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.
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