More Investors Are Turning to FIAs to Protect and Grow a Part of Their Retirement Nest Egg
The scene plays out everyday. An insurance agent or financial advisor hands an investor a glossy brochure touting a product called a fixed index annuity with a value proposition that’s hard to ignore: the ability to grow an investment with little risk of losing that money. Once that grabs the person’s attention, the question becomes, “Why wouldn’t I invest my money in a product like this?”
The truth is, fixed index annuities, or FIAs, do offer a value proposition that makes them unique and in many situations, highly suitable for investors seeking growth potential in tandem with downside protection of their investment principal. What’s more, many of the FIAs available today are more investor-friendly than their predecessors, with lower fees and richer benefits. All this would seem to make it the ideal vehicle for someone who’s approaching, or already in, retirement. If recent sales figures are any indication, more investors are indeed buying into the FIA value proposition. For the second year in a row, FIAs sales hit record highs in 2010, climbing six percent to an estimated $31.4 billion, according to Beacon Research.
Under the Hood of a Complex Vehicle
Lots of moving parts make fixed index annuities a relatively complex investment. Here’s a quick primer on features common to many FIAs, to help investors distinguish one product from the next. Word of caution: Some contracts give the insurance company the right to change these terms, even after the purchase of an FIA. Another reason to read the fine print before signing on the dotted line.
- The UNDERLYING INDEX is the equity-based index to which the interest crediting mechanism is linked, such as the S&P 500®.
- The INTEREST CREDITING FORMULA uses many of the factors listed below to calculate the overall rate of return for the FIA.
- The GUARANTEED MINIMUM RETURN is the percentage of premium that the insurance company guarantees the annuity will return to the contract-holder, plus interest.
- Just how much an investor can participate in the positive movement of an equity index depends largely on the contract’s PARTICIPATION RATE. For example, a participation rate of 80 percent means 80 percent of the gains of the underlying index will be credited to the contract.
- Instead of (or in addition to) a participation rate, some FIAs incorporate limiting factors such as a SPREAD, MARGIN or ASSET FEE — essentially a percentage to be subtracted from index gains.
- The CAP, usually stated as a percentage, puts an upper limit on an FIA’s rate of return. This cap rate is generally stated as a percentage. This is the maximum interest rate the contract will earn.
- Some contracts offer a BONUS — an extra incentive paid by the insurance company to the investor, often in the form of a percentage of premium paid into a contract over a period of time.
- Insurance companies use a range of INDEXING METHODS to compute changes in the underlying index over a period of time. Methods include ANNUAL RESET, POINT TO POINT and HIGH WATER MARK, each with merits and drawbacks.
Still, with all their moving parts (see the sidebar, Under the Hood of a Complex Vehicle), fixed index annuities are not always as simple as the sales brochures portray. That complexity has contributed to a negative perception of FIAs and other kinds of annuities (see the sidebar, Annuities Satisfy Investors, Even If Their Name Doesn’t). Nor are FIAs suited to everyone. So if you’re intrigued by the FIA value proposition, the wise move is to read between the lines of those slick brochures so you can make a well-informed decision about whether one of today’s breed of FIAs is right for you.
Somewhere Between Fixed and Variable
First unveiled in the mid-1990s, the fixed index annuity is a variation on a traditional fixed annuity. Like their traditional cousins, the FIA is an insurance product designed to provide investors peace of mind by guaranteeing they cannot lose their initial investment. The insurance comes in the form of downside protection from loss of principal, with a guarantee that the contractual rate of return can never go below zero.
What distinguishes an FIA from a traditional fixed annuity, whose rates are locked in for a set period of time, is that its rate of return can move. Any movements are based on a formula established by the insurance company providing the annuity. And that formula is linked to the movements of an index tied to the equities market, such as the S&P 500®. The overall rate typically includes a minimum guaranteed interest rate combined with an interest rate linked to the equity index. So when that index posts gains over a given period of time, the FIA’s rate of return increases, too.
The access to positive equity market movements isn’t unfettered, however. FIA investors must sacrifice some upside potential to gain downside protection from negative market movements. The sacrifice comes in the form of caps and participation rates that limit just how much the investor can participate in positive movements in the underlying equity index.
It all amounts to a financial instrument that falls “halfway between a variable annuity and a traditional fixed annuity,” explains Dana Pedersen, vice president of annuity product development at the Phoenix Companies, a leading FIA provider. “An indexed annuity gives the investor some upside potential but also has a guarantee of principal. It sheers off a little upside to provide that guarantee.”
“Their return varies more than a fixed annuity, but not as much as a variable annuity. So [FIAs] give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity,” echoes FINRA, the agency that regulates financial instruments, points out in a recent notice about FIAs.
Annuities Satisfy Investors, Even If Their Name Doesn’t
People like what a product such as a fixed index annuity can do for them. It’s the name they could do without.
Asked in a recent survey to identify their preference between an investment vehicle that delivers four percent return on their money with a guarantee against losing value and a vehicle that delivers eight percent return but subjects their money to market risk, an overwhelming 80 percent of the 3,200 people surveyed expressed a preference for the former. Yet even after describing an annuity-like solution as their preferred financial vehicle, more than half — 54 percent — of Americans aged 44 to 75 expressed distaste for the word “annuity.” The findings come from a survey conducted by Allianz Life Insurance Company of North America (Allianz Life).
The bottom line: Retirement-minded investors who can get past the negativity conjured by the term “annuity” will likely find a viable solution for protecting and growing their retirement nest egg.
