Is your Advisor a Fiduciary?

What is a Fiduciary?

A fiduciary is a person or organization that acts on behalf of another person or persons, putting their client’s interest above their own in all instances. Being a fiduciary requires being bound, both legally and ethically, to act in their client’s best interest. In essence, they are the guardians of their client’s money.

Commissioned salespeople are not considered fiduciaries because they are representing a product or a company, not the individual to whom they are selling a product, and they are not bound by the higher ethical standard of a fiduciary. Commission salespeople follow a different suitability standard in which the transaction must be suitable for a client, not necessarily the best solution. The commissions they earn can create a huge conflict of interest which effectively eliminates them from the fiduciary standard.

All too often, individuals trust advisors that promote themselves as fiduciaries, only to get talked into buying high-commission/high-fee annuities or real estate investment trusts by these same advisors as these advisors fail to live up to fiduciary standards. Sadly, many investors fall prey to the unethical, yet legal, practices of financial advisors who promote themselves as trusted fiduciaries as a door opener to selling expensive, inappropriate, big commission products to the unsuspecting public.

Unfortunately, some investment advisors are allowed to wear multiple hats at the same time, which allows them to be fiduciaries for a part of a client’s money that they manage, and a commissioned salesperson for the balance of the client’s money. It is not right, it makes no sense, but that is how it works.

Who regulates – or better said, doesn’t regulate –  Advisors?

The Securities and Exchange Commission (SEC) typically oversees the activities of the fee-based fiduciary while another regulator, the Financial Industry Regulatory Authority (FINRA) oversees the activities of the broker-dealers who are typically those persons and firms that are commissioned salespeople. Additionally, the State Insurance Commissioners oversee the sale of commission-paying insurance products such as annuities within their respective states.

The problem lies in the fact that the SEC is only interested in the activities of the advisors relating to the advisor’s roles as fiduciaries and does not pay any attention to the non-fiduciary sales activities that are being carried out by the advisors.

So, the sale of commissioned securities and insurance products by a fiduciary is not their concern as they view these activities outside of the scope of their jurisdiction. The deception takes place when advisors advertise themselves as fiduciaries, draw clients into their offices, then act as fiduciaries for a small amount of the client’s assets (10%) and then proceed to sell the client big commission products that are not in the best interest of their clients with the rest (90%) of the client’s money.

As I listen to the radio and see advertisements online, it is usually these bait and switch types of advisors that are promoting themselves as fiduciaries. Buyer beware, you need to do your homework.

How can you tell if an Advisor is truly a Fiduciary?

1. Check out the firms Form ADV and CRS. Form ADV and CRS are the uniform documents filed by investment advisors to register with the SEC. They will let you know how a firm is compensated and will identify conflicts of interest such as receiving commissions in the sale of investments and/or insurance products. You can find a firm’s Form ADV and CRS on the SEC website www.adviserinfo.sec.gov. If the firm, or advisor you are investigating, earns a commission by the selling of an investment or insurance product then I would suggest avoiding that advisor. They may be “fee-based” which means they act as a fiduciary for some of the client’s money they manage but in the end, they are commissioned salespeople.

2. Know that any product that has a surrender charge, or limits your access to your own money, pays a commission to a salesperson. When an insurance agent sells an annuity, they get paid an upfront commission typically of 6-7%. So, if the agent talks somebody into investing $100,000 in an annuity, the insurance company pays the agent a 6% commission or $6,000. So how does the insurance company protect themselves from losing money on this transaction? Insurance companies place a surrender charge on the annuity that keeps the purchaser from liquidating the annuity for a specified number of years, or at a large cost if the annuity is surrendered prior to when the stated surrender charge expires. This allows the insurance company to recoup the upfront $6,000 commission they paid by collecting large management fees for a number of years or the investor reimburses the insurance company in the form of a surrender charge if they surrender the product early. You are unlikely to get stung as long as you never place your money into a product that charges a fee to withdraw your own money or that imposes a timeframe that limits your ability to withdraw your money.

3, Search Google for a list of “fee-only” investment firms in your area. “Fee-based” advisors are not always true fiduciaries as part of their income comes from selling commission-paying products. Fee-only advisors are compensated by an agreed upon fee and don’t accept, or are even licensed to receive, commissions.

