Buffer annuities have been gaining attention in the investment world. At its most basic, a buffer annuity allows you to participate in the growth of a stock market index while protecting you from certain amounts of loss in your savings.
There are, however, many details that are worth understanding. First, these annuities will typically cap the amount of growth you can see every year. Second, there is potential to lose money if the stock market indexes fall farther than the level of protection offered by the annuity.
(To learn more about fixed income annuities, we recommend checking out our comprehensive guide)
How a Buffer Annuity Works
So let’s say you put some money into an annuity for a lockup period of six years, and that annuity is linked to the S&P 500. You can then choose an option where you are protected against a loss of up to 10%. If the market goes down 15% in the first year, you are protected from the first 10% in that loss, meaning you’re only on the hook for a loss of 5%.
Lets now say that the market went down 5% that year. You lose nothing in this case. The insurance company incurs the full loss, because you are protected up to 10% for that year.
The trade-off? Buffer annuities also put a cap on your gains by capping your upside at an agreed upon rate. So if the cap rate is 5% and the market goes up 10%, you’ll only receive a 5% return on that investment for the year.
If the market goes up 3%, you’ll get your full return. This is because 3% is still below the cap rate for that year. These cap rates are reset by the insurer depending on market conditions at the end of each year, meaning there’s no way to know what your contract will look like for the whole term.
Pros and Cons of Buffer Annuities
So what are the pros and cons? Although you absolutely can lose money with a buffer annuity, one pro is that you get a market-linked upside with some downside protection. While the principal investment isn’t 100% guaranteed, as is the case for fixed index annuities and bonds, the opportunity to participate in stock market growth with controlled downside may be an interesting complement to portfolios for investors nearing retirement.
The downside? This product is very complicated, with a cap rate that changes every year so you can’t know the full terms you’re agreeing to over the course of your contract. This makes financial planning difficult, as it can be hard to visualize what sort of average return to expect on your investment. Additionally, these products tend to come with a high commission—typically 5–10% of what you put in—so even though there isn’t a headline cost that you’re taking on, you need to take an expensive sales process into account. Should you decide the buffer annuity isn’t for you, these products also typically come with a steep surrender charge, so you might pay dearly for any cancellation.
The buffer annuity is still in its infancy, so it is important for you and your financial advisor to really educate yourselves about the product to ensure that your interests are being met.