Fixed Index Annuities Provide Upside Market Returns and Avoid the Declines
By Louis Horkan
Reviewed by Nathan Kattner
Last Updated: 3/24/2024
Fixed Index Annuities have long received a pretty bad wrap in the media and among some in the advisory industry, yet many advisors and investors are waking up to some of the unique benefits and guarantees they can deliver.
You owe it to yourself to learn more about these retirement tools to determine if they might be well-suited to your situation, needs and goals.
Introduction
No doubt you’ve heard or read about annuities at some point. The media and many advisors treat them like the plague and make all sorts of negative statements and warn investors away from them at every opportunity.
Despite the negative noise often surrounding them, they aren’t scary or mysterious, or instruments created by insurance companies for the sole purpose of robbing you of your hard-earned money.
Simply stated, they aren’t meant for everyone or for all situations – no financial product is. That is especially true with a fixed index annuity or FIA.
But they are intended to address certain types of needs and situations and are often a great choice for doing so. They’ve grown in popularity and usage as more advisors and their customers have learned about them and how they can be a good tool for use in a portfolio.
You’ll actually find you have a lot of company when it comes to investors purchasing annuities.
According to trade industry group LIMRA, annuity sales totaled a record $385 billion in 2023. Of that amount, nearly $96 billion were FIAs.
Don’t know about you, but that sounds like testament to the fact that a lot of people have learned about them and are using these financial instruments as intended – as a financial tool for investors with specific needs dealing with assorted situations.
Ultimately, only you can decide if an annuity such as an FIA is right for your portfolio. Today we are going to provide some basics to help you gain a greater understanding of this unique financial product.
Armed with that knowledge you can begin to make an informed decision as to whether an FIA might be well-suited for you and your situation.
What is an FIA?
Straight up, an FIA is a type of annuity. And an annuity is simply a financial contract between you and an issuer (usually an insurance company) that guarantees certain things, such as a rate of interest that will be paid over a stated period of time.
In exchange for the interest that will be paid, and guarantees that are included, you place a sum of money with the issuer. In turn the issuer uses the money over the period of the contract to earn money themselves.
That’s no different than a bank or a government or corporate entity paying you interest for the use of your money. You see this every day – think bonds, CDs and savings accounts.
That’s all pretty straightforward…nothing scary or mysterious.
Granted, as it is a contract there is a lot of legalese included, but basically it lays out the terms, guarantees, rules, procedures, limitations and other important information that will be associated with the FIA (e.g., financial tool) you purchase.
Financial tool is the operative concept here. They can be a very useful tool in an investment portfolio – think equities, funds, bonds, and more – if they are used correctly and in the right scenarios.
This is especially true for those nearing or in retirement, as a part of their retirement planning and where they are seeking to address specific issues, needs or goals.
Pertaining specifically to an FIA (introduced in the mid-90s), it is actually a type of fixed annuity that is intended to provide principal protection combined with growth potential. They come with lifetime income guarantees and other options for you and often your spouse.
They are meant to be a stable, long-term tool (contracts are often 5+ years) and are not intended to be traded like stocks or bonds in the secondary market.
Unlike other types of annuities, or fixed income instruments such as bonds and CDs, an FIA offers potential upside in your return because it is benchmarked to an index, such as the S&P 500. There’s actually an industry study that details the fact that FIAs outperformed long-term bonds over a 25-year period of time.
There are in fact up to hundreds of indices that can be selected with an FIA, depending on the issuer. The FIA enables you to capture a portion of the positive growth in any of those indices in any given year.
But unlike other portfolio tools, such as stocks and bonds, an FIA is not invested directly in the market, so you don’t participate in losses due to market declines.
In fact, insurers place various types of floors in the contract so your principle and the interest you earn over time is guaranteed to never decline.
Where do you start?
One of the first things that you have to do if considering the purchase of an FIA is to familiarize yourself with some key details:
- Who they are best suited for
- Don’ts
- Components
- Realistic expectations
- Benefits
Who should consider an FIA?