Unfortunately, I don’t see the regulatory environment changing anytime soon and vulnerable investors will continue to be duped by advisors, who claim to be fiduciaries but fail to act as fiduciaries by selling high commission investments and annuities to the public. This travesty will continue as long as the multiple regulatory bodies and insurance commissioners limit their focus on their own perceived jurisdictional responsibilities while ignoring the big picture of what is taking place with the client’s investment portfolios.

If you want an advisor that is truly a fiduciary, one that always acts in your best interest, then it’s critical to understand the potential conflicts of interest that exist in the investment industry before hiring any advisor. My best advice is that you should limit your search for a fee-only advisor whose investment philosophy matches your own.

This Time Really Isn’t Different: What to do When the Stock Market Crashes

Anytime the blended price of America’s 500 largest companies (S&P 500) drops by 34%, you know that there is something significantly wrong going on. This is the fourth time we have experienced this magnitude of decline in my thirty-four year career and every time such an event comes around, we tend to surmise that, “this time it is different”. We conclude this because the details of each crisis are fundamentally different from anything we have before faced.

Thus, the COVID-19 pandemic, and the economic panic it has engendered, seems entirely unique in our history. Moreover, we are without historical precedent as the equity markets become unmoored from valuation fundamentals. We have no idea how the pandemic will affect the earnings of corporations nor how much future dividends will be cut. Furthermore, we don’t really have an idea how long it will take for the economy to stabilize and return to a sustainable path of growth. We are mired in a bog of uncertainty as to how the immediate future will play out.

During times of uncertainty and fear, human nature defaults to the conclusion that our current crisis is fundamentally, and even fatally, different from past bear market episodes. That has always been human nature’s rationale for not staying the course and selling out in a panic. This fear of uncertainty caused the epic selloff in February and March when the stock market dropped 34% in thirty three days.

As I think about the three analogous bear markets of this magnitude that I have experienced during my tenure, I recognize that even though each is radically different in its particulars, each was fleeting in its long term effects once we got through them. The three events I am referring to are the Global Financial Crisis of 2008-09, the terrorist attacks of September 11, 2001 and the stock market crash of 1987.

Global Financial Crisis of 2008-09

During the Global Crisis of 2008-09 the world’s financial system found itself over-leveraged and holding trillions of dollars of worthless mortgage derivatives. Under this burden, the credit system broke. Many of the nation’s largest banks, brokerage firms and insurance companies were teetering on the brink of bankruptcy. In response, the S&P 500 declined 57%, making it the worst equity wipeout since the Great Depression. Liquidity was gradually restored, bad loans were written off and from the market trough of March 2009 to the market’s peak in February of 2020 the S&P index delivered an annualized return of 16.7% and stood almost five times higher in 2020 than its 2009 level.

The Stock Market Crash Following 9/11

As the nation reeled from the events of 9/11, Americans feared that World War III had begun. We waited for the next surprise attack fearing that the next one might be nuclear. The stock market was closed for a week and America was convinced that life as we knew it would forever be changed. We will never forget what transpired on that infamous day yet, economically and financially, 9/11 ended up being just a temporary distraction.

Black Monday, October 1987

On a beautiful fall day in October of 1987, the stock market had its single worst day in recorded history. The S&P 500 plummeted on Black Monday by 23%. Nobody understood the drop and we all wondered if this was our generation’s crash of 1929 and the ushering in of our very own Great Depression. I remember a couple of investors shooting their stock brokers while other distraught investors jumped from buildings and bridges. As disturbing as the events of Black Monday were, the stock market quickly rebounded, ushering the unprecedented growth that was experienced from the date of that crisis until the year 2000.

Today it is difficult if not impossible to envision that the financial effects of the COVID-19 pandemic will soon be a distant memory, a mere paragraph in a history book that will be added with the other Black Swan events of our times. This will happen because there simply is no other option. There are 330 million hungry American consumers and almost 7 billion additional consumers worldwide that will keep the market’s permanently marching on to new heights. The human race is too adaptable, too motivated, and too ingenious to let terrorism, viruses, or come what may derail our progress. There will be other crisis, there always are, but history has proven that whenever the human race is faced with a challenge, we ultimately overcome the challenge and move on.

