Devil’s Advocate: Understanding the Shortcomings of Index Interest

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We’ve discussed before the concept of classifying index interest as an asset class. Continuing along that thread, there are other sides to the argument – making it necessary for us to truly understand advantages and disadvantages of the indexed products we sell.

For all the benefits that Index Interest has to offer investors, it also has some limitations.  As both an advisor and as a securities principle, skepticism has been a required skill to protect both my clients and the firms I have managed.  In both roles, there exists a responsibility and a duty to make sure any financial product for use with clients is fully vetted before being offered or used.  This process is called “due diligence” and involves looking at any potential investment through somewhat cynical eyes to see if it does or can do what it claims.
In an ideal world, we would have an investment product that was completely liquid, completely safe, and gave the investor double digit returns every year.  Unfortunately, we don’t live in a perfect world.  Instead with any investment, there is always a trade off.  You can have one or two of these characteristics, but no investment offers all three.  Investments that are very liquid, like stocks and commodities, can produce big returns but there is no safety or guarantee.  Things that are secure will either have nice rates and low liquidity (long term CDs and long bonds), or have lots of liquidity but very low rates (savings and money market accounts).  This concept is important to understand; there is no perfect investment.  Instead each investment and investment product must be weighed and judged based on these trade offs between liquidity, safety, and potential.  Keep this in mind as we go over the limitations of index interest and view them as what they are, investment trade offs.

Dividends Not Included
Let’s start with a limitation that is true of all index interest products; that the dividends of the index are not included when calculating returns based on the change in the index level.  This is a valid point and is entirely true.  Regardless of which crediting method an index interest product uses, the dividends are not included in the calculation because they are not included in the indexing number itself.  So to simplify, someone who buys the actual index gets both the dividends and the gain in the index, where as the index interest investor only gets the benefit of the index gain and not the dividends.  This is probably an unfair comparison as the underlying idea is that an investor would be better off buying the actual index verses buying an index interest product.  This is really an “apples to oranges” comparison because of the protection of principle offered by index interest products.  Keep in mind that the trade off for getting the dividends is the possibility of a loss due to a drop in the index value.  But, to be fair, let’s look at how much an investor would have given up by not getting the dividends with index interest.  Let’s take one of the more popular indices, the S&P 500 and see what amount in dividends the investor would have missed had they owned index interest products over the past 30 years.  Let’s look first at 1980 to 1995.

Over this 15 year period, the dividend yield averaged 3.74% per year.  This would have added significantly to the returns of the investor who bought an S&P 500 index fund and held it during this time.  An investor in index interest products during this same time period would have missed out on this dividend yield.  The problem with this comparison is that index interest products did not exist for most of this time period.  So let’s look at the next 15 years, when index interest products were actually available, and see what would have been missed.

For the past 15 years, when index interest products have been available, the dividend yield has been substantially less than in previous decades.  From 1996 to 2010, the dividend yield of the S&P 500 averaged 1.74% per year.  From 1996 to 1999, when the S&P 500 almost doubled in value, this small dividend yield would have hardly been noticed by investors in an index mutual fund.  However, over the next 10 years it would have helped cushion the loss of almost 15%, felt by the same investors had they held the same index mutual fund for that period.  This does not take into account the expenses of index mutual funds.  Even low cost, no load index mutual funds will have expense ratios that will run between .25% and .75%, reducing the true dividend yield by this same amount.

So to briefly summarize; prior to 1995, when index interest products started to become widely available, an investor in these products would have missed out nice dividends verses investing in a stock index fund.  Since then, the dividend yields have been so small that the minimum guarantees offered by index interest products would have offset them during down markets but would have reduced returns slightly during bull markets.  It should also be remembered that dividends are not a factor in other indices such as gold or commodities, as they go strictly off the change in market price.

 Another drawback to index interest products is their lack of liquidity when compared to stocks, mutual funds or commodities.  This reverts back to our earlier discussion on the trade offs between liquidity, safety and potential returns on any investment.  Index annuities and index life insurance both have surrender charges.  Index CDs and index / structured notes both may sell for less than their principle value if they have to be liquidated prior to maturity.  These products have high potential returns and a high degree of safety but give up differing degrees of liquidity to have the first two qualities.  Stocks, mutual funds and commodities offer high potential returns and daily liquidity at market value but have a low degree of safety.  Depending on the individual investor, giving up liquidity to gain increased safety may or may not be a good trade.  Let’s think through this.  Most “investment experts” say that you need to take a long term view if you invest in stocks or mutual funds and be prepared to stay in the market for 15 years to give it time to work.  If we apply this same logic to index interest products, then maturities of 5, 10, or 15 years should not be an issue.  If on the other hand, an investor has a shorter time frame, then having an index interest product with a maturity matching that time frame could make sense.

