Watch Out for Structured Annuities

My car radio is always tuned to the Baltimore sports talk radio show. So on Saturday mornings, I sometimes catch a certain financial radio show that preempts the sports shows.

The hosts of the show are pretty good — they seem to know their way around the economy and the stock market. But they consistently pitch a product that is simply too good to be true.

It’s a retirement income product. Depending on how much you put in, you get an instant bonus of as much as 15%. And their sales pitch for the product says it pays you a guaranteed baseline amount, but that baseline amount can be more if the S&P 500 rallies for the year. 

In other words, you get a bonus, you get guaranteed income, plus you get all the upside of the S&P 500 but none of the downside…

Do the words TOO GOOD TO BE TRUE mean anything to you? 

Because that’s what this product is: too good to be true.

Structured: That Word Doesn’t Mean What You Think It Means

This guaranteed income product that’s being pitched is a structured annuity. And while it’s true that an annuity will give you guaranteed income, it is very likely to not be as good as it sounds. 

First off, it’s an annuity. That means you’re not going to get your initial investment, the principal, back. In essence, when you buy an annuity, you are buying a steady income stream that adjusts for inflation. An annuity is an insurance product. It works like any insurance: the company invests your money at, say, 5% to 8% and then pays you maybe 4% of it a year for as long as you live. 

The risk for the insurance company is the same as with any insurance policy. They are betting that they can make more money off your money than you will ever collect. On an individual basis, they may be wrong. But if you’re familiar with how actuarial tables work, you know the insurance company will always get the better end of the deal every time. I mean, if they weren’t making money off it, they wouldn’t offer it, right?

But of course, people like security. They like to know that they will be safe, that another financial crisis won’t come along and wipe them out. The companies that offer annuities know this. And they prey on that fear…

These companies also understand greed. And that’s why they’ve come up with structured annuities. A structured annuity ties the performance of the annuity to some benchmark, like the performance of the S&P 500. (There are also certificate of deposit products that do the same thing. There were some structured CD products that used gold as a benchmark: If gold went up, you made more. I don’t think they’ve done very well over the last few years.)

So if you buy a structured annuity that’s benchmarked to the S&P 500, you are promised that you will be paid more if the S&P 500 rallies, but you will never be paid less if the S&P 500 has a down year. All of the safety and upside, none of the risk…

Better Read That Fine Print

Here’s the thing: When Wall Street pitches structured annuities and CDs to people, they are likely to be benchmarked to a “proprietary” index. What’s a proprietary index?

Well, it’s an index that the investment bank creates on its own. A proprietary index may sound like it will be the same as, say, the S&P 500 or the price of gold, but they often have differences that mean there will be a significant difference in performance. (Deutsche Bank had a proprietary index named the Liquid Alpha USD 5 Total Return Index. What the heck does that mean?)

Wall Street salesmen will show a prospective buyer how a structured annuity has been backtested against a proprietary index. One study showed that proprietary indexes averaged 9.5% annual gains when backtested. But in reality, once the proprietary index went “live,” performance was actually around 2.5% a year.

If you’re counting on income, the difference between 9% and 2.5% is significant. 

Bloomberg reports that Wall Street sold around $3 billion of these structured annuities and CDs that were benchmarked to a proprietary index in 2015. That may not sound like a ton of money unless you bought one. 

And if you bought one, you might have paid some ridiculously high fees. These structured products can carry fees as high as 3% a year!

With Wall Street, it’s always about the fees. And if you get sucked into an investment that comes with high fees, there’s just no way you’re going to get the performance you need. 

So please, always pay attention to the fees, whether it’s a mutual fund, annuity, or any other Wall Street financial product.

Who is Wall Street?

I get the feeling there’s a lot of misconception about who Wall Street really is. Many people I talk to think Wall Street rules anything financial: stocks, the stock market, bonds, any mutual or hedge funds, even their personal IRA accounts.  

But for the most part, Wall Street is a bunch of salesmen and women who sell bonds and complicated products like credit default swaps to big institutional investors like pension funds. In a very general sense, individual investors are just too small game for the big investment banks. 

If you simply buy stocks or Vanguard Index funds, you’re not putting yourself at the mercy of the Wall Street sharks — likewise if you have a financial advisor.

There are a lot of ways you can avoid being hoodwinked by Wall Street…

Remember, if it sounds too good to be true, it probably is. Always be skeptical when you hear that something has been “backtested.” And most important of all, make sure you know about all the fees.

Some investments have initial commissions, then annual fees, and even fees if you sell before a certain amount of time. Make sure you find out about all of these before you buy something, and you’ll do ok.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.