Low interest rates make some fixed-index annuities shine
July 21, 2016 by Andrew Murdoch
This is an unusually tricky time to be a prospective annuity buyer. Previously low interest rates have slipped further, to subterranean depths, illustrated by the fact that the yield of the benchmark 10-year U.S. Treasury note closed at a record low 1.37% in early July.
The conundrum is this: Experts have consistently said that ultra-low interest rates have no place to go but up, but the financial markets continue to ignore them and push rates down further. Who is to say that the U.S. won’t wind up with negative interest rates – the case today in Japan and Europe?
If you’re thinking about buying an annuity, which is pegged to interest rates, what should you do?
Rather than ponder the future direction of the markets, typically a fruitless exercise, let’s get straight to the point. For fixed-income investors wishing to maintain control of their principal, the best annuity today is a fixed-indexed annuity (FIA) — a fixed annuity pegged to a market index. With interest rates so low, the under-performance risk of a FIA is so negligible that investors should take on that risk and try to beat the traditional alternatives, such as CDs and fixed annuities. By comparison, for example, five-year CDs are yielding under 2% annually and five-year fixed annuities about 2.5%.
If you opt to buy a FIA, it’s very important that you understand crediting methods — the formulas used by insurance companies to calculate how much of an increase in the investment index you actually get to keep. Then make a point of buying a FIA that is truly attractive. I’ll talk more about this shortly.
Unlike variable annuities, FIAs offer principal protection. If the markets fall, you lose nothing. In addition, a growing number of FIAs invest in low or minimum volatility indexes, which invest in stocks, bonds, future contracts and commodities and rely on algorithms to guide asset allocation. This seems preferable to placing your investment bet on today’s pricey stock market.
As I mentioned earlier, it is imperative that a prospective FIA buyer choose a FIA with good crediting methods. Most of the time, this probably means turning to independent brokers for help because they usually have the biggest product inventory.
The range of crediting methods is enormous. To be avoided at all costs are some FIAs with caps as low as s 2% of the index’s return. Studies show that the market historically rises 70% of the time. If this remains true over the next 10 years, somebody with this FIA would earn a token average return of 1.4% annually, making your link to the stock market worthless.
Similarly worthless are FIAs on the market that pay an index “participation rate” of only 15%. If the market rose 10%, an owner of this FIA would receive only 1.5 percent.
Another option to avoid is a FIA with a spread — a portion of an index gain that you do not get — that is nearly as high as the historical performance of the index. This leaves you with almost nothing.
By contrast, one good FIA pays a 100% participation rate on a low-volatility index. Another pays a 45% participation rate on the S&P 500 — probably less attractive, but still impressive given that the average participation rate today on the S&P 500 is only 20%-25%. A third attractive FIA on the market pays a 112% participation rate on a low-volatility index — minus a 1.45% spread.
One common feature you should not shy away from is an index that credits payments every two to three years, rather than annually. This means fewer opportunities for an insurance company to make changes, lowering its internal costs and improving crediting methods.
As I said, a good FIA is an excellent alternative investment amid today’s extraordinarily low-interest-rate environment. Different people, however, have different mind-sets. So, in my next column, I’ll explore suitable FIA alternatives today for them and others.
