Market upside without the risk

Beware of annuities promising high returns at low risk. Most clients would do better investing on their own.

By The Mole, Money Magazine's undercover financial planner

(Money Magazine) -- Question: In "The truth about can't-lose funds," you did a good job of making fixed-indexed annuities (FIAs) look totally worthless.

I provide FIAs to my clients, and I think several of your comments are not based in fact. FIAs are not appropriate for everyone but they do have their place. An FIA will not make you rich, but it is not intended to do so.

What is your recommendation for the client that wants market participation without risk?

The Mole's answer: You are referring to my November 8 column about an insurance product called an equity-indexed annuity, a type of fixed income annuity that promises upside stock market participation without any downside risk.

I am not against all fixed-income annuities, but I am against equity-indexed annuities because the premise of these products is essentially to try to cheat capitalism.

I agree with you that equity-indexed annuities are not appropriate for everyone. In fact, I've never found them to be appropriate for any of my clients.

When you look under the covers of this type of annuity, you usually find two things:

• Complex terms and formulas that make it hard for the consumer to understand how payments are calculated.
• A clause that unilaterally lets the insurance company change the payment terms of the agreement.

Further, since the insurance company is invested mostly in bond-type instruments, the returns will be similar to those of bonds, which are generally much lower than stock returns. Returns are further reduced by commissions, marketing and operating costs, and insurance company profits.

Bottom-lining it, these types of annuities are good for those who sell them, but not so good for the consumers who buy them.

What do I tell the client who wants market participation without risk? Well, plain and simple, you can't have it both ways. But capitalism says that if you take a smart risk with your money, you should expect a long-term real profit.

So I try to assess my clients' willingness and need for risk, and help them to take smarter ones. One way of taking a smart risk is by keeping costs low. That's why the type of annuity that pays handsome commissions to the planner that sells it doesn't fit in with my clients' goals.

I do, however, have a solution for someone wanting to maximize their participation and minimize their risk. Let's use a $10,000 investment as an example and spread it out over two low-cost investments.

• The client puts $5,744 into a 10-year CD paying 5.70 percent annually. In ten years, this CD will mature with a $10,000 balance.
• The client puts the other $4,256 in a total stock market index fund with fees as low as .07 percent annually.

The first part of the investment ensures that the consumer is guaranteed their money back and that guarantee happens to be backed by an agency of the U.S. Government (FDIC) rather than a private insurance company. The second part reaps the benefits of the stock market.

Even if the stock market stays flat, which is statistically very unlikely over a 10-year period, you still get back $10,000 from the CD, plus the $4,256 investment, which averages out to a 3.6 percent annual return. A much more realistic 9 percent average annual stock market return yields a combined 7.2 percent average annual return for the entire build-it-yourself product.

The higher returns are attributed to rock bottom costs. You also get the lower tax rates from long-term capital gains, and you can even defer the CD interest payments by putting your CD in your IRA account.

Now you may be asking, if this strategy is superior to buying an equity-indexed annuity, why isn't it more popular? The fact that no one has the economic incentive to sell it is exactly why it's so rare. The book "Freakonomics" explains the consequences of economic incentives, not the least of which is that the-do-it-yourself strategy doesn't pay people to sell it or bear the high costs of marketing glitz.

In my view, it's critical to know the client before designing an appropriate portfolio, so it's hard to confirm that a single investment is good for a client. It is far easier, however, to recognize a product is not good for a client since there are usually low cost alternatives that better meet client risk and return goals.

I suspect you and I will have to agree to disagree on this one and you will continue selling these annuities and I will continue to recommend against them. I sure appreciate your letter. I have received many letters from those that sell annuities, and allow me to say that yours was one of the few that could be printed.