An FIA is best suited for investors in (or at least near) retirement who are seeking safe accumulation and the potential for upside appreciation, but without introducing direct market risk.
They are also suitable for investors seeking guaranteed lifetime income to help mitigate longevity risk – the risk of outliving your assets.
Additionally, they are useful for investors looking to maximize their ability to increase their tax-advantaged investment. An investor can contribute to an FIA beyond their IRA and 401(K) account contributions.
Keep in mind there are qualified annuities (generally purchased in an IRA or employer-sponsored plan) using pre-tax dollars, but they are subject to the annual IRS contribution limits.
A non-qualified FIA investment is unlimited in size (using after-tax dollars) and provides the advantage of tax-deferred growth, with no tax due (on gains) until such time as distributions are taken, hopefully at a much later date.
Don’ts
Suitability and intended use are big issues with any financial tool – that is certainly the case with FIAs. Just as there are certain scenarios and uses where they are appropriate, there are those where they aren’t. Unsuited for certain investors, lack of liquidity and over-allocation are key issues to avoid.
Wrong investor profile – first up, they aren’t generally appropriate for younger investors. They are not suited for the 30- or 40-year-old investor who would probably be better served with direct investment in the market. Investors with a longer-term investment horizon and a greater appetite for the rewards that can come with market participation, and who are fine with increased risk, should avoid.
Illiquid – An FIA is not intended to be a trading instrument, like a stock, funds or bonds. In fact, they are not registered securities, which is the reason they don’t come with a prospectus.
To ensure investors don’t move in and out of them, they come with what can be steep surrender fees of 5- to 25-percent, and more, starting in year one. More on that shortly.
Issuers include the surrender fee on purpose to dissuade investors from the bad habit of tapping into their retirement savings and ensure they (the insurance company) has use of the money invested for a set period of time.
Ultimately, an FIA is intended to be held for longer periods so that interest (compounded) can have a chance to accumulate for the benefit of the investor.
Over-allocation – Another important issue when it comes to investing in an FIA is the fact it is never supposed to be where you put all of your money. As with any investment tool, and your portfolio as a whole, proper allocation is critical.
We all know that putting all your eggs in one basket exposes you to myriad risks. Proper allocation allows you to diversify, spreading your money around and minimizing overexposure to any one asset, industry or investment type.
Wade D. Pfau, PhD, CFA, RICP®, considered a leading industry expert in planning and annuities, actually suggests no more than 40-percent of one’s portfolio be invested into annuities, with many others suggesting 20- to 30-percent as a maximum allocation for this type of financial tool.
Important components in a contract
There are many things included in an FIA contract, but there are number of key components you should understand and be aware of before ever purchasing.
Some can sound very limiting, such as participation rates, caps and spreads. They are used by insurers to help mitigate their own risk, given the guarantees and benefits they provide to the investor.
Frankly, insurers wouldn’t offer annuities if they couldn’t make some profit over time and be able to mitigate their own risk.
It’s helpful to recognize why some of these things are included. Most FIAs issued don’t come with an upfront sales charge or load. (When used we always suggest no-load products). The issuer will use these features to help price the FIA.
As with any type of product, more bells and whistles, as well as available options, comes at a cost. Same holds true with purchasing an FIA with fewer restrictions. End of the day, you are free to make decisions in terms of what’s offered.
The key is understanding what these features/components are and why they are used, as well as how they might impact your returns. And equally important, recognizing they are disclosed in the contact so that you are fully aware of their inclusion before purchasing an FIA.
Key components of an FIA contract include:
Account value – this is also referred to as cash value and is based on a number of factors. The account value includes the premium paid (lump sum or multiple purchases) plus growth or interest accrued, minus fees paid and withdrawals that have been taken.