Thus, the lesson of this crisis, as well as every other crisis past and future, is that although the exact nature of every crisis is unique, the resulting economic and financial impact of these crisis are remarkably similar and remarkably negligible. Long term investors cannot allow themselves to buy into the most destructive and expensive phrase ever uttered….. this time is different. “This time is different” will forever be the anthem of the failed investor and we can’t allow that phrase to creep into our psyche. History has proven that it is a losing proposition to bet against the ingenuity and indomitable spirit of the human race to succeed. We will overcome COVID-19, and this soon will become just another blip on a chart.

Stay the course, and remember that this time really isn’t different!

Strategic Opportunities in a Market Decline

“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.” – Winston Churchill

As I watch the emotional reaction of investors during market turbulence, I concur with Churchill as I see individual investors categorize themselves into two separate camps. They are either victims or they are opportunists.

Beyond reminding the self-prescribed investment victim of the overwhelming historical evidence of the resiliency of the stock market, there is little that can be done to save them from themselves as they panic and sell as markets decline. Therefore, let’s not waste our time discussing how to rescue the lemmings as they throw themselves off a cliff

Let us focus instead on the positive steps that can be taken by an investment opportunist when stock markets retreat. There is so much that can and should be done in every financial crisis. The prepared opportunist can turn today’s temporary stock market lemon into tomorrow’s lemonade.

An investment opportunist recognizes that every downturn is temporary, every bear market is eventually followed by a bull market, and that the stock market will eventually go on to reach new record highs. There has never been an exception to this pattern, only the timing and duration of the bear and bull markets is uncertain.

Six ways to take advantage of a temporary market downturn:

1. Roth IRA Conversion

A traditional IRA will someday be taxed while a Roth IRA grows tax-free. Therefore, Roth IRAs are more advantageous to own than traditional IRAs. You can convert a traditional IRA to a Roth IRA, but you must pay income tax on the entire amount of the traditional IRA that you convert. So, let’s say you own 10,000 shares of ABC stock that are priced at $10 per share. The value of your investment is therefore $100,000. If you were to convert these 10,000 shares at the $10 price you would need to pay income tax on the $100,000 converted to a Roth IRA.

In a down market, an opportunist would realize that his ABC stock is now only worth $7 per share. If he were to convert all 10,000 of his shares that are now worth only $70,000, he would only have to pay tax on the $70,000 Roth conversion, not the full $100,000. When the price of ABC stock rebounds to $10 per share our optimists would have $100,000 worth of Roth IRA value but they would have paid tax on $70,000 worth of Roth IRA conversions.

2. Refinance Your Mortgage

When the stock market recedes, it is common for the Federal Government to step in and attempt to jump-start the economy. They do this is by reducing interest rates. This move will often temporarily reduce mortgage interest rates. The opportunist would jump at the chance to refinance their mortgage because a thirty-year, $300,000 mortgage with a 3.5% interest rate costs $60,000 less over thirty years than the same mortgage with a 4.5% interest rate.

3. Fund IRA/Increase 401(k) Contributions

An easy way to take advantage of a temporary market downturn is to contribute additional funds to retirement accounts. We have all heard the maxim, “buy low, sell high”. Well, then buy when equities are selling at a discount.

Some of you will remember the years 2000-2009 which was the worst decade for investing since the great depression. Large stocks ended the decade at the same levels that they began the decade. That’s right, ten years with zero growth. The pessimist would say, “I am glad, or I wished, that I missed out on that disaster”. Meanwhile, for the opportunist, this decade was a wonderful investment opportunity! As markets went down the opportunist systematically purchased depleted equities in their 401(k)s and IRAs at a substantial discount. These once depleted shares are now worth 400% of their 2009 value and that’s taking into consideration the latest downturn.

Those who make annual contributions to retirement accounts should contribute when markets plummet. Those who systematically contribute to 401(k)s should consider reallocating conservative investments within their 401(k)s to equities and/or increasing their 401(k) contribution rates.

4. Rebalance Your Portfolio

There is proven value and additional security when investors diversify their investments. Few would argue that diversifying or creating the proper mix of investments to accomplish specific goals is important. The challenge is keeping portfolios diversified. As markets fluctuate, portfolios get out of alignment as top-performing investments become a bigger allocation and underperforming investments shrink to a lesser allocation of the original portfolio mix. Rebalancing brings the investments back to the original mix. The process of rebalancing requires buying and selling securities which ofttimes create unwanted taxable gains. Rebalancing can be accomplished during market downturns with greater tax efficiency because the capital gains incurred are less as depleted equities are sold.

