There is something special about a particular type of annuity you may or may not have heard of – a so-called fixed indexed annuity (FIA). Its sales have been climbing briskly and steadily while sales of most other annuities have been generally flat or down.
This trend is the all the more interesting given that these annuities – introduced roughly two decades ago – are in fact less attractive than they once were, although there are signs they are starting to become more generous again.
Nonetheless, it turns out that FIAs – despite these and other warts – are the right product at the right time for many pre-retirees and retirees. In a year of dour stock market performance, they offer market exposure with no risk and, with a rider, relatively generous income payments. Look at it this way: FIAs offer a better-than-average deal on the income stream – certainly more than you can get on a traditional fixed annuity – plus exposure to the market, and investors bypass the pain of a bear market should one crop up.
There are some obvious drawbacks, which we’ll address in short order. But a growing number of people are deciding that the pros outweigh the cons.
Definition of a FIA
A FIA is a type of fixed annuity, which is a savings contract with a tax-deferred interest component. Fixed indexed annuities link the annual interest to an investment benchmark, mostly commonly the S&P 500. Buyers are protected against market losses because the indexes are purchased with options, which simply expire worthless in a down market. Offsetting this is that upside gains are capped and dividends are excluded from the calculation of payouts.
Sales of FIAs rose a striking 24 percent to $48 billion in 2014, up from a still-impressive 14 percent (to $38.7 billion) in 2013 according to the Insured Retirement Institute. In the second quarter of 2015, the latest figures available, FIA sales totaled $12.6 billion, up 8.3 percent from the previous quarter and near an all-time high. FIA sales now account for 52 percent of all fixed annuity sales, up from about 15 percent a dozen years ago.
FIAs appeal to pre-retirees and retirees who want principal protection and income guarantees and who also want to roll the dice, at least a bit, via some exposure to the equity market. But unlike the case with variable annuities, these people want to protect that exposer: There is no threat that a prolonged bear market can wipe out the cash value of the annuity. And the income guarantees are typically better than they are in variable annuities, the most popular sellers.
The Right Tool
Today’s FIAs are not as attractive as pioneering FIAs 20 years ago, which paid much higher stock market index participation rates and roughly 4 percent annual interest rates without a rider. But most other annuities are also less attractive – particularly VAs – and the good news is that some FIAs are starting to get better again. For example, Nationwide and Guggenheim, two huge annuity vendors, this year substantially increased the so-called participation rates on FIAs – the percentage of the rise in the equity index that the investor actually receives – to roughly 100 percent.
None of this should suggest that FIAs are a panacea. The aforementioned participation rates are most typically 50 percent. This means investors will get the guaranteed interest rate, not the percentage increase in the stock market index, unless the market enjoys an unusually good year. In addition, there are commonly caps, which limit the amount of the increase in the index investors can reap, and spreads, which subtract some of the market’s gains from your earnings.
Fidelity Investments Study
The impact of these so-called crediting methods was highlighted in a recent study by Fidelity Investments. It spotlighted 2013, the best performance for the S&P 500 in 34 years with a gain of 29.6 percent (and 32.4 percent including dividends). According to Fidelity, a “representative” FIA with a monthly cap on upside returns credited investors only 10 percent that year.
FIAs also tend to have longer surrender schedules than other annuities – the penalty paid for exiting the contract prematurely — and are harder to understand because they have a lot of components. These include riders, rider fees, participation rates, caps and spreads. “There are more moving parts, and so there is more confusion,” says Andrew Murdoch, president of Somerset Wealth Strategies.
Also, unlike VAs, FIAs are not regulated securities, and so they may be misrepresented by brokers. Some, for example, may claim that these have as much upside potential as a VA, which is not the case.
The significance of these drawbacks depends on the sophistication of the buyer. Those who do their homework and are quick to ask questions will not be confused or come away with the mistaken notion that a FIA can be almost as lucrative as a VA under the right circumstance. These people know this is incorrect.
They also know exactly why they are buying the product. “Fixed indexed annuities have become very popular because people understand them better and find the benefits much more appealing than the drawbacks,” Murdoch says.
The fact that investors cannot lose money in a FIA because of poor stock market performance, adds Somerset’s Tschirgi, is a huge lure in the wake of a disappointing year in the stock market and the widespread belief that 2016 will be another rocky year. “Remember that principal, as well as income payments, is guaranteed.” Tschirgi says. “Investors like that a lot.”
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