Call him Jim Smith. A 60-year-old, lifelong Midwesterner interested in burnishing his future retirement portfolio, he heard on the grapevine that he should look into buying an annuity – specifically a fixed indexed annuity (FIA). He was told that it invested in the stock market indirectly and that – hard though it seemed to believe — it would not lose money in a year in which the stock market declined.

So Smith picked up the phone and chatted with a financial planning firm advertising FIAs. Sure enough, it told him that a FIA was an excellent investment that invested in a stock index and did not, in fact, lose money in a down market. The FIA would even provide a 10 percent upfront bonus on the “income base” of his annuity, his broker added – explaining that this was the foundation on which annual cash withdrawals are calculated.

Smith invested $200,000 in the annuity. He isn’t a studious man and doesn’t yet know that he didn’t get the whole story, largely because he didn’t ask good, penetrating questions. When he receives his quarterly and annual statements, he will learn what he should have asked and may regret not buying a different annuity — perhaps a variable annuity, which invests directly in the market, not in a market index, and pays 100 percent of market returns. Smith ultimately learned that his FIA pays only 25 percent of the stock market’s annual return.

The Smith story is apocryphal. But this scenario unfolds all the time, and it’s a big reason why the U.S. Department of Labor has crafted new regulations, effective in January 2018, regarding the way FIAs and select other retirement products are sold. Brokers will have to follow new fiduciary guidelines. They will only be able to sell FIAs to a client, for example, if they put a client’s needs ahead of the FIA’s generous commission.

FIAs — fixed annuities with a variable rate of return, pegged to an investment index such as the S&P 500.– are in the spotlight today because they have been selling extremely briskly in recent quarters, while annuity sales overall ae flat.

In 1Q 2016, the latest figures available, FIA sales reached $15.6 billion, a 35 percent increase over 1Q 2015 and the second-highest quarterly sales mark ever, according to the Insured Retirement Institute. Total 1Q 2016 annuity sales, meanwhile, totaled $56.7 billion — a 7.6 percent decrease from 1Q 2015.

Some FIA buyers know the ins and outs of the product and are happy about their purchase. Select FIAs are good buys. These typically invest in increasingly popular low volatility indexes, which invest in stock indexes but also other assets, enhancing stability, and sometimes pay as much as 100 percent of the gains of the underlying indexes. They may be even better if purchased without a lifetime income rider, which is costly and undermines returns.

But too many buyers are not in this camp. Because the DOL regulations are not yet in place, they often buy into an exaggerated product story. They are not buying an FIA pegged to a low volatility index. They are not told that their FIA excludes dividends, which is a significant negative, nor are they told that they are saddled with an unusually long surrender penalty fee schedule.

An analysis by Fidelity Investments underscores the downside of many FIAs, notwithstanding the periodic bonuses paid. Over the 10-year period ended in 2015, the S&P 500 average annual return was 7.3 percent (5 percent without dividends). These numbers compare to a 3.14 percent annual return for a representative FIA that Fidelity chose to spotlight for comparison.

The bottom line is that the purchase of an FIA may make sense, with or without a lifetime income rider, depending on the preferences of the buyer. But shopping around is critical because many FIAs are poor buys. Until 2018, buyers must be committed to doing independent FIA research. If they are not, they should take FIAs off their shopping list.

Other Annuities on the Menu

No doubt about it – this is a challenging time to contemplate the purchase of an annuity. Seemingly rock-bottom interest rates have declined still further, to unchartered depths. Early in July, the yield of the benchmark 10-year U.S. Treasury note tumbled to a record-low 1.37 percent.

Rates could finally rebound, or they may drop even lower, as they have in Japan and Europe. If this concerns you, one smart strategy would be to buy a ladder of fixed annuities maturing in, say, three, five and seven years, each paying more and, just as importantly, maturing at a different date. This maximizes the odds that an investor can re-invest at a higher rate should one materialize.

Fixed indexed annuities, the topic of the adjacent story, offer lifetime income riders currently paying guaranteed withdrawal rates as high as 5.25 percent. In some cases, these may be another good option, but only if you are comfortable with the fact that the alternative return from investing in the index itself too often will disappoint.

In any case, here is a look at the four major types of annuities in addition to fixed indexed annuities:
 

Variable Annutiies

VAs, the best-selling annuities, make sense for retirees who want full exposure to the stock market. VAs invest in subaccounts (mutual funds) and also offer guaranteed life time income riders. Sales have been falling, perhaps because of fear of above-average market volatility. This isn’t a reason for concern, however, if you have a long-term investment horizon.
 

Fixed Annuities

Fixed annuities are much like bank CDs, but pay substantially more. They are guaranteed by insurance companies — not as good as the U.S. government guarantee, but close. Buyers of fixed annuities should make sure they buy a Multi-Year Guaranteed Annuity (MYGA). MYGAs pay a guaranteed rate of interest, generally 2 percent to 3 percent, depending on maturities, which range from three to 10 years.
 

Immediate Annuities

Immediate annuities target people who want to reap the highest possible interest rate. The annual payout of an immediate annuity can be as high as 10 percent, roughly double withdrawal rates in a typical non-immediate annuity. How much you get depends on your age. Payouts include money from tax-free principal invested in the immediate annuity, as well as interest rates — and so the tax rate on payments is lower. Buyers do sacrifice principal in exchange for more generous payouts.
 

Deferred Income Annuities

Deferred income annuities are for people who want payments in the future, not today. Payments are particularly high in comparison to the size of the investment because these are a form of immediate annuities and because payouts obviously last a shorter time, saving insurance companies money. Tax rates on payouts are also lower. Deferred income annuities are attractive to people who are still working and don’t plan on retiring anytime soon. Only people with strong longevity should buy these because there is no death benefit.

— Steve Kaufman