If it so happens that your rebalancing requires purchasing equities to bring your portfolio back to its original composition, then rebalancing adds additional value as temporarily beaten up equities are purchased at discounts.

5. Tax Loss Harvesting

Let’s say that Clara bought a mutual fund three months ago for $100,000. Because of the recent slide in equities, this investment is now only worth $80,000. Clara could simply hold on to that investment and wait for it to rebound to $100,000. There would not be any tax benefits or consequences by waiting for the depleted shares to rebound.

However, Clara is an opportunist and hates paying income taxes. She decides to sell the diminished investment and create a $20,000 capital loss which would benefit her taxwise. She then invests the $80,000 into a very similar investment to that which she sold and when the market rebounds she would still have the $100,000 of value plus a $20,000 capital loss that could save her several thousand dollars in income taxes.

6. Invest Excess Cash

The most important criteria to consider when deciding how to invest is time horizon, or how long money can be invested until it is needed. Money that will be required in the next five years for a purchase or for income should not be invested in equities because of the short-term volatility that accompanies the stock market. Money needed between five to ten years should be moderately invested into a mix of equities and fixed-income investments. Money that will not be needed for ten years and beyond should be invested in equities to help fight inflation. Market corrections provide opportunities to reassess portfolios and put money that is on the sidelines to work.

A Concluding Thought:

The richest men in the world, from every generation, did not get that way by betting against the ingenuity and indomitable spirit of the human race to create a better life for itself. Successful investors have always been richly rewarded for their willingness to invest in the future. This generation is no exception. Today’s optimists, or those willing to invest a better tomorrow, are thriving.

Creating Retirement Income from your Investments

At retirement once you have made thoughtful decisions about how to get the most out of your Social Security and pension, the balance of your retirement income will have to come from your investments. The distribution of your investments will need to be coordinated with these other streams of income for tax purposes, as well as to help you stretch your income out to last a lifetime.

We liken the accumulation and distribution of retirement funds to what a skier experiences at a ski resort. Riding the chairlift up the mountain is the easy part of skiing. It takes no skill, and even the most inexperienced skier can ride the lift without running into too many difficulties. The skier simply must stay on the lift and they will get to the top of the mountain. Just a warning: abandoning the lift could prove to be fatal.

Having a 401(k) is like riding the lift. A certain percentage of the worker’s check is systematically deducted by an employer, oftentimes matched, and then deposited directly into an investment portfolio. It is easy, even automatic. But, as abandoning the ski lift could prove to be fatal, not participating in a 401(k), or failing to invest into an IRA, will have catastrophic consequences.

New skiers once off the lift, are bound to have difficulties. Getting down the mountain can turn into a frustrating and even a dangerous endeavor to the novice skier. Help from an experienced instructor is invaluable.

Likewise, new retirees often make mistakes as they begin retirement, crashing, so to speak, as they make poor choices regarding their Social Security and pensions benefits. These mistakes can be compounded if investment accounts are not properly managed and distributed. The key is choosing a proper mix of investments and then properly liquidating those investments to provide an income stream that will last throughout retirement.

Accumulation Vs. Distribution

So, why is distributing retirement funds so much more difficult than accumulating funds? One only must go back to the decade 2000-2010 to understand how volatility in the stock market impacts the accumulator, versus someone who is retired and is distributing retirement funds. 2000-2003 were awful years for equities. The stock market declined by 49% before recovering. From 2004-2007, the stock market finally gained some momentum, then the worst market downturn since the Great Depression occurred in 2008-2009 (declining by 57%). The net result for the U.S. stock market was that it ended the decade in 2010 at about the same level as it started in 2000. Ten years without growth.

You might ask, how did this volatility and ten years of no growth affect the accumulator? Well, it was a wonderful blessing! Those of us who were systematically contributing to 401(k)s and IRAs from 2000-2010 were able to purchase greater quantities of equities as the price of stocks plummeted during the decade. Certainly, our account balances suffered temporarily, but as the share prices dropped, the number of shares we were able to purchase rose as we systematically purchased beaten-down shares of stock month by month. Once we had accumulated a bunch of cheap shares over the decades, the stock market shot up to record highs. Those downtrodden stocks we purchased so cheaply during the “lost decade” have now caused our account balances to explode with value.

