Why fixed indexed annuities are strong sellers
March 7, 2016 by Andrew Murdoch
At first glance, a fixed indexed annuity (FIA) might seem almost too good to be true. Among its biggest attractions — and one you can be sure a broker will tout — is that you can invest in the stock market with impunity because you can’t lose money.
Should you hear this, immediately temper your expectations.
The above statement is true in only a narrow sense. FIA owners don’t lose money in the market, but they also earn materially less because returns are tied to an index, such as the S&P 500 or a lower-volatility index, and investors are paid only a portion of its increase(vis-a-vis the so-called participation rate). Unfortunately, brokers don’t always tell clients this because FIAs are not regulated securities.
This caveat notwithstanding, many prospective annuity buyers should take a hard look at FIAs. It’s no coincidence that their sales were up 22% in the third quarter of 2015, while annuity sales overall rose only 3%. FIAs are the right product at the right time for many pre-retirees and retirees because at least they provide some equity exposure with no downside risk. In addition, they offer income protection through riders with relatively generous lifetime income payments.
The contrast of FIA sales with sales of variable annuities — which offer full market exposure, with the attendant risk — is instructional. While FIA sales posted the aforementioned gain, VA sales plummeted 9%. This is because the market did nothing last year, and along the way, buckled deeply, as it is also did earlier in 2016. In addition, many people still have not forgotten the enormous market selloff in 2008. An FIA makes perfect sense for those who want to dip their toe in the market — but gingerly.
An FIA is essentially a fixed annuity with a variable rate of return, depending on the performance of the underlying market index. It typically offers a guaranteed minimum income benefit, plus, as mentioned, the chance of upside pegged to a market-based index. Some people buy an FIA without the income benefit; their goal is to catch a rising market and earn more than they can in a traditional fixed annuity.
Regardless, all FIA owners receive only some portion of the market’s gain, depending on how their gains are calculated.(Buyers are protected against market losses because the indexes are purchased with options, which simply expire worthless in a down market.)
This limited upside is the drawback of FIAs. In addition to the participation rate, there are caps (which limit the amount of the index increase that investors can reap) and spreads (which subtract some of the market’s gains from your earnings). So an FIA never keeps pace with a robust market.
These various calculations used to compute your actual gains — so-called crediting methods — can be somewhat confusing, but are crucial to understand. Their impact was highlighted in a study by Fidelity Investments that spotlighted 2013, the best performance for the S&P 500 in 34 years with a gain of 29.6% (and 32.4% including dividends). According to Fidelity, a “representative” FIA that year — one with a monthly cap on upside returns — credited investors only 10%.
In addition to crediting methods, FIAs also tend to have long surrender schedules. This refers to the penalty paid for exiting the contract prematurely. In extreme cases, these can last as long as 16 years,compared to an average of about seven years for variable annuities.
Ultimately, these drawbacks are insignificant to a savvy buyer. Those who do their homework and set realistic expectations will not be disappointed. Most FIA buyers have a lifetime income rider; for them, market gains are just icing on the cake. Those without the rider are seeking an alternative to a fixed annuity in hopes of earning more in a strong market. Should they earn less, they still lose no money. For most annuity buyers, guaranteed principal, with some upside potential and guaranteed lifetime income is an unbeatable combination.
Andrew Murdoch, CFP, is president of Portland, Ore.-based Somerset Wealth Strategies and a principal at Annuity FYI, an informational resource for annuity shoppers. Previously, Andrew was a wholesaler for Jackson National Life and a financial adviser for Morgan Stanley, where he advised clients on managed money, mutual funds, municipal and corporate bonds, stocks, annuities and option strategies. He is well-versed in various annuity and retirement strategies, including potential pitfalls that advisers overlook.