Were you to walk away before expiration of the FIA this is what you would receive, minus any surrender charge that might be due. If instead you decided to annuitize the contract at some point, this is the value of the income stream that would be created and distributed in payments.
Reset period – this is date when the issuer applies the interest that has been earned on the FIA. Many are 12-months from date of purchase, but the period can be one, two, three years, or even longer.
Crediting method – the date when interest is credited to your FIA is based on the crediting method built into the contract, which is stated at the time of purchase. Many are designed to credit on a point-to-point basis tied to the reset period of the contract, such as 12-months, but you’ll find some are two years or more.
An alternative is monthly, but we don’t suggest that crediting method.
Renewal rate – this is the new terms offered at the date of reset (reset period) for the FIA. This includes participation rate, caps, and spreads. They can change from the original contract, but typically remain close to what was originally contracted.
Participation rate – this is the percentage of performance participation you have in the index the FIA is tracking, such as the S&P 500. If you have an FIA tracking the S&P 500 and the index earns 15-percent in a year, and you have a participation rate of 50-percent, you would be credited with 7.5-percent interest for that period.
These can often range from as low as 30- to 40-percent for aggressive vehicles with high equity returns to as much as 100- to 200-percent participation for indices designed to consistently return 4-, 5-, 6-percent to an investor.
Caps – these are restrictions placed on an FIA’s return over a period, such as 12-months. A cap of 8-percent means you would receive up to an 8-percent return based on the performance of the index, but no more, even if the index earned much more during that period.
For example, if you own an FIA tracking the S&P 500 with a cap of 8-percent and the index returned 16-percent for the year, you would be credited 8-percent due to the cap. If the same index earned 6-percent, you would be credited with 6-percent.
Keep in mind that a cap is separate than a participation rate. If you have a FIA with a participation rate of 80-percent and a cap of 8-percent, and the underlying index earned 20-percent for the period (12 months), your participation rate would be limited to 16-percent, but due to the cap your account would be credited with 8-percent interest.
FIA returns can be capped or uncapped. We prefer to have clients purchase products that are uncapped.
Spread – this is also referred to as index margin. It is not a fee that you owe, but it does effectively reduce how much you will earn on the FIA during the period. If the spread on the FIA is 3-percent and the index earns 12-percent, you will be credited with 9-percent for the period.
Surrender charge – as previously detailed, an FIA is intended to be held for longer periods, with most issued for 10 to 30 years. An insurer will build in a charge to discourage an investor from walking away early in the contract.
The surrender schedule usually includes a high fee that starts in year one that then scales down over a period of years. A typical schedule might start with a 9-percent fee for surrender in year one that scales each year down to a zero fee in year 10 and thereafter.
Typical surrender periods are around seven years, but they can go out much longer depending on the insurer. Keep in mind that if you do pass away during this period the surrender charges do not apply.
Expectations
When considering an FIA, it is very important to do so with a good understanding of what they are, how they work, are designed to do, and an overall realistic expectation of what they can deliver in terms of returns.
This approach is the same as with any financial tool that is to be potentially used in your portfolio.
Unfortunately, due to the way some have promoted them in the past, as well as the lack of understanding and/or education among investors regarding these instruments, proper, realistic expectations are sadly lacking when it comes to FIAs.
The critical point that needs to be made crystal clear to any investor considering an FIA is the intended use. They are not supposed to be an alternative to equities, such as stocks, mutual funds, ETFs, et cetera. And they certainly shouldn’t be compared to those instruments when it comes to returns.
They should be considered as a potential alternative to some portion of the fixed income tools you are using or might employ within your portfolio. We’re talking fixed income instruments you purchase to safely provide interest to your retirement savings, such as government bonds, CDs, et. cetera.
Some FIAs could return 10-, 15-, 20-percent, and even more in a given year, but those are not the norm or what should be expected. They are designed to return 3- to 6-percent on average in a safe manner that doesn’t create market risk within your portfolio.