Contrast this with what happened to the unfortunate retiree who was distributing investments during the first decade of the century. Many of those investors were forced to sell their equities at the worst possible time. They had no choice; they had to sell at a loss to provide the income necessary just to pay the bills. Many well-funded retirement accounts were devastated during this turbulent time.

Systematic purchasers of equities do well investing in volatile, down markets, while systematic liquidators of equities are crushed during down-market cycles. During 2000–2010, buyers were blessed, and sellers suffered. This decade perfectly illustrates the difficulty of accumulating retirement funds versus simply managing and distributing retirement funds. The good news is that there are plans that can be implemented to help protect future retirees from having to liquidate equities at a loss to create income, should you be unfortunate enough to begin your retirement at the beginning of a bear market. The Perennial Income Model which we created is such a plan and is further explained in other blog posts and in the video below.

The Need for Growth

Given the history of 2000-2010, you may think that you will just avoid equities altogether, so you will not be forced to liquidate those volatile investments in a down market. That will not work. Keeping ahead of inflation is essential to having enough income to last throughout retirement and equities are one of the few investments that will be a necessary component of your portfolio.

As we see things, there are only two categories of investments: fixed-income investments and rising income investments. Fixed-income investments are characterized as slow-growing and non-volatile investments such as bank deposits and certain types of bonds. Certainly, there is an appropriate time to own fixed-income investments. They should be the investment of choice when you have a limited time for your money to grow (less than five years) and you can’t afford to wait out a stock market correction. Fixed income investments protect us from short-term volatility but are damaging to own over the longer term, as they offer little protection against the erosion of purchasing power.

In the long run, the only rational approach to protect against the erosion of purchasing power is to invest in rising-income type investments, in other words, owning equities. As a shareholder, or the partial owner of some of the greatest companies in America, you have the rights to the profits those companies make. These companies pay their shareholders their proportional share of the profits in the form of the dividends. Historically, the dividend rate of the greatest companies in the world, or the S&P 500, has increased about one and a half times faster than consumer prices have gone up. In other words, their dividends have managed to stay ahead of inflation. Besides the growth of dividends, historically, stocks have additionally experienced a tremendous amount of growth in their value.

Stocks, Bonds, and Compound Interest

Government bonds are the classic fixed-income investment. They are very stable and are backed by the federal government. For the last thirty years, these bonds (as measured by the ten-year treasuries) have had an average annual return of about 5%. If $100,000 were to have been invested into these bonds in 1987, the value of that investment would be $460,000 today.

Meanwhile, stocks, the classic rising-income investment, have averaged more than 10% during the same time. $100,000 placed into an investment that mirrors the S&P 500 for the past thirty years would be worth $1,650,000 today. Inflation-beating growth is necessary to maintain your purchasing power over retirement, and that kind of growth is achieved by investing into equities.

When you purchase a share of stock, you become a partial owner of the company whose stock you purchased. As an owner of the company, you are entitled to all the profits and growth associated with that company, according to the proportional amount of the company that you own.

Land, cars, homes, and essentially anything that can be bought and sold on the open market will have a price that fluctuates. Buying and selling partial ownership or shares in corporations is no different than buying and selling anything else, but somehow the simplicity of the concept is lost when it comes to buying shares of stocks.

Far too many times we have had people tell us after a market downturn that they were not going to buy equities until things stabilized a bit and prices rebounded. That is like saying, “I’m not interested in buying that cabin for a 30% discount; real-estate prices are just too uncertain. When cabin prices stabilize, and the price goes back up 30%, I will write you a check.” We wouldn’t conduct any of our other business in this manner. Why do we treat our equity purchases differently?

Certainly, the daily selling prices of corporations fluctuate, but being an owner of a diversified portfolio of these corporations over a long period of time has been and will continue to be the recipe for success. The key to investment success throughout retirement is to have a plan. A plan that overcomes the effects of inflation as well as takes into account the occasional bouts of stock market volatility. You need a plan that matches your current investment portfolio with your future income needs.

 

Scott M. Peterson is the founder and principal investment advisor of Peterson Wealth Advisors. Scott has specialized in financial management for retirees for over 30 years. Scott is a regular presenter at BYU’s Education Week and speaks often at other seminars regarding financial decision making at retirement. He also literally wrote the book on retirement income, Plan on Living: The Retiree’s Guide to Lasting Income & Enduring Wealth.

If you are getting close to retirement and will have at least $500,000 saved at retirement, click here to request a complimentary copy of Scott’s new book!

