Stocks and bonds have lost value in 2022, and that’s increased the popularity of fixed indexed annuities (FIAs). FIAs set sales records in 2021, and sales in 2022 are well ahead of 2021’s levels. A new quarterly sales record was set in the second quarter of 2022, according to currently, eclipsing the previous record in the fourth quarter of 2008.
FIAs not only are popular, they’re also controversial and widely misunderstood. Their benefits are clear in the right circumstances. But it’s important to understand exactly what FIAs are and aren’t and be sure any FIA you buy is right for you. A clear benefit of FIAs today is that you’re guaranteed not to lose money, except in a few circumstances.
Your principal is protected. In addition, your account has the potential to earn interest each year, and that interest could exceed what you’d earn from any other fixed income investment. Despite the benefits, many in the media and a number of financial regulators don’t like FIAs. They cite high fees and complicated terms as the main reasons. In addition, misleading and downright fraudulent sales practices have been used to sell FIAs.
The bad sales practices are greatly reduced because of regulations, court cases and self-policing in the industry. FIAs are not stocks or stock-like investments. They’re not even investments or securities. FIAs were exclud- ed from being regulated as securities in 2010. Salespeople used to call them “equity indexed annuities,” but they’re no longer allowed to do that.
FIAs are insurance contracts. They’re also called structured products. Under the contract, you make a deposit with an insurer. The insurer guarantees the safety of the principal and credits interest to your account under the terms of the contract.
The interest is credited based on the performance of one or more indexes or benchmarks. Often you select the indexes from among those allowed by the insurer. In some FIAs, the insurer selects the indexes.
An index might be well-known, such as the S&P 500. But FIAs also use little-known indexes, and it’s not unusual for an insurer to create its own indexes or benchmarks for FIAs. I’ve seen estimates of the number of indexes used in FIAs today range from 150 to over 750.
Many FIAs now don’t allow only one index. Instead, a hybrid index com- posed of several indexes is used. You’re not investing in the index. This is where an FIA can become com- plicated because the interest credited to your account is based on the return of the index.
The interest might be based on the difference between the index level on a starting date (the contract date of the FIA) compared to the level on the ending date, usually 12 months later.
Or the interest might be determined based on the average level of the index during the 12 months. There are other formulas used in FIAs. In addition, when a stock index is used, dividends often aren’t included in determining the return used to calculate your index.
To evaluate the FIA, you need to know, not only the index used, but also the formula for calculating the return used to credit interest to your account. FIAs don’t credit interest daily.
The interest credited to your account usually is determined on your contract anniversary date, which is the date you opened the annuity, based on the return of the index at the end of the 12 months. Variations during the 12 months don’t count. But if interest is credited to your account on your contract anniversary date, that is locked in.
The account won’t fall below that level even if the index declines over the next 12 months. In effect, you’re buying a call option on the index or indexes used for the FIA. Really, the insurer buys call options to hedge the promises made to you. You also should know that the account will earn only a participation rate, not the full return of the index.
The participation rate is the percentage of the index’s return that your account could earn. If an FIA has a participation rate of 80% and the index earns 10% for the year, the return that counts toward your account is 8%. An FIA also has a cap rate, the maximum level of interest the account can earn regardless of how well the index performs. Suppose the FIA has a participation rate of 80% and a cap rate of 10%.
The index earns 25% for the year. Under the participation rate, a 20% return would apply to the account (80% of 25%). But the cap rate applies, so a maximum of 10% interest would be credited to the account. The average cap on FIAs these days is more than 6%.
Several insurers recently increased their participation rates to more than 100%. They’re earning much more interest on their bonds than they were a year ago and this allows them to in- crease potential returns on their FIAs.
In addition, the insurer might deduct some fees and expenses before interest is credited to the account, especially if you added a rider such as an income rider. Another FIA complication is the insurer has the right to change most of the terms over time. Insurers are especially likely to change the indexes available. Suppose an FIA has a 10-year surrender period and a one-year guarantee.
That means you can’t get out of the FIA with- out a penalty until 10 years have passed, but the insurer can change most of the terms after the first year. When your FIA’s indexes do well, you could earn much more interest than you could from other interest-earning investments. And your principal is protected. But you aren’t guaranteed to earn interest.
FIAs used to guarantee a modest minimum return, but for most the guaranteed return now is 0%. If the index is lower on your contract anniversary date than it was 12 months earlier, no interest will be credited to your account. Don’t give much weight to presentations of past performance or hypothetical performance for your indexes and the FIA. Many of the indexes used for FIAs these days didn’t exist 10 years ago.
More importantly, the investment environment in the next few years is likely to be very different from the last 10 or 20 years. If I’m right about that, performance over the last 10 or 20 years will be meaningless for planning. FIAs are for the conservative part of a portfolio.
They were initiated in 1995 as alternatives to certificates of deposit (CDs) and fixed annuities. They’re designed to earn you higher interest than CDs in good times and preserve principal in bad times. Despite the principal protection, there are two times when you could lose money in an FIA.
An FIA requires you to commit for a minimum period. If you withdraw money or liquidate the annuity before that time, your principal will be returned, minus a surrender fee. Lock-up periods on FIAs tend to be seven to 10 years. Typically, if an FIA has a seven-year commitment, surrendering the annuity during the first year will result in a 7% surrender fee. The fee usually declines by one percentage point for each year until it is down to 0% at the end of the seventh year.
You also might lose money in an FIA when you add a rider, such as an income rider. An annual fee, that usually is a percentage of your deposit, is charged for the rider. The fee will be charged even if the account earns 0% interest for the year. So, if the index for your FIA loses value and you have a rider, the account value will decline because the rider will be deducted and no interest will be credited.
There are a lot of FIAs now that offer bonus interest when you sign up. As soon as you make your deposit, interest is credited to your account. Don’t let bonus interest sway you. Bonus interest is offset by changes in other terms of the annuity. Don’t reject an FIA because it offers bonus interest. But consider all the terms of an FIA and buy the one that seems best for you, whether or not it offers bonus interest. You should work with an unbiased ex- pert before buying an FIA.
I recommend Todd Phillips and Stan Haithcock. You can reach Todd at Phillips Financial Services at 888-892-1102 or visit https://epmez.com or https://epmez. com/annuity-analysis. Stan also is known as “Stan the Annuity Man.” Review his annuity calculators and other materials at www.stantheannuityman.com and book a call with him.
Both Todd and Stan have detailed books about FIAs that are available through their websites. You also should know that the account will earn only a participation rate, not the full return of the index. FIAs are for the conservative part of a portfolio. They were initiated in 1995 as alternatives to certificates of deposit (CDs) and fixed annuities.