An illustration showing $100 bills and indexed annuities

Financial planners and regulators are increasingly warning consumers to think twice about buying a popular annuity that promises better-than-average returns but carries high fees.

Sales of indexed annuities, as they are known, have soared in recent years as insurance agents and brokers pitch the product as a way for investors, particularly older Americans, to boost their retirement income.

The problem is that the annuities are extremely complex, carry high fees and surrender charges, and often fall short of their promised returns.

“These annuities are like investment timeshares,” says Tony Isola, a certified financial planner in New York City. “You can’t get out of them easily, the costs are high, and the salespeople are often misleading about your returns.” 

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Isola has clients in their 70s who were sold indexed annuities and have to wait until age 80 to exit without paying surrender fees, leaving them little free cash for emergencies.

“They really didn’t understand what they owned,” Isola says.

The insurance industry, by contrast, says indexed annuities offer investors an opportunity to beat the returns of regular annuities and other fixed-income instruments.

“This has been a strong stock market, and anyone near or entering retirement doesn’t want to lose the principal they’ve gained over the years,” says Michael Morrone, vice president of annuity product strategy at Nationwide Financial, an annuity and insurance provider. “For customers who don’t want the volatility of the market but want more upside than fixed income investments provide, indexed annuities are very valuable.”

The increased marketing has had a big impact. Sales of indexed annuities hit a record $20 billion in the second quarter, 18 percent higher than the prior year, according to LIMRA Secure Retirement Institute, an industry research group. LIMRA projects sales of indexed annuities will exceed $70 billion by the end of 2019.

The surge in sales recently prompted the Securities and Exchange Commission to issue an investor bulletin explaining the risks of indexed annuities.

“We are seeing an increase in the number of filings and sales of these products,” Lori Schock, director of the SEC’s Office of Investor Education and Advocacy, said in an email statement. Schock also says that the agency sees a need to provide nonbiased, accurate information to help educate investors.

On the local level, some state securities commissioners have noticed an increase in insurance agents who aren’t licensed to advise on securities improperly recommending sales of investments in 401(k)s and individual retirement accounts in order to roll over that money into indexed annuities.

“There have been more of these cases in Vermont and in other states, many of them involving seniors,” says Michael Pieciak, president of the North American Securities Administrators Association and commissioner of the Vermont Department of Financial Regulation. “At NASAA, we are going to prioritize it as an issue that we’ll be looking into.”

Complexity and Costs

Unlike regular annuities, which give a fixed payout, returns on indexed annuities rise and fall with the stock market. But these annuities don’t invest in stocks. Instead, that money is invested in bonds and stock options, and your returns are based on a formula linked to an index, says Sheryl Moore, president and CEO of Wink, a life insurance and annuity research firm in Des Moines.

So even if the stock market posts strong gains, your return may be considerably less. Indexed annuities often cap your payout, sometimes at 6 to 8 percent, not including dividends. That means if the stock market climbs 12 percent, you may earn just 6 percent. These terms may change, depending on guarantee periods and economic conditions.

“With indexed annuities, the simple question of ‘what am I getting for my money’ is very hard to answer with a high degree of confidence,” says Glenn Daily, a fee-only insurance analyst in New York City.

Investors do receive downside protection, typically in the form of a minimum guaranteed rate of return or a promise that you won’t lose money, even if the market falls. That minimum return may range from 0 to 3 percent.

But indexed annuities carry fees or spreads, which may take 2 to 3 percent annually out of your returns. Most also impose surrender charges, perhaps 10 percent of the account value, which typically don’t expire for 10 years, Moore says. (For tips on minimizing investing expenses, see “How to Avoid Investment Fees,” which is part of Consumer Reports’ What the Fee?! campaign.)

“In the end, you may be getting a net return that is closer to a bond or CD than the stock market,” says Scott Dauenhauer, a certified financial planner in Murrieta, Calif.

Conflicts of Interest

Still, these costs and complexities are typically hidden in the fine print of the annuity contracts.

“You may not hear about these conditions from the annuity salesperson pitching investors at the free lunches or dinners for retirees,” says Micah Hauptman, financial services counsel at the Consumer Federation of America, a nonprofit group.

The annuity salesperson—often an independent agent representing multiple carriers—has a strong incentive to get you to sign because the commissions may amount to 5 to 8 percent of the sale.

As further incentive, agents who hit certain sales targets may also receive cash awards, free trips to vacation resorts, or other bonuses, according to a 2017 report [PDF] by Senator and presidential contender Elizabeth Warren, D-Mass.

An Obama-era rule instituted by the Labor Department would have banned some of these incentives for advisers working with retirement accounts and required disclosure of conflicts of interest. It would have also required that the advisers act as fiduciaries, meaning that they put the customer’s interests first. The fiduciary rule was put on hold in 2018, however, and indexed annuity sales have climbed.  

Consumer Reports offers a charitable gift annuity, which is a common form of giving and different from indexed annuities. 

Consider Income Alternatives

If you are looking to create a steady stream of income in retirement, be sure to review all your options. Here are three possible strategies:

1. Make the most of Social Security. The best annuity you can find is available from Social Security, which pays you a steady stream of inflation-adjusted, guaranteed income over your lifetime, says Steve Vernon, author of “Retirement Game-Changers” and consulting research scholar at the Stanford Center on Longevity in California. 

Before claiming, however, be sure to compare the impact of filing at different ages, because each year you wait to file, your payment increases until maxing out at age 70. (To find out your benefit at different ages, go to my Social Security.) You will also want to coordinate your strategy with your spouse.

For those who intend to claim early, buying an annuity doesn’t make sense, Vernon says. Instead, he recommends using the money you would have spent on an annuity as a Social Security bridge strategy, covering your expenses to delay claiming by another year or so, which can significantly increase your benefit. 

2. Design a portfolio withdrawal strategy. Another option is to build a diversified portfolio of stocks, bonds, and other fixed-income assets, using low-cost investments, such as index funds. Then choose a withdrawal rate that will ensure you won’t run out of money for 30 years.  

Your withdrawal rate should be geared to your financial circumstances. But as a rule of thumb, consider withdrawing 4 percent initially, then adjust that amount for inflation in future years. The 4 percent strategy has held up historically in bad market environments, says Michael Kitces, a certified financial planner and director of wealth management at Pinnacle Advisory Group in Columbia, Md.

3. Focus on low-cost annuities. If you need additional guaranteed income from an annuity, perhaps to cover certain essential expenses, don’t overdo it. As a guideline, Isola suggests investing no more than 20 to 25 percent of your portfolio in one. Most investors should stick with a simple, low-cost option, such as a single premium immediate annuity, which gives you a regular monthly check when you invest a lump sum. (You can compare rates at ImmediateAnnuities.com.)

Editor's note: This article was updated to say that Consumer Reports offers a charitable gift annuity, which is a common form of giving and different from indexed annuities.