Know These 3 Things Before You Invest in a Fixed-Indexed Annuity

To evaluate whether a FIA is right for you, you need to understand how you'd make money on the investment, how the insurer profits and how and at what point you can get access to your funds.

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With interest rates as low as they’ve been lately and stock markets as volatile as we’ve been seing, the stage appears to be set for a different kind of investment: fixed-indexed annuities (FIAs).

Created more than 20 years ago, FIAs salved the wounds of many investors who had their portfolios whipsawed by the great recession. Offering some upside potential with a guarantee against losses, these investments are principally a trade-off: You transfer some risk to the issuing insurance company in return for limited participation in the gains of an index. On the other hand, equities offer more growth, but … they can't guarantee anything.

Because of the low interest rate environment, finance experts like Dr. Wade Pfau and economist Roger Ibbotson have recommended that financial advisers and their clients think of FIAs as another asset class, framing them as an alternative to fixed-income investments like bond funds. Dr. Pfau believes that the guarantees afforded by FIAs may be especially beneficial for retirees during volatile conditions, saying that "This protection may make it easier to retire successfully in down market environments."

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It's easy to see how they could appeal to investors. As markets grow more volatile, FIAs are enjoying a swell of popularity … but they are sometimes oversold and misunderstood. Before you buy a fixed-indexed annuity, you need to understand these three things:

  • How you earn money with that investment.
  • How the insurance company earns money.
  • How access to your money may be limited for a period of time.

We will get to all of that. But first it makes sense to take a look at how we got to where we are now.

The Interest Rate/Stock Market Roller Coaster

Major artifacts of the great recession 10 years ago include the low (but rising) interest rates we see today. They were lowered as part of the Federal Reserve's loosening of monetary policy to promote borrowing and stimulate the economy. Policymakers chose this route, rather than the austerity policies favored by other central banks.

That's great, because it may have saved our bacon, and may be due credit for the 10-year-long bull market we've been riding. But some economists believe this expansion cannot continue.

If they are right, the low-interest piper may be coming to collect because as markets begin to grow volatile, or a correction seems imminent, the fixed income investments most folks would turn to for safe harbor are most sensitive to interest rate risk. Which is to say that interest rates and bond prices have an inverse relationship. With rates so low, bonds may not offer the ability to de-risk as they have in the past.

The bottom line: Long-term bonds purchased today will be worth less in the future if rates rise, and short-term bonds (with yields as low as they are right now) simply may not offer enough “oomph” to meet investing goals over the next few years.

Consider the average 5-year CD, as well. According to the FDIC, the average interest rate for jumbo deposits in early November 2018 was 1.2%. Investing $100,000 in a 5-year CD offering 1.2% would grow the account to only $106,145 at maturity. It's hardly worth locking that money away for such a long time.

3 Fixed-Indexed Annuity Lessons for Investors

Demand for safe harbor with higher potential returns has folks seeking alternatives like fixed-indexed annuities. Here’s what they need to know before they decide to buy.

No. 1: How You Are Paid

One of the primary confusions about fixed-indexed annuities is how they earn money for their owners. Folks selling them may sometimes say things like, "They offer equity exposure without any of the risk." It's important to understand that there are no underlying investment options in a fixed-indexed annuity, so there is no actual exposure to equities.

  1. Instead of investing directly in underlying investment options, you are credited interest via a market index of your choosing. Some of these indices are common and widely known, like the S&P 500, EAFE or Russell 2000. Others may be proprietary, and not as well known. It's always a good idea to ask your adviser for help selecting an index.
  2. Index return is usually credited to FIA accountholders less any dividends. When the actual S&P 500 index delivers a 14% return, that generally means with dividends reinvested. Dividends may comprise 1% to 2% of that return, so the actual credit may be more like 12% to 13%.
  3. Commonly, interest is credited yearly on an anniversary (“annual point-to-point crediting” for instance). This means that there is usually no new daily value for these products. If you invest $10,000 in a FIA with an annual point-to-point crediting, the contract value will be $10,000 for 364 days until the contract anniversary. If the index returns 4%, excluding dividends, your account is then credited with $400, and your account balance grows to $10,400 on day 365. Then the cycle starts again.
  4. If you were to withdraw all of the funds from the policy on any one of the 364 days until that day when earnings are credited to the account, you would not be credited for any earnings and you may be on the hook for surrender charges and MVA. (More to come on that in a bit.)
  5. These products are not securities, so they're not regulated by the Securities and Exchange Commission. They are not sold with a prospectus.
  6. Bonuses are not free. Some insurance companies incent the sale of FIAs by offering contract owners a “bonus” when the initial investment is made. Understand that these bonuses are priced into the product in a variety of ways. You will ultimately pay for that bonus one way or another.