The World’s Worst Investments – Gold and other precious metals, and Index Annuities

In past blogs, we have offered you some insight into the very temporary nature of a bear market as well as the illusion that equities are a dangerous place to invest. With these two blogs as a foundation, we would like to warn about certain types of investments that could do serious damage to your retirement. These investments not only have horrendous track records, but they are almost exclusively purchased as a result of an emotional reaction to a short-term downturn of the stock market or as an emotional reaction to the mere possibility that the stock market will decline. As we have seen again and again, when emotions and investing combine, there is seldom a good outcome.

In our estimation the worst types of investments you can buy are precious metals and index annuities. You may be very familiar with these products because these industries are the predominate advertisers on the cable news networks. One can surmise, from the sheer volume of these industry’s advertisements, that they must be very successful. First, they are successful in convincing the unwary public of the virtues of fleeing the stock market and also in duping the public into buying their perennially underperforming products.

The argument against buying Gold and Precious Metals

The thinking is that if, for whatever reason, countries and their currencies cease to exist, then precious metals will be one of the few items that will hold value and preserve purchasing power. The question is, “To purchase what?”

If all the currencies of the world had no value, the world would be in utter chaos. Anarchy and revolution would rule. This has never happened on a large scale in the history of our world, so nobody has a credible idea of what a world without currency would look like. There would be no manufacturing, no food production, and no police or armies to protect us. There would be no commerce—that’s right, stores would be shuttered. Why would anybody choose to work if there was not a way to be paid for labor rendered?

So, even if your ounce of gold held its value, what could you buy with it? Where? How? In our estimation, a homemade meal would be worth more than an ounce of gold, if you were fortunate enough to locate the food and a willing cook to put it together for you.

Doomsday predictions and conspiracy theories have never been a friend of the disciplined investor and at Peterson Wealth Advisors, we simply refuse to fan that flame. If, however, you are one of those who thinks that chaos and revolution are the destiny of our society, you might as well step away from the computer and get back to building your bunker. But before you go, we would like to share with you one important thought. The richest men in the world, from every generation, did not get that way by betting against the ingenuity and indomitable spirit of the human race to create a better life for itself. Successful investors have always been richly rewarded for their willingness to invest in the future. This generation is no exception. Today’s optimists, or those willing to invest in a better tomorrow, are thriving.

For those of you who are not planning on living in a bunker, but are considering owning some gold, perhaps as an inflation hedge, let us share with you some facts.

First, although touted as an inflation beater, gold does not keep up with inflation. In 1980, the price of gold was $850 an ounce. The price started a decline over the next twenty years and bottomed out at less than $300 per ounce at the start of the new millennia. It then shot up during the first decade of the century, peaking at over $1,800 per ounce in 2018, and now has settled back to about $1,300 per ounce.

With all its volatility, gold has gone from $850 an ounce to $1,300 an ounce over thirty-seven years. That works out to be a rate of return of less than 1% per year. Meanwhile, the cost of goods and services, or inflation, grew by 3.1% annually. The price of gold does not keep up with inflation and no matter how many times the lie that “gold is an inflation fighter” is repeated on your cable news network doesn’t make the lie anymore true.

Precious metals are advertised as safe havens from the turmoil of the stock market, yet they are neither safe nor dependable. The price of gold, and other precious metals is extremely volatile. In fact, the price of precious metals has historically been more volatile than the stock market. It is hard to understand why anyone would want to own any investment that fluctuates wildly in price, never pays a dividend, has a dismal track record and can’t keep up with the inflation.

So, when well-known actors advertise that they buy gold because they are “good Americans concerned about the future,” please try to see through the deception. They tell you to buy gold because they are actors who get paid to tell you to buy gold.

Index Annuities are insurance products

They advertise that you can participate in some of the returns of the stock market in the good years but that you will not lose money in the years when the stock market retreats.

The sales pitch of these products is enticing, but the devil is in the details.  First, these products have caps or limits on how much they will pay when the stock market goes up. So, when the stock market goes up, earnings within these products are limited to the prevailing cap of the product. If the stock market goes up 10, 15, or even 30% in a given year, these products will pay to you only the prevailing market cap. In most instances, these caps can be changed by the insurance companies without warning. The consumer has no say. The prevailing market cap currently is 5%.

