinion, indexed annuities are somewhat complex products. So much so, that it can be very difficult to understand them or compare one to another. And, if you can’t easily understand the product, how do you know whether the guaranteed return is sufficient for the cost involved? New York Life Insurance Company, in fact, doesn’t sell indexed annuities, in part because they are too difficult to understand.

An article in the Wall Street Journal titled “How Well Do You Know… Indexed Annuities?” (September 2, 2009), noted some of the typical features. Below are some of the more interesting facts about indexed annuities included in the article:

(1) They return the higher of a fixed interest rate or an amount tied to a market index, such as the S&P 500 Index.
(2) They contain restrictions on how much of the index’s gain you get to keep. It could be a fixed percentage (e.g. 80%), a cap such as a maximum of 8%, or an amount less than the index’s return ( e.g. 3% less than the index)
(3) They often include steep surrender charges (sometimes as much as 10% to 15% in the first year).
(4) Many of the products allow insurers to change the contract rules after purchase.
(5) Usually, equity dividends are not included in the index portion of the return. Dividends have historically been a significant part of total equity returns.
(6) Some contracts guarantee the minimum return on only a portion of the amount invested (e.g. 90% or 85% of what you invested).
(7) Commissions generally range from 6% to 10% of the amount invested. You don’t pay the commission (the insurance company does) but it affects your total return and can incent the sales agent to sell you something that is not appropriate for you.

As you can see from the above facts, the devil is in the details. We believe that unless investors are extremely risk averse, they will be better served over the long run with a well-diversified portfolio that utilizes low-cost no load mutual funds, index funds and exchange-traded funds (ETFs).