Because I’m licensed in all 50 states, I get a ton of calls from across the country with the following question, “Are Fixed Indexed Annuities a good investment and do they really get stock market returns?""
The official name is Fixed Index Annuities (FIAs), but the product is also referred to by the public as Indexed Annuities and Equity Indexed Annuities. Some agents even over-hype the product by calling it a Hybrid Annuity. On a side note, a hybrid is a plant, a car, and even a mattress. It is not an annuity.
So the short answer to the initial question is that Fixed Index Annuities can be a good investment if you fully understand the benefits and limitations of the contract and if it fits properly within a portfolio. As for the stock market return question, that one is trickier. The short answer is that occasionally FIAs do get market type returns, but not the majority of the time. That occasional dream return scenario is what agents too often point to.
For FIA critics, they would say that a broken clock is right two times a day when it comes to the market return question. In other words, don't believe the hype. It’s important to know the facts about this popular and controversial strategy before believing that too good to be true sales pitch, because there is a good possibility that your agent or advisor will try to sell you one.
CD Design with a Stock Market Pitch
So how does a fixed index annuity work? Fixed Index Annuities were designed and introduced in 1995 to compete with CD (Certificate of Deposit) returns, and those are the return ranges that have been historically produced. In a non-qualified (non-IRA) account, FIA gains grow tax deferred, but they can also be used both IRA and Roth IRA accounts as well.
FIAs have a guaranteed minimum fixed interest rate that is a separate calculation from the call option accumulation value calculation just in case that index option strategy doesn't work over the long term. This is a benefit of the product that is too often overlooked.
A common call I receive is “What is the difference between a fixed annuity and a fixed indexed annuity?” First of all, FIAs are fixed annuities but there is another fixed annuity type called a MYGA (Multi-Year Guaranteed Annuity). MYGAs are the annuity industry’s purest version of a CD, and the returns are solely interest based. FIA returns are based on call options, so let’s dig a little further into how those work.
So is an Indexed Annuity a stock market return product. The answer is an emphatic NO.
Calling All Options
OK, that’s a bad play on words...but Fixed Index Annuity returns are typically based on a one year call option on an index such as the S&P 500. That is the most popular market index used, but there are over 40 indices currently used with FIA product offerings.
It’s important to point out that the FIA index return does not include dividends with most of these index choices. That’s a big deal when you consider that over 50% of the S&P 500 index (i.e. market index) returns have historically been attributed to the dividends. So the FIA return is based on the performance of that chosen index without the dividend. If the S&P 500 index return starts at 3,000 and ends a year later on the contract anniversary date at 3,500, that northern movement is where the FIA return is calculated. That is a very basic Fixed Index Annuity example called a “point to point” call option, or contract anniversary date to contract anniversary date the next year for the contractual lock in.
To validate the complexity of the FIA product, there are currently over 700 index option choices to go with the previously mentioned 40+ index choices, with some of those indices are made up out of thin air. That’s another argument for another day, but you get the gist when I use the word "complex" to describe Fixed Index Annuities (FIAs).
The FIA index return has limitations (called “caps” and “spreads”) on the upside, but those gains (if any) are permanently locked in on the contract anniversary date. FIAs can be complicated and difficult to understand, so take your time and don’t be pressured into making a buying decision.
Lifetime Income Delivery System
In my opinion, Fixed Index Annuities are best used as an efficient delivery system for guaranteed income and lifetime income by attaching an Income Rider at the time of application.
Income Riders are contractually guaranteed future pension type payments that are a separate calculation from the accumulation (i.e. index call option) value. By using FIAs with Income Rider guarantees, you retain full control over the asset even when you are receiving lifetime income payments. This is important because many people want the lifetime income guarantee, but don’t want to “annuitize” and create an irrevocable income stream contract.
Income Riders attached to Fixed Index Annuities gives you the income guarantee, principal protection, and the potential for better than CD type growth. Not too good to be true, but not a bad combination.
Not A Security
Another typical question I get on a consistent basis is “Are fixed index annuities insured?” An FIA is a fixed annuity issued by a life insurance company and is backed by that carrier’s full claims paying ability and financial strength. It is not a security like a variable annuity. Because FIAs are regulated at the state level, there is also a State Guaranty Fund that backs the cash value of the policy to a certain level. Each state is different, and you can check your specific state coverage limits here.
All annuities are contracts and all annuity contracts are different depending on the carrier and product type. There is no one size fits all annuity type.
Best Story = Top Seller
Indexed annuities are a great sales pitch story. “Market upside with no downside.” That sounds good on the surface, but isn’t factual. Occasionally, you might get a good return on some random year but the blended long term returns will be in line with CDs...or a little better.
FIAs should be valued first for their principal protection and then for their potential returns. You should also look at the surrender charges of the contract and try to shorten that maturity if possible. You should also consider what are those index participation rates and the renewal history of the issuing carrier.
The bottom line is that if the index performs, then you will most likely get a portion of that. In addition, that gain will be permanently locked in on the contract anniversary date. To me, those are good things but certainly not too good to be true.
Sales Pitch Dreams vs. Contractual Realities
If you decide to purchase a FIA, you need to “own if for the steak, not the sizzle.” You need to fully understand Fixed Index Annuity pros and cons, shop all carriers for the best Fixed Index Annuity rates, and find an agent or advisor who has access to a very good Fixed Index Annuity Calculator.
So when you look for the best fixed index annuity rates, understand you are really shopping for an enhanced return CD strategy. That’s the rational approach to take.