No. 2: How the Insurance Company is Paid

There are no additional fees charged for investing in a FIA, but investors “pay” for FIAs in the form of limited participation in a given index's return via caps, participation rates or spreads.

A very small portion of the funds you contribute to purchase a FIA are invested in call options to provide the market-linked growth. The cost of those options then determines the caps, participation rates and spreads.

A large portion of the funds contributed to the purchase of a FIA are also invested by the insurance company in investment-grade bonds. The company pays itself the difference between the yield on this investment portfolio and the cost of the call options.

Remember that while performance on the upside may be limited, a floor protects you from any losses. This is what you are paying for: a guarantee against any losses.

  1. Like a "ceiling," caps limit how much money you may earn via a particular index. When you choose an index, your account is subject to the rates offered at that particular time. If a cap of 8% is placed on the S&P 500 index of a given FIA, then 8% is the most you may be credited for that period. If the S&P 500 returns 12% that year, you get 8%. If it returns 7%, you are credited with 7%. If it returns 50%, you get 8%. However, if it suffers a negative year, say it falls 30%, your account value doesn't change for that year.
  2. Participation Rates work much like caps but limit gains to a certain percentage of a given index's return, rather than a fixed limit. If you choose the S&P 500 index with a participation rate of 80% and the S&P returns 10% in a given year, you are credited 8% (which is 80% of the S&P’s return). If the S&P returns 50% in a year, you are credited 40%, etc.
  3. Spreads work a little differently than caps or participation rates. They offer a baseline over which interest may be credited. If you chose the S&P 500 index again, with a 4% spread, you'll only be credited with interest if the index performs better than 4%. If the index returns 4%, you are credited with nothing. If it returns 6%, your account will be credited 2% and so on.

Once you select an index for a given period, you are locked in to the cap, spread or participation rate for that whole period. When the period ends, you may then select a different (or same) index with potentially different caps, spreads or participation rates, and begin again.

No. 3: How Access to your Money May be Limited

To understand how access may be limited to your investment, you must first understand how insurance companies cover their obligations in these products. Basically, they make long-term investments (like puts in the options market) for a specified period of time … call it five years or seven years. These investments insure the company against losses, making it possible for them to offer these benefits.

  1. Typically, these products offer “free” withdrawals of up to 10% annually, but they aren’t exactly free because these withdrawals will, of course, impact the account value.
  2. To further protect their investment, insurance companies impose “surrender periods” during which investors are charged CDSC (contingent deferred sales charges) or surrender penalties. These penalties reimburse insurance companies if clients cash out, and typically decrease annually until they are exhausted by the end of the surrender period.
  3. This surrender period may correlate to the period of the long-term investments they make for risk-management purposes.
  4. I've learned that the sweet spot for surrenders (where the products tend to offer the most value for the least amount of time) is right around seven years. Some products have extraordinarily long surrender periods of 14 years or more! We recommend zero-commission products with surrender periods of five or seven years.
  5. MVAs, or market value adjustments, may also be applied if an amount over the free withdrawal threshold is taken out of the FIA during the surrender period. An MVA is computed to adjust your annuity's value based on the broader interest rate environment. It can increase or decrease your account's cash value. Insurance companies are then able to manage risk by aligning your account's cash value with the long-term investments they've made to back your account's guarantees. If interest rates are higher when you withdraw than when you made your initial investment, the MVA will have a negative impact on your cash value. If interest rates are lower, the opposite is true.

The Bottom Line for Investors

Built to offer better returns than CDs (certificates of deposit), fixed-indexed annuities are a fairly conservative investment. If you are nervous about upcoming market volatility, and want to take some risk off the table, then a fixed-indexed annuity may be a good option. Like investments in bonds and CDs, they may require locking your money away for a prescribed period of time. Make sure you consider liquidity needs over the next five to 10 years before making a decision.

No-load fixed-indexed annuities are likely your best bet. By removing commissions, insurers can afford to shorten surrender periods, raise caps, sweeten participation rates and minimize spreads. Improving upside potential can help you meet your retirement investing goals easier.


This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

David Stone
Founder and CEO, RetireOne

David Stone is founder and CEO of RetireOne™, the leading, independent platform for fee-based insurance solutions. Prior to RetireOne, David was chief legal counsel for all of Charles Schwab's insurance and risk management initiatives. He is a frequent speaker at industry conferences as well as an active participant on numerous committees dedicated to retirement income product solutions.