With interest rates still near historic lows, and stock market volatility near all-time highs, it’s little wonder that fixed indexed annuities are being hyped to investors as the solution to all their problems. One of the more modest advertisements stated that “a fixed indexed annuity offers the opportunity for tax-deferred growth based on changes in a market index plus the option to convert your annuity into a steady, guaranteed, lifetime income stream, all while protecting your hard-earned principal from the uncertainty of market volatility.” Some of the more extreme ads imply that these products will also cure a common cold. But what is the truth about fixed indexed annuities? Space prevents us from delving into every aspect of these products, but let’s look at the key components you need to know before buying one.
Annuity Basics Reviewed
In the simplest form, an annuity is considered a deferred account or a deferred investment. Despite the different descriptions, it is in fact, an insurance product. You are the annuity holder, and you pay premiums during an “accumulation” phase. The money is invested, and then you are given various options for how you can withdraw your money, plus any growth, during the “payout” phase. When the money is invested, how it is invested, and who does the investing, are the key issues that separate a fixed indexed annuity from other types of annuities.
Immediate Annuities vs. Deferred Annuities
The accumulation phase can be a one-time event or can span many years. This is the essential difference between an immediate annuity and a deferred annuity. If you purchase an immediate annuity, you would contribute all the money lump sum immediately, and then you would begin taking payments. If you purchase a deferred annuity, you would make regular contributions over several years – perhaps even decades – until you’re ready to start taking payments. During this deferral period, your money is placed in the deferred account.
Depending on how long you are making contributions, a deferred annuity may lock up your money for years, or decades, before you can receive payments. Suppose you need to access your money before the end of this contribution period. In that case, you will typically pay hefty surrender charges, even if you need the money for emergency medical expenses or other significant changes in your living circumstances.
Surrender charges can be as high as 25% of the principal invested in the annuity. It’s almost a guarantee that you’ll lose some of your principal if you need to withdraw while these surrender charges are still in force. While this is always “disclosed”, it is most often buried deep inside legalese that would put a lawyer to sleep.
So bad has the practice been with some insurance companies that the Attorney General has filed lawsuits against insurance companies which sold annuities with inappropriately long surrender periods, which in some cases exceeded the reasonable life expectancy of the annuity owner.
Fixed Annuities vs. Variable Annuities
Who invests the money and how it is invested determines whether the annuity is “fixed” or “variable”. A fixed annuity earns a guaranteed interest rate, which is determined by the insurance company offering the annuity. Not surprisingly, the insurance company decides how to invest your money. They may promise to credit to your account a 3% rate each year (as an example), but they almost certainly will invest your money to earn a higher return. In such a case, they keep the difference.
A variable annuity earns interest which can fluctuate over time. The specific investment products available in the annuity are what determine the fluctuation. In the most basic type of variable annuity, the insurance company provides a list of mutual-type funds which you can choose. You can choose to invest your annuity money in bonds, stocks, mutual funds, or in any combination of these. Whatever you choose will determine the investment rate that is earned. Of course, in a straight variable annuity, your value will fluctuate based on the earnings from the funds you select. That means if the market value of those funds goes down, your annuity value will likely go down as well. The annuity does NOT protect you from market volatility.
Fixed Index Annuity Dynamics
A fixed index annuity (FIA) is a hybrid of the variable annuity. During the accumulation phase – the time when you’re paying premiums into the annuity – an (FIA) provides a fixed floor interest rate that pays to credit to your account AND it allows you to control which investment options will be used to grow your money.
That may sound confusing, to say the least. The insurance company wants you to believe that you can have your cake and eat it, too. They want you to believe that you can use the annuity to invest in stock funds, earn higher investment returns, and yet not experience any downside. A very typical advertisement for these types of annuities typically says you “can’t lose your money.”
How can they do that? This is accomplished by offering you a handful of “indexes” to invest your money and then by applying a participation rate and/or a cap rate on your earnings. A widespread index used in FIAs is the S&P 500, so we’ll use this to illustrate.
Participation Rate
The participation rate is simply the portion of the index return which you will receive. If you have a 90% participation rate, it means that you will be credited with 90% of the earnings from the index you selected. If you chose the S&P 500 index, and earned 10% during a set period, you’ll be credited with 9% (90% of the 10%).
Cap Rate
On the other hand, a cap rate is a cap on the amount you can be credited. Let’s say the cap is 8%. Using the S&P 500 index again, if the index returns 10%, you’ll be credited with 8%.