In the Allianz study, Reclaiming the Future: Challenging Retirement Income Perceptions, 76 percent of annuity owners indicated they are “very happy” with their purchase — so much so that consumers ranked annuities second-highest (50 percent) in satisfaction among all financial instruments, easily surpassing mutual funds (38 percent satisfaction level), stocks (36 percent), U.S. savings bonds (35 percent) and CDs (25 percent).
Trouble is, the public continues to cling to long-held, often misguided, views on annuities, Allianz concludes. Fifty-three percent of study participants said they first formed their opinion of annuities 10 to 20 or more years ago, while 64 percent said they haven’t researched annuities since that time.
Why FIAs Are Worth a Closer Look
The recent surge in FIA sales is no fluke. Today’s FIAs are much more user-friendly than their predecessors, say financial advisors like Thomas B. Hamlin who have been following indexed annuities for years.
Lower fees and greater access to optional lifetime income guarantees, plus new features that give investors more flexibility with their money, have prompted Hamlin, CEO of Somerset Wealth Strategies in Portland, Ore., to once again start recommending FIAs to his clients after a decade of steering people clear of the product because, he believed, it wasn’t in their best interests to invest in one.
Now, he says, it’s in the best interests of some investors to consider FIAs for a portion of a retirement nest egg. “The best thing to happen to fixed index annuities in years is the lifetime withdrawal benefit. Now we can look out over the long haul and know exactly what we will be receiving for income starting in 10 or 15 years, regardless of what the market does.”
But the case for an FIA goes beyond lifetime income. Many FIAs now come with shorter surrender periods (five years instead of seven or 10). Many others don’t require annuitization to start taking income. Some give investors more choices regarding the indices to which their money is linked. Others offer a walkaway option.
These kinds of features (see the sidebar Five Top-Shelf FIAs for details) make FIAs more appealing to investors, giving them the ability to adjust to changing conditions, such as fluctuations in interest rates, inflation, etc. What’s more, FIAs, like other forms of annuities, offer tax-deferred growth on gains within the annuity contract, plus a death benefit as a wealth transfer tool. Then, of course, there’s the combination that makes the FIA unlike other investment vehicles: principal protection on the downside with positive market participation on the upside. And with today’s lower-fee FIAs, investors now may pay less for the entire package.
Working As Advertised
One reason fixed index annuities may be worth a closer look is that over time, that package of benefits does deliver as promised. A study published in late 2010 by the widely respected Wharton School (and based on “the most comprehensive FIA performance data ever assembled,” according to its authors) concludes that “FIAs have performed better overall than many alternatives.” Certain FIA products, it says, “have been truly competitive with certificates of deposit, fixed rate annuities, taxable bond funds, and even equities at times.” What’s more, FIA returns “may actually be better over time than [returns from] mutual funds or variable annuities.”
Five Top-Shelf FIAs
Here are a few FIAs that financial advisors mention as among the best in their class, not only for their rich features and benefits but for the strength of the insurance company backing them:
- Great American Financial Resources.® The Great American Safe Return™ is a single-premium FIA with a guaranteed return of premium feature. It also offers a choice of index strategies that come with a bailout feature, allowing investors to withdraw their money without penalty if the cap for an indexed strategy ever falls below a predetermined bailout cap level.
- North American Company for Life and Health Insurance.® The North American Paramount Choice 10™ is a flexible-premium FIA whose interest crediting options incorporate a range of indices, both domestic and international. It provides a 10% premium bonus on premium received in the first six contract years.
- The Phoenix Companies.® The Phoenix Reflections Gold Bonus℠ is a single- premium deferred product that adds an amount equal to 7% or 10% of the single premium to the accumulation value at issue (based on state approval). It features index credits linked to the positive performance of five measuring indices, both domestic and international. Phoenix’s Index Select Gold Bonus℠ adds an amount equal to 5% or 8% of the single premium to the accumulation value at issue (based on state approval). It offers a choice of two optional guaranteed minimum withdrawal benefit riders.
But really, who’s best suited to an FIA? “They’re for people who are nearing or at retirement who are looking for principal protection — people who might be looking at other traditional fixed instruments but who want some equity market participation,” explains Dr. Geoffrey VanderPal, CFP®, CLU, RFC®, a co-author of the Wharton study and chief investment officer for Skyline Capital Management in Austin, Texas. “Because with fixed index annuities, it’s not what you make, it’s what you keep. These products aren’t designed to beat an index. They’re designed more to compete with bonds, bank CDs and traditional fixed annuities.”
They’re best suited, then, to investors who are nearing retirement and thus can’t afford to leave their nest eggs vulnerable to another sharp market downturn. People who have endured two major market declines in less than 15 years welcome having a solid floor underneath their assets. “The value of the fixed index annuity becomes apparent in a storm. People see an asset that did not erode or decline in the financial crisis a few years ago,” explains Mike Ebmeier, senior vice president of annuity distribution at Forethought Financial Group®, whose FIA products include the Forethought Income 125™ (see the sidebar, Five Top-Shelf FIAs).
And, adds Hamlin, having that guaranteed floor underneath can afford investors the freedom to position other parts of their portfolios more toward longer-term growth as a potential hedge against inflation, so they have a better chance of their assets outlasting their retirement.”
In the face of so much uncertainty, it’s no wonder investors are finding the new generation of fixed indexed annuities so appealing.
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