What are Fixed Index Annuities and are they Right for You

Is it possible to protect your principal and still have the potential to earn double-digit returns? [music]

Hi, I’m Troy Sharpe, CEO Oak Harvest Financial Group, host of the Retirement Income Show, author of the upcoming book, Core4, and CERTIFIED FINANCIAL PLANNER™ Professional (CFP®).

You got lots of information out there. Most of it’s misinformation when it comes to fixed indexed annuities. What is a fixed indexed annuity? A fixed indexed annuity is a contract issued from a life insurance company that guarantees your principal’s protected and allows you to participate in the upside of the market. You have misinformation out there on the positive side, pros about fixed indexed annuities, and you have a whole lot of information out there that’s incorrect, inaccurate, and misleading for the negative side of fixed indexed annuities.

We’re going to talk about the policies today, the contracts today, how they work, the pros, the cons, everything you need to know to learn about this versatile tool and see if it’s appropriate for something in your retirement plan. I use the word tool there. This is a very important concept because there is no such thing as a financial tool that is good or bad. None of them are inherently good or bad.

They are designed for a specific purpose, a specific use, and every financial tool has different pros and different cons. Stocks, the pros are you can make a lot of money over the long-term. The con is you can lose a lot of money in the short-term. Bonds, the pro is you can generate interest. They’re less risky than stocks, but the cons are bonds go down in value when interest rates rise. Every financial tool has a positive and a negative and a specific purpose for which it’s supposed to be used. When you read a lot of information about fixed indexed annuities, what I often find is that the people writing are either ignorant when it comes to how they actually work, or there is an agenda, either an anti-annuity agenda or a for annuity agenda. We want to cut through all that.

We want to give you the information today so you can understand how fixed indexed annuities work. We start with just the basics. What is a fixed indexed annuity? A fixed indexed annuity is a contract issued from a life insurance company. It protects your principal 100% guaranteed and allows you to participate in the upside movement of an external index like the S&P 500. That’s the safe growth component. Now, fixed indexed annuities also have a guaranteed income component. Throughout history, the only annuity that’s been available to people has been what we call the variable annuity.

You look back to the ’70s, the ’80s, most of the ’90s, variable annuities very high in fees, expenses, and really, in our opinion an inferior investment choice. The first distinction you want to make is that fixed indexed annuities and variable annuities are two completely different things. You hear a lot of people say I hate annuities or annuities are bad. Oftentimes, they’re talking about the variable annuity, and fixed indexed annuities get lumped into that. Annuities historically have been designed for guaranteed income, but that’s not the case anymore. Today’s fixed indexed annuities can also be used simply for safe growth.

You can take income as needed, and when the contract’s over, you can walk away with your money and do whatever you choose to it. You don’t have to take a guaranteed lifetime income. Now, the guaranteed lifetime income feature is valuable to a lot of people because three out of four retirees fear running out of money more than they fear of death. This is a valuable feature to have as part of an overall retirement plan, but it’s not necessarily– You don’t have to take a guaranteed income from your fixed indexed annuity. Some of the basics are you have either a participation rate, a cap, all fixed indexed annuities have a reset feature. Then I want to talk about fees for a minute. A participation rate just simply means it’s how much you participate in the external index, like the S&P 500. A cap means the maximum amount that you can earn.

If you have 100% participation rate and a 5% cap, that means you’re never going to lose any money, but the most you can make is 5%. Now, today’s fixed indexed annuities, the best growth vehicles out there have no caps whatsoever.

Now, because there’s no cap, you get a lesser participation rate. If you can get somewhere between a 40% to 55%, maybe 60% participation rate and no cap, you position yourself for the best safe growth opportunities in the marketplace. The reset feature is designed to give you peace of mind. This is how your gains become locked in. Now, everyone should have money in the stock market if you’re comfortable with the stock market. It’s the best place to make money long-term, but people who aren’t comfortable with the stock market and want higher potential returns than what bonds and CDs offer really find value in the fixed indexed annuity because of this reset feature. What we like to see is an annual reset, and that means that the gains that you earn they’re locked in every year.

If you make 5%, that’s your new principal, will never be worth less than that. If you make 10%, it’s never going to be worth less than that. We’ll go through an example of this reset feature. Finally on fees, you hear a lot of people say that annuities have high fees. They’re partially correct. Variable annuities are the ones that have high fees. We do these analyses all the time, and we see 3%, 4% or 5% a year in annual fees when it comes to variable annuities. Your fixed indexed annuities, 95% of the fixed indexed annuities in the marketplace have zero annual fees. When you hear high fees and annuities, that’s variable annuities. Fixed indexed annuities have no annual fees.

