As we have said before on Annuity FYI, fixed indexed annuities (FIAs) are hot sellers, and we have some fresh numbers to prove it. But if you’re willing to be a bit creative – i.e., strip out some of the bells and whistles and combine the FIA with an immediate annuity – you can do better than you can with solely a FIA.
It makes sense if you think about it. People buy these annuities for two reasons, which is why they’re also known as hybrid annuities. They want the ability to participate in equity growth via an index, such as the S&P 500, coupled with downside protection, and they want lifetime income. This is fine as far as it goes and explains why FIA sales skyrocketed nearly 15 percent in the third quarter of 2015 to a record $14.4 billion and have become the second best-selling annuities (behind only variable annuities)..
But there is a catch: You seldom get the best of both worlds when you combine two into one, and FIAs are no exception.
If the participation rate in the index – the percentage of an increase in the index you actually receive — is set higher, then the lifetime income benefits will be set lower.
The exact opposite is true if the lifetime income benefits are better than average – i.e., the participation rate will be lower. This helps insurance companies maintain their profitability.
“Every annuity buyers tries to get this seesaw to balance, but one end will always be lower than the other,” says David Smith, a financial advisor at Somerset Wealth Strategies.
There is a solution, however. You simply have to break out from the crowd. Specifically, split your pool of money in half – or however you prefer – and buy two annuities – an FIA without a lifetime income rider, which costs about 1 percent a year – and a no-fee immediate annuity, preferably a period-certain immediate annuity.
This way, you still get exposure to the market, but it costs less. And you get more income because an immediate annuity pays higher rates. This will be particularly true if you buy a period-certain immediate annuity, which today offers two additional advantages.
The first is that interest rates are far more likely to rise than fall now that the Federal Reserve has begun increasing them. So if, say, you buy a five-year period-certain immediate annuity, interest rates – and hence your monthly payout – are highly likely to be higher when your first immediate annuity expires and you buy your second to replace it The second advantage is that you will be older when you buy your second immediate annuity. So as long as interest rates don’t decline, it will pay more for the same dollar investment.
Illustrating the advantage of a period-certain immediate annuity, Smith notes that a 60-year-old single man who invests in a lifetime immediate annuity would receive about $500 a month. If the same person invests just $50,000 in a five-year period-certain immediate annuity, he will receive much more — $858 a month.
Annuity buyers will also fare better if they shop hard for a FIA that has the highest participation rate available, if any, as well as a high cap rate (the maximum you can earn a year in the stock market, regardless of performance) – and no spreads (a formula that also undermines the performance of the index).
There are people for whom this split annuity strategy makes lots of sense and others for whom it does not. Many buyers of FIAs care about growth, but more about guaranteed lifetime income. For them, the best path is to stick solely with an FIA.
This strategy is generally best for younger annuity buyers – those 65 or younger – because they generally have the time to let their money grow for a decade or so, heightening the odds of coming out well ahead of the person who instead buys solely an FIA bundled with guaranteed lifetime income. “For them, 10 years of growth is still on the table, and that is a huge advantage in terms of accumulating wealth,” Smith says.
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