Additionally, most index annuities and index CDs offer liquidity with a known or estimated penalty as opposed to the unknown value of the actual index or an index mutual fund, should the money be needed prior to maturity.  This known cost verses an unknown cost of liquidation can be attractive to some investors.  However, one benefit of owning an index mutual fund is the ability to liquidate and “lock in” gains whenever you chose as opposed to having the date set for you in an index interest product.  Though most investors don’t do this and instead ride the fund up and then down before selling, some like having the ability to try and time the market in this way.

Tax Implications
The taxation of index interest products has long been touted as a negative aspect, particularly in the case of index CDs and structured notes.  While paying the OID tax on these investments is not pleasant, I have yet find any tax that investors really like to pay. This is typically portrayed as a negative when it is compared to the lower long term capital gains tax rate investors pay if they purchase a stock or mutual fund and then sell it for a profit, after holding it for a year or more.  This is probably another “apples to oranges” comparison, due to the OID tax being the result of having the principle protected in index interest products and assuming there will be a gain in the stock or mutual fund.  But, let’s look at it and put it into perspective anyway.  If the index increases in value over 5 years and the index interest investor’s CD matures and the index mutual fund investor sells the fund, both will owe taxes.  The index CD investor will have paid OID taxes every year on part of the gain and will owe taxes on the rest as extra interest in that year as ordinary income.  The index mutual fund investor will have paid taxes on the dividends generated by the mutual fund every year and will owe taxes on the rest of the gain as a long term capital gain.  So, in this example, both have paid some taxes every year on the investment and both owe additional tax at the 5 year mark.  The difference is the rate at which the additional amount is taxed which has been at a much lower rate for capital gains.  For someone in the highest tax brackets, this is quite a difference and should be factored into any decision on purchasing index CDs and structured notes.  For those in lower tax brackets, the difference is not as substantial.  But, what if instead of comparing index CDs and structured notes to index mutual funds, we compare them to the investment class they should be judged against for tax purposes; traditional CDs and bonds.  When looked at in this light, there is little difference as all interest is taxed as ordinary income.  The same is true for index interest in an annuity as regardless of the calculation method used all gains are taxed as ordinary income when withdrawn.

However, if any of these index interest products are held in either a traditional IRA or Roth IRA, there are negative tax consequences when compared to other investments.  For this reason, investors should first consider using IRA accounts for the portion of their assets they want to allocate to index interest.  For non-IRA accounts, the investor should simply be aware of the tax implications and judge for themselves if the safety of principle is worth the possible higher tax rate on the gains.

High Fees
This negative is typically leveled at index annuities by TV talking heads that don’t realize they are not a variable annuity. Index annuities don’t have fees like variable annuities do.  They are instead a fixed annuity that uses index interest to credit gains.  Anyone making the comment that “index annuities have high fees” is doing so out of ignorance.  Sometimes the same accusation is put forth against index CDs and structured notes.  Again it is usually due to a lack of knowledge, but I will attempt to address this issue anyway.  What the naysayers are generally looking at is the underwriting costs that the bank or investment company discloses in the prospectus.  These costs include building and distributing the product, backing it with any guarantees, and paying the advisor a sales credit or commission.  In fee based accounts, the commission is removed but replaced by a management fee which generally shakes out about the same.  These total costs can range between 2% and 7%, and in fairness do reduce the total return the investor might receive if they built the product themselves.  By the same logic, imagine how much money every investor would save if they generated their own electricity, sewed their own clothes, and grew their own food.  Think of all of the “fees” they are paying to electric companies, clothing manufacturers, and grocery stores for simple convenience.  I realize this is going a bit overboard, but the convenience of having packaged products always comes with a price.  If an investor is both a competent bond and options trader, has the time to dedicate to research and pricing, and is comfortable not having a third party or bank guarantee, then they absolutely should build their own index interest products.  For the rest of us, whatever fee is built into the products are probably worth it.

Default on Structured and Index Notes

With the collapse of Lehman Brothers and Bear Sterns in 2008, many investors in structured notes and index notes issued by these firms lost money when they went basically worthless.  While this could happen again, it is probably less likely as both the government and the investment banks seemed to have learned from their mistakes in this situation.  But due to this risk of default, structured and index notes should be viewed and used in the same manner as bonds issued by these institutions.  Just as no investor should put all of their money or even a large pert of it into the bonds of one company, neither should they over invest in the structured notes of one company.  Any investment into structured notes should be spread between several issuers to guard against the possibility of default.  And, if the investor has any concerns about the credit quality of a structured note then they should avoid it altogether.  Instead, they can invest in an index CD with similar terms and have FDIC coverage up to $250,000.  Or alternatively they could use an index annuity that would be covered by their State Guaranty Association for between $100,000 and $300,000 per company depending on their state.
So play devil’s advocate with your own product, understand it from both sides, and you’ll be in a better situation to make the best recommendation.

J.R. Thacker is President and Founder of Thacker & Associates Inc. and President of Center Street Securities, Inc. He has worked in the financial services industry since 1996. Thacker founded his own firm specializing in retirement planning. His unique approach to retirement investing quickly became popular, and the firm was voted “Best Financial Planner” for six years in a row. He can be reached by e-mail at or

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