Combined, the interest rate floor, participation rate, and cap rate determine what you will earn inside this type of annuity. Your earnings will always remain somewhere between the floor and the cap rate. Even if the index goes higher, your earnings will never go above the cap, but on the flip side, they will never fall below the floor, even if the index (like the S&P 500) loses money during the period.
How Do You Get Paid?
Understand how you will be paid is critical. You cannot determine whether an FIA is good for you if you do not understand what you can earn.
It’s important to realize that you are not investing directly in the index (like the S&P 500 in our example). The insurance company will credit to your account an amount of money based on the index, but you are not yourself investing in that index.
Many indexes are obvious – like the S&P 500. But there are others, including bond funds and some proprietary creations of the insurance carrier which is offering the annuity. They can be confusing and anything but transparent.
It is also critical to understand that you will usually not receive credit for the dividends which are part of the index. For an index like the S&P 500, you can usually expect that the dividends will generate about 2% of the total return. So, if the index’s total return is 14%, the return eligible for consideration in your annuity is probably 12% when you strip out the dividends (14% less 2% in our example).
Let’s do the math combing all these concepts. Let’s assume you purchased an FIA using the S&P 500 index with a 90% participation rate and an 8% cap. If the S&P 500 earns 12%, the index will earn 10% because the insurance company strips out the 2% in dividends. Your participation amount would be 9% (90% of the 10% index return), but you would be credited with 8% because of the cap. That’s a lot of steps, and as you can see there’s a lot that is scalped off the top.
When Do You Get Paid?
Most commonly, the annuity earnings are credited to your account on an anniversary date. This is called “annual point-to-point crediting”. It means that earnings in the middle of each year don’t count. There is no daily value or crediting of earnings during the year, only at the end of the year. If you invested $100,000 in an FIA, then your value will remain $100,000 for a full 364 days. On the 365th day, the insurance company will calculate what the earnings were over the full 365 days and credit you with your portion.
If the index is up for 364 days, then suffers a loss on the 365th day, you won’t receive anything more than the interest rate floor, even if the index recovers its losses in the weeks immediately following the anniversary date. Each anniversary date, the cycle begins again.
How Does the Insurance Company Get Paid?
The traditional sales pitch ignores the fees that are charged inside annuities. These take the form of administrative fees, mortality fees, insurance fees, annual fees, contract fees, etc. The language changes a bit from one annuity contract to another, and it can be very difficult to determine the true cost of annuities. Specifically, part of the sales pitch is usually that there are no “additional” fees charged for investing in an FIA. While that may be technically correct (depending on the annuity contract), it is still very misleading.
You “pay” for fixed indexed annuities through the participation rate, the cap rate, and the point-to-point accounting technique, all of which limit your earnings. The insurance company keeps the difference. That is how they are paid, and it is a cost you bear, even if it isn’t a fee you pay. Additionally, if you need to withdraw money during the surrender charge period, there will be a fee in the form of the surrender penalty.
Remember, you always have an alternative to the FIA. In our example above, you can easily open a regular investment account at any brokerage firm and invest directly in the S&P 500 index yourself. If you do that, you would have earned and kept all of the S&P indexes earnings, including the dividend. That means you would have received the full 12%. You also would receive earnings during all parts of the year, not just on the 365th day of each cycle.
In this example, the FIA would “cost” you 4% even though you wouldn’t “pay” 4%. You could have earned the full 12%, but instead, the insurance company only credits you with 8% due to stripping out the dividend and applying the participation and cap rates.
What Are You Paying For?
So… what do you get for this 4% cost? The answer is protection from losses. As long as the insurance company remains financially sound, they will absorb any losses in the stock market, or any other index you select in the annuity. The floor interest rate is commonly 0%. So when there is a hiccup or even a bad recession, you won’t see the value of your investment inside the FIA deteriorate. If the S&P 500 index loses 15% in a given year, you would earn 0%. This is what you’re paying for.
How Do You Get To Your Money?
Access to your money will be limited. Typically, these products have “surrender periods,” during which they will charge you a substantial penalty if you withdraw your money or try to switch to a different annuity. The most common surrender period we’ve seen is around 8 years, and the surrender charge starts around 10% and then gradually decreases over the 8 years to 0%. After the surrender period, any withdrawal can be made without a surrender charge.
