With interest rates still near historical 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 an insurance product. 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. How the money is invested, and who does the investing, are the key issues which separate a fixed indexed annuity from other types of annuities.
Fixed Indexed Annuity Dynamics:
During the accumulation phase – the time when you’re paying premiums into the annuity – a fixed indexed annuity (FIA) allows you to control which investment options will be used to grow your money and it provides a fixed floor interest rate which it guarantees to pay. The FIA also applies a participation rate or cap rate on your earnings.
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 an S&P 500 index, and it earns 10% during a set period, then you’ll be credited with 9% (90% of the 10%).
A cap rate, on the other hand, is a cap on the amount you can be credited. Let’s say the cap is 8%. Using the S&P 500 index as our example, if the index returns 10%, you’ll be credited with 8%.
The interest rate floor, participation rate, and cap determine what you will earn inside the 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’ll never fall below the floor, even if the index (like the S&P 500) loses money during the period.
How Do You Get Paid?
It is critical that you really understand how you’ll be paid. 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 others are proprietary creations of the insurance carrier which is offering the annuity. They can be confusing and anything but transparent.
You will usually not receive credit for the dividends. For an index like the S&P 500, you can usually expect that about 2% of the total return will be from dividends. So if the index return is 14%, it’s probably 12% when you strip out the dividends.
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 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.
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?
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, it is still very misleading. You “pay” for fixed indexed annuities through the participation rate and cap, 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.
Remember, you always have an alternative to the FIA. In our example above, you can easily open a brokerage account 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?
The logical question is 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 you will be charged 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%. Any withdrawal after the surrender period can be made without a surrender charge.
You may be offered “free” withdrawals during the accumulation phase. If offered, these are around 10%, meaning that you can withdraw 10% annually without incurring any surrender charge.
At some point, you will want to withdraw from the annuity in order 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 that payout option for the remainder of the contract’s life.
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. It is totally determined by your lifespan. 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 – 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’re 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 them. Your heirs will lose the remaining balance which has not yet been paid out.
20 Years Certain – the insurance company will pay to 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, and instead often reduce the value of the retirement savings that you, your spouse and/or family would otherwise enjoy.
Unfortunately, annuities are too often 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.
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. If you want to learn more about how portfolio diversification can mitigate risk, see our article on Stocks and Bonds Diversification.
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 need and to determine how best to meet your needs and control your risk. We promise to do that in a 100% objective environment, so give us a call or send us an email if you’d like some assistance or just a good second opinion.