We currently live in a world where interest rates are low (at least in the United States) and income needs for retiree investors are quite high. This has ushered in a wave of financial products engineered to do their best at providing solutions to the fear of outliving retirement savings. It is very easy however to either ignore or get lost in the complexity of these products.
This post will focus on Fixed Index Annuities. In full disclosure, at the time of this writing, we rarely if ever think that these products are appropriate given the current offerings in the marketplace. We believe that similar results can be attained in a more efficient and beneficial manner. We will discuss some of this later on.
So what are fixed index annuities?
This annuity, like most others, is a contract between you and an insurance company. All guarantees are backed by the claims-paying ability of the insurer. This is why it is very important to investigate the credit rating of the insurance company and also understand your specific state’s insurance guarantee limits.
Below are some of the beneficial features available inside a fixed index annuity:
Tax deferral on the growth not subject to IRS limits – to be fair, IRA accounts also have the feature of tax deferral (meaning you won’t pay taxes until you withdraw the money later) but IRA’s and 401(k)’s are subject to IRS contribution limits. Unless you are a super-saver these limits will be unlikely to inhibit your saving and investing goals.
Protection from market downturns – these products say that they offer market upside without the risk of loss. We shall shed light on this claim in just a moment.
- Income and Death Benefit guarantees – these products may also offer income and death benefit options (called riders) that are attractive to the investor.
To address the second point above about protection from market downturns, in our discussions with investors, this has been the #1 feature that attracted them to the product. It comes at a cost. In order to provide you with the downside protection of not losing anything in a down market, the insurance company will limit how much you can make on the upside so that they can keep the rest for themselves (sometimes called spread cost). Some of the methods for limiting your participation will be discussed more below.
Beware of Surrender Charges
Before you purchase or even consider an annuity product, understand that there are typically surrender charges that apply. Often times these surrender periods last 5-10 years and any large withdrawal or liquidation will likely result in a penalty. The penalties tend to be higher early on and decline over time until the contract term is over. So know your contract terms before you commit any money.
In the examples below and throughout the article, when we refer to the S&P 500, this is simply a reference to a popular stock market index that is often used to calculate the underlying returns of the index annuity.
Understanding Crediting Method Options
When making contributions to a fixed index annuity, you will choose from a variety of crediting options. These crediting options are just the method by which returns on the underlying stock market index (i.e. S&P 500) will be reviewed in order to calculate the return that will be credited to your contract.
Annual Point to Point – for most people this will not be a typical annual return (i.e. January to January) but rather the point to point performance of the underlying index from your contract anniversary date to the next one. So if you bought the contract on June 20, then the return would be calculated from June 20 to June 20 of the next year)
- Monthly Sum – this method takes the ups and downs of each month in the market and adds them together to create a rate of return.
- Monthly Average – this method adds the monthly index value each month and then divides by 12. This is then compared to the index value at the starting point (i.e. your policy anniversary date)
Performance Calculation Nuances – Price Return vs Total Return
Beware that in any of the above crediting methods, the returns of the underlying index are “price-return” and not total return. Total return takes into account dividends being reinvested on the underlying index. In years like 2015, dividends can make the difference between a positive and a negative year for the index.
How Much Will You Participate in Market Gains/Losses?
So now you know how the returns on your contract will be computed based on movements in the underlying index. Now it’s time to look at how much of that you will get to keep for yourself (if any). The attractive feature to most buyers of these products is that your downside is limited to 0% even when the market is down 36% or so as it was in 2008. Be aware that if you have any additional riders attached to the contract that it is possible to lose money in a given year due to rider cost.
Important Terminology regarding various options for your level of participation in “market-like” returns in Fixed Indexed Annuities:
- Cap Rate – this is the maximum rate of interest you can earn each year (i.e. if the cap rate is 5% and the S&P 500 is +10% then you will receive 5%)
- Participation Rate – this is the percentage of return of the underlying index that you receive as interest on the contract (i.e. if the S&P 500 is +10% and your contract has as 75% participation rate your actual return will be +7.50%)
- Spread – this is a percentage that the insurance company deducts from the index return. (i.e. if the spread is 4% and the S&P 500 finishes the year +10% then you receive 6% (10% return less 4% spread cost = 6%)
The above factors represent the real cost in the product. By offering you the downside guarantee that you won’t lose anything, you are often times greatly limited to participating on the upside.
At the Mercy of the Insurance Company
If you read the details of most contracts, you may find that the level of participation they allow (how much you can earn in the best case) can be adjusted at each policy anniversary. This means that a product that you purchased based on how it looks today could change and drastically limit your earnings potential in the future.
Make sure you read about the flexibility the insurance company has to change such provisions in the contract.
Complexity Is Usually Not Your Friend
In our research of a variety of investment products, it tends to be the case that more complex products do not necessarily yield superior end results for the client. If you find yourself confused over the complexity of something you own (or something you are considering for purchase) stop and ask some questions before making a commitment.
A Historical Perspective
While the future economic landscape is uncertain and always has been since the beginning of time, we extrapolated the returns of various product options since 1896.
Weighing Your Options
As the above table demonstrates, when you consider using a Fixed Annuity or a Fixed Index Annuity, even in the worst case scenarios, you still make money, at least in nominal terms. What inflation was at various times is relevant but not included in this study.
Investors may decide that they are better served to avoid the sequence of return risk (different returns each year, with some years at zero) associated with a Fixed Index Annuity and instead take a small amount of exposure to the stock market in such a way that their returns are un-capped and reserve the bulk of their money for something more simple and guaranteed like a fixed annuity.
Fixed Index Annuities may be right for you if…
- You do not require liquidity (access to your money) for typically 5-10 years or as the surrender schedule of your contract dictates. Many contracts allow for a small percentage withdrawn each year without penalties.
- If you are not willing to tolerate any volatility from investing directly in the stock market (which we think would be a mistake historically speaking).
- If you have weighed the options of this product versus others against your goals and determined that this increases the odds of success towards reaching your goal for investing in the first place.
If you are considering a Fixed Index Annuity and want a second opinion of the product you are considering, send us an email and we would be happy to conduct a complimentary review.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Stock investing involves risk including potential loss of principal.
All annuities are long-term investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Guarantees are based on the claims paying ability of the issuing insurance company.