You may also be offered “free” withdrawals during the accumulation phase. If offered, these are around 10%, meaning that you can withdraw 10% annually without incurring a surrender charge.
At some point, you will want to withdraw from the annuity to fund your retirement. When – and only when – you get to the payout period, the insurance company will offer you various options to “annuitize” your contract. This means that you will select your payout option, and you will be locked into a payout rate for the remainder of the contract’s life. This is often referred to as “guaranteed income.” or in other words, it simply means getting your money back over time.
We cannot possibly cover all the payout options, but here are a few of the most common ones:
Single Life
The insurance company will pay you a set amount for the remainder of your life, no matter how long you live. If you live to 100, they pay all the way. If you only live to age 65, then they stop paying after that. Your lifespan totally determines it. This can be very hurtful to your spouse if he/she outlives you. They would not receive anything after your death. This bears repeating. Your spouse and your heirs could lose, when you die, whatever remaining balance has not yet been paid out.
Joint Life
The same concept as above except the insurance company agrees to pay for the remainder of your life or your spouses. The monthly payment amount will also be lower than it would be with the single life option. But if you die first, the insurance company will keep paying until your spouse dies. After you are both deceased, your heirs would not receive anything. So, if you both were in a tragic car crash when aged 65, the insurance company would stop paying then. Your heirs will lose the remaining balance which has not yet been paid out.
20 Years Certain
The insurance company will pay you, your spouse, or your heirs for at least 20 years. The monthly amount will typically be lower than in the single life or joint life options above.
Combinations
Most of the time, the insurance company will offer you some combinations of the above options. One common combination would be “joint life and 20 years certain”. The insurance company will pay for as long as either you or your spouse is alive, but under no circumstances would they pay fewer than 20 years. If you and your spouse both died early, your heirs would at least continue to receive payments for the remainder of 20 years.
What Is Your Bottom Line?
Fixed Indexed Annuities can be a good solution to a very specific problem. In our humble opinion, those situations are few and far between. For the vast majority of people, fixed indexed annuities are not a good retirement option. There are potential pitfalls of relying on annuities in retirement. Instead, they often reduce the value of the retirement savings that you, your spouse and/or family would otherwise enjoy.
Annuity sales are big business because they can be so profitable for insurance companies. Unsurprisingly, we often see annuities being marketed as the best solution for every problem. Salespeople stress, if not stretch, the benefits and neglect to point out or explain the details; and the devil is always in those details. Make no mistake; an annuity is a product, not a retirement savings strategy.
What sounds like a pretty good trade-off (protection from the downside in exchange for giving up a portion of the upside) is often a very expensive way to try to reduce stress and worry. In almost all cases, if you can be patient and view the stock market’s volatility in the proper context, then giving up a big chunk of future gains may not seem like a prudent option. After all, giving up just 3% per year over 22 years is equivalent to giving up half of what you would otherwise accumulate if you invested in the index directly. We believe that proper allocation across stocks, bonds, real estate, and money market instruments will better prepare you for the future and protect you against the intermittent ups and downs of the stock market.
What to Do When You’ve Already Bought an Annuity
You need to consider everything above before choosing to buy an annuity. It doesn’t matter whether you’re considering an immediate annuity, a deferred annuity, a fixed annuity, a variable annuity, or a fixed index annuity. Do your due diligence and go slow. Once you buy one, you will be locked in for some number of years.
But, what should you do if you have already purchased an annuity and now know that it was a mistake?
There are ways to mitigate the potential damage. These strategies are dependent on your unique situation and timeframes and it’s always good to get the advice of a 100% objective financial advisor. The highest category of these advisors is the fiduciary financial advisor. In fact, fiduciary advisors have a legal obligation to act in your best interests. As great as that sounds, the sad truth is that the majority of “advisors” are not advising as much as they are selling, and even among the true advisors, even fewer are fiduciaries offering 100% objective advice. They can help you read the details of your contract and look at the options available to you to get out of an annuity and move to a better solution.
Annuities are sophisticated and complicated products, and an objective opinion is critical to choosing the right one, or in deciding whether or not the trade-offs are worth the cost. We’d be happy to help assess your needs and to determine how best to meet your needs and control your risk. We promise to do that in a 100% objective environment. So whether you are considering or have already purchased an annuity, schedule a 15-minute discovery call with a fiduciary advisor to review your options.