I’m going to give you an example of how this reset feature works in a participation rate. Let’s say we have a 50% participation, 50% par rate and no cap. We call this an uncapped strategy. 50% participation, no cap on the upside earnings. This example, this is the S&P 500. If the S&P 500 does 12%, your contract goes up 6%, and then the gains that you earn are locked in. They can never be given back. That’s your new baseline. From year one to year two, the market goes up again. Let’s say this is a 20% gain in the market you make 10%. You made 6% the first year, you made 10% the second year.

Those gains are locked in, that’s your new base principal, your account will never be worth less than that. Now the next year, the market after a nice rally, it retreats it pulls back, let’s say, 25%. With a fixed indexed annuity, you don’t lose, you don’t go down, you stay right where you are. You earn zero so you won’t earn any interest that year, but you go sideways, you don’t lose any money. Your principal’s protected, your interest gains are locked in, and you start a new horse race essentially at your next contract year. Now, from here, when the market starts to go up again, with the fixed indexed annuity, you don’t have to wait for the market to get back to where you left off before you start earning interest. As soon as your reset period happens, when the market starts going up, you start going up from there.

If the move from here to here in the market is 12%, you’re going to make another 6%, and then those gains get locked in again. This trend continues for the life of the contract. The market goes up again, we participate in those gains. If the market goes down, you go sideways, you don’t lose. Contract locks in, your gains lock in, your principal’s protected. When people say fixed indexed annuities, there’s a lot of misinformation out there. They’ll say you have low caps or low returns. Yes, there are fixed indexed annuities on the marketplace where you’ll have a 3% cap. That’s not something you want to own.

You’ll have 100% participation but a 3% cap. That’s not a good growth fixed indexed annuity, but if you have the uncapped ones like we like to use for our clients, we’d like to see for the best growth potential, you want the highest participation rate. Anywhere between 40% to 60% participation rate, you can expect returns averaging in between 4% to 6%, historically speaking. We’re going to go to the website now and we’re going to look at an example. We have this on the website here. This is our website, it’s oakharvestfg.com. It’s under Resources, the power of zero, scroll down.

This is a fixed indexed annuity linked to the S&P 500 with a 50% participation rate and no cap on earnings. Going back to 2007 to 2018. We wanted to show what happened in 2008 and the power of zero with a fixed indexed annuity. In 2007, the S&P did about 3.5%. You would have made 1.77%. 2008 was down big. Everyone remembers 2008. You make 0. 2009, 23.5%, 11%. We’re getting 50% of the gains the positive movement in an external index like the S&P 500 without any of the downside risk. See all the negative years, 0000. Annual returns at 1.7%, 11%, 6%, 6%, 14%, 5%, 4% and 9%.

Yes, you can have the potential for double-digit returns with a fixed indexed annuity while also having your principal protected. The key is you don’t want to have a cap. You want to have a participation rate and an uncapped strategy. When we look at the growth of an investment, over the same period, we look at $500,000 invested in the S&P 500 in 2007 versus $500,000 in a fixed indexed annuity with the 50% power rate and no cap. You can pause the video if you want to look a little bit more closely, but the end result here is in 2018, you have $900,000 in the FIA, $883 in the S&P 500.

FIAs are not designed to compete with the stock market. That’s not what they’re designed to do. You should not expect to outperform the stock market, but what this shows you in retirement is the power of zero. You have the risk of big losses in the stock market. We all know that, but the FIA eliminates that potential for loss. The FIA is a tool, it’s nothing more than a tool. It has pros, it has cons, it has downsides but it’s meant to compete with bonds.

It’s meant to compete with CDs. When we look at a traditional 60-40 portfolio, the way you use a fixed indexed annuity is in conjunction with stocks. You don’t replace your stocks and buy a fixed indexed annuity necessarily. In appropriate portfolio, just like a 60-40 stock in bond portfolio should be a mix between stocks, possibly bonds, and a fixed indexed annuity.

When they all work together, you lower your overall risk without sacrificing the potential for too much return. When I say they’re an alternative for bonds, this is really important. When you look at the economic environment that we’re in, where interest rates are rising, this is the Vanguard Total Market Bond Index Fund. If we look over the past two years, the bond fund has went down in value. As interest rates rise, bonds go down. Over the past 30 years, we’ve been in the opposite environment. Interest rates have been coming down and bonds have been going up.

Moving forward, most experts think that interest rates are going to continue to rise so you should expect bonds to gradually decline in value. This is why the fixed indexed annuity, in our opinion, is a superior tool to a bond fund in this type of economic environment. First and foremost, the FIA, you’re guaranteed against principal loss. Your gains lock-in, but you participate in the upside of the market, if the market goes up, you’re going to participate in those gains and this safe tool is going to- the FIA is going to give you a better potential for long-term growth.

This is the Vanguard total bond market fund. I have another one up here, this is the iShares AGG, it’s the US Aggregate Bond. Over $80 billion is invested in this bond fund. If we look over the past two years, same thing, it’s down a little bit. Both of these, if you look over the past five-year period it’s the same story. As interest rates rise, bonds go down. This is why we feel the fixed indexed annuity can be a superior tool for retirement for somebody who is conservative, who doesn’t want a lot of stock market risk, and really doesn’t want to see a lot of their money in bonds that aren’t expected to increase in value as interest rates rise.