Benefits
An FIA can be purchased with riders and other options that can enhance them, but as with anything else in life, those things come at a price. In this case, they can reduce your overall return.
There are several important benefits that are worth reviewing as they pertain to gaining access to your money: free withdrawals up to a certain percentage each year, the ability to annuitize the contract to provide long-term or even lifetime income you can’t outlive, and the death benefit.
Free withdrawals – even though an FIA should be considered illiquid, most do offer a free withdrawal provision allowing you to take a distribution of a certain percentage of the value of the contract (often up to 10-percent a year) without incurring a surrender charge. You can continue to do so year after year as long as there is remaining cash value in the FIA.
For example, if you have an FIA with an account value of $500k, and needed to take out $40k for whatever use, you could do so without incurring the surrender fee.
If you do take a distribution above the free withdrawal percentage set by the issuer (say 10-percent), you will pay a surrender charge on the amount exceeding the 10-percent.
Using the above example, if you needed to withdrawal $60k during a year, $50k would incur no cost (10-percent of the cash value of the contract), but the additional $10k would incur a surrender charge. With a 10-percent surrender fee, you would owe $1k on the additional $10k withdrawn in this scenario.
It should be noted there are certain exceptions that are offered by issuers regarding surrender, such as confinement to a nursing home or a terminal illness diagnosis. Those are set by the issuer and are important details to nail down before ever purchasing an FIA.
On the issue of taking distributions you have to keep in mind that you will pay taxes on the interest earned in the FIA (taxable portion), as this is tax-deferred income (not tax-fee even though purchased with after-tax dollars), so the gains in the instrument will be taxed as ordinary income in the year the distribution is taken.
Also, there is the 10-percent penalty imposed by the IRS if you do take a withdrawal before reaching age 59½, which is considered an early distribution by the agency. The penalty is in addition to the tax due on the gains.
Annuitization – you can turn (convert) your cash value in an FIA into a series of regular income payments that can last for a set period of time, or even for the remainder of your lifetime. Taxes will be due on the payments (taxable portion/gains incurred), as just explained, but you gain the benefit of a regular income stream for a set period or for your remaining years.
Many FIAs offer an “income rider” for a fee. This feature enables you to set up a future lifetime income stream without being forced to annuitize the actual FIA, enabling it to continue gaining in value over time.
Death benefit – the death benefit associated with an FIA allows for the remaining contract or cash value of the annuity to be paid to beneficiaries of the account owner in the event of their passing. This can occur in the form of either fixed payments or a lump sum distribution.
Conclusion
Okay, we did say FIAs aren’t scary, but the research can be a bit daunting, obviously. We definitely didn’t say you could learn all you needed to about them in 10 or 15 minutes.
There’s a fair number of moving parts and you really do need to take time to get to know them before deciding to purchase one.
In that light, you owe it to yourself to talk with someone who is an actual expert in annuities in general, and with FIAs specifically.
At Oak Harvest Financial Group we have a ton of resources you can access to learn more about this type of retirement tool.
And we have annuity specialists that can answer your questions and assist you in determining if an FIA is suitable for you and your situation. They can also assist you in terms of selecting the FIA best-suited to your needs.
Additionally, If you are currently utilizing a retirement plan (either your own or one created for you), our team would be happy to review it to determine if it is capable of really meeting your goals.
Or we can assist you by creating a retirement plan capable of helping you to retire with confidence. We can build a holistic, comprehensive retirement plan addressing relevant issues, utilizing strategies that cover taxes, income, spending, healthcare, legacy, and more, customized to your family’s specific needs.
A plan created with the goal of ensuring you can successfully live out the retirement you envision.
If you are ready to take the next step and talk to a team of retirement planners who can advise on all your retirement needs, and who will put your interests first, Schedule a call today!
Related Content
Fixed Index Annuities – The Basics
Fixed Indexed Annuities: What is a Participation Rate, Cap, Spread and Reset Period
What Happens At The End Of An Annuity Contract?
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