Second, these products have severe penalties if you liquidate your investment before the surrender period expires. Surrender periods are imposed because the insurance companies that create these products pay a large upfront commission to the insurance agent who sell these products. If an index annuity owner cancels their annuity before the surrender period expires, the insurance company can recoup the commission paid to the agent from the surrender charge assessed to the annuity owner. The surrender periods typically last seven to ten years. Surrender charges can run as high as 10% of the value of the annuity.

Third, index annuities don’t participate in the dividends of the underlying indexes they follow. This is significant. Almost half of the returns of the S&P 500 can be attributed to the dividends of the companies that make up the S&P 500 index. So, if you choose to invest into the stock market via an equity index annuity, you automatically cut your profits in half by foregoing future dividend payments.

To better illustrate the absurdity of these products, let’s apply the same investment criteria used in an index annuity to a real-estate transaction.

The deal would go something like this: “We will take your money and invest it into a rental property. Your investment is guaranteed to never lose money, as long as you leave the money with us for at least ten years. If you liquidate prior to ten years, you will be subject to a surrender charge as high as 10% of your initial investment. Additionally, you will not receive any rental income stemming from your investment, but we will pay you a portion of the annual increase of the value of your property each year, and the amount we will pay you will be completely up to our discretion. Oh, and by the way, thank you for paying us an upfront commission of 7% of your purchase. It’s been a pleasure doing business with you.”

Of course, nobody would agree to a real-estate deal like this! Why would we agree to similar terms with our other investments? There are hundreds of index annuities to choose from, and they all have variations on how they credit earnings and apply surrender charges. Even though all index annuities are different, they share a common trait. Index annuities are complicated products. Few owners of index annuities really understand how their annuities really work. People buy these products because they know that there is some type of guarantee associated with them. However, it is our belief that if the consumer really understood index annuities, they would never purchase one.

Before investing any money into an equity index annuity, do your homework and understand how these products are structured. The Securities and Exchange Commission has issued alerts to the public regarding the potential pitfalls of index annuities. The only advocates of index annuities that we come across are those companies that create them and the insurance agents who sell them.

What About the Guarantees?

The draw to these products is their guarantees. The only positive guarantee is that index annuities offer is that you won’t lose money when the stock market goes down. Since every market downturn is temporary, that isn’t much of a guarantee when you consider all that you lose by owning these products.

Owning an index annuity will certainly provide additional guarantees—undesirable guarantees.

Owning an Index Annuity Guarantees:

  • That you will never get stock market–like returns. Market caps ensure this will never happen.
  • That you will never be paid a dividend. Dividends historically account for almost half of the growth of the stock market.
  • That you will never be able to beat inflation over the long run by investing into their annuity, again thanks to market caps and no dividend payments.
  • That you just paid one of the highest commissions in the investment universe to the insurance salesman who sold you the annuity.
  • That the bulk of your money will be locked up inside one of these products for as long as a decade. Certainly, lump-sum distributions are available to you if you are willing to forfeit as much as 10% of your principal to access your money earlier than what is allowed by the annuity contract.

So, why are index annuities so prevalent? Unfortunately, they pay some of the highest commission of any product in the investment industry. Need we say more? Index annuities are sold by insurance agents, and for many agents, index annuities are the only product in their quiver that could loosely be called an “investment.”

Frightened, unwary investors purchase precious metals and index annuities because they fail to distinguish the difference between volatility and risk. Those who purchase these products have been duped by the emissaries of gloom that promote an irrational fear of equities, and fear is a powerful tool. A tool so powerful that the impressive weight of historical evidence manifesting the inflation-fighting power of equities is ignored and traded for the false promise that your money can “safely and dependably grow and beat inflation” while invested in precious metals and index annuities. Thankfully, knowledge is likewise a powerful tool and as you continue to investigate, you will become increasingly aware of the foolishness of owning precious metals and index annuities.

Scott M. Peterson is the founder and principal investment advisor of Peterson Wealth Advisors. Scott has specialized in financial management for retirees for over 30 years. Scott is a regular presenter at BYU’s Education Week and speaks often at other seminars regarding financial decision making at retirement. He also literally wrote the book on retirement income, Plan on Living: The Retiree’s Guide to Lasting Income & Enduring Wealth.

If you are getting close to retirement and will have at least $500,000 saved at retirement, click here to request a complimentary copy of Scott’s new book!