That’s the safe growth component of the fixed indexed annuity, but there’s another component to fixed indexed annuities, and this is the guaranteed lifetime income. I said earlier, three out of four retirees fear running out of money more than they fear death. When we look at the guaranteed lifetime income component, we’re going to have more videos on this. Make sure to subscribe and hit the little bell icon to be notified when we upload them. Your fixed indexed annuity, if you want guaranteed lifetime income, one of the best ways to do it is by adding what we call a guaranteed lifetime income rider.

Let’s say you put $100,000 in. Your money is tracked two different ways. This is the safe growth part, everything that we just talked about is your walkaway money. You can make simple withdrawals from it, just like any other account. If you want to go in and take out $5,000, $10,000, and it’s also your death benefit. Now, if you attach the lifetime income rider, what happens is you’ll get a guaranteed growth rate that can be used for lifetime income purposes.

Today’s rates are around 6% to 7% guaranteed, usually for up to 10 years. Then whatever this grows to, you can activate a guaranteed lifetime income, and a really cool concept that’s pretty new to the market over the past four or five years is what we call a doubler for long-term care. How this can be used is either for safe growth or you can attach the rider, and even many policies today, these riders come included at no cost. Some of them you have to add the rider, and it’s usually an annual fee of about $0.95 to add it, but this is going to grow safely while participating in the upside movement of the market without risk of loss. This side, you’re going to get guaranteed growth which if you start with $100,000, in 10 years, it’s going to guarantee that you have about $200,000 to take an income from.

Whatever that income is, let’s say it’s $10,000 a year to supplemental income designed to supplement your social security. If you need long-term care or home health care later in life, if you have this doubler feature, that $10,000 a year of guaranteed lifetime income will double to $20,000 a year of guaranteed lifetime income. This is just an introductory summary. We’re going to have more videos like I said that gets into more depth about both sides of these contracts. I just want to give a high-level understanding of what the fixed indexed annuity is and the versatility that it brings to the table.

The downsides. Most of your fixed indexed annuities will give you 10% annual liquidity. Now, this is not a short-term strategy. It’s not something you put your money in and you’re going to take it out the next day. It’s for money, a portion of your retirement, that you want to be safe and protected, providing you income, but you don’t need to touch all of the money for some time. If you do need to go in and touch the money, most policies out there, over 90%-95% of them are going to allow you to access 10% of your account value each and every year during what we call the surrender charge period. Life insurance companies, in order to make these promises, they have to be able to accurately project their assets and liabilities into the future.

This is why they impose surrender charges because they can’t have you put all your money in and then take it all out the next day because then they couldn’t provide principal protection with a reasonable opportunity for interest gains if they don’t know what they have on the books. Most fixed indexed annuities come with either somewhere between a 6 and a 10-year surrender charge schedule. The difference between the 6-year and the 10-year is the 10-year surrender charge schedule is going to give you more growth potential. The best 10-year FIAs on the marketplace, reasonably you can expect to earn 6% to 7% at least based on the past 10-year history of the returns in the market.

Now, they’re not guaranteed. The 6-year FIAs, reasonably you can probably expect to earn somewhere around 4% to 5%. Now, these are the best ones on the market. They’re the uncapped ones with somewhere between a 40% to 60% participation rate. When we look at wrapping this up, the fixed indexed annuity is a bond alternative. In an increasing interest rate environment bonds are inefficient investments. They just are. The FIA is not designed to compete with the stock market. It’s not designed to replace the stocks in your portfolio, but it should be viewed as a bond alternative. If you’re comfortable having some money in the stock market, maybe 40%, 50%, 60% of your money, that’s completely fine.

When you start to look at the remaining portion, if you value protection of principal, if you’re okay earning 4% or 5% or 6% annually, or at least having the potential to, then a fixed indexed annuity could be a valuable part of a comprehensive investment strategy for you. It’s just a tool. I’s not inherently good, it’s not inherently bad as we’ve went through in this video. They have positives, they have negatives, it’s just a tool.

Then finally, they can be used for safe growth or guaranteed income and both. With the guaranteed income component, you also have the long-term care benefits that some of the fixed indexed annuities provide. This is just meant to be an introductory primer for fixed indexed annuities because there is a lot of misinformation out there and it’s usually coming from people who have a vested interest for you to not buy a fixed indexed annuity, or for people who have a vested interest for you to buy a fixed indexed annuity.

Make sure to hit the subscribe button because we’re going to have a lot more videos about fixed indexed annuities and retirement planning in general. Hit the little bell icon to be notified when we upload a new video. Visit the website at OakHarvestfg.com, and feel free to reach out to us with any questions. Leave your comments down below and we’ll see you on the next video. [music]