The Risk with Fixed Indexed Annuities
Investors looking for safety and reliability often consider annuities, but fixed indexed annuities can have some variables to them that you need to be aware of.
In uncertain times, investors often look for safety of principal. One popular place to look for financial safety is fixed indexed annuities, but they come with risks that consumers should be aware of.
A fixed indexed annuity’s performance is based on the growth of an external index. If the index is positive, then you are credited interest based on your participation in the index. However, when the index is negative you do not lose money. Your principal is locked in annually and does not directly participate in the stock index.
While you are guaranteed not to lose money due to stock market or index losses in a fixed indexed annuity, you aren’t guaranteed to make money. But that’s not the only risk.
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Traditional fixed indexed annuities are designed to renew their rates each year, and the annuity company could increase, lower or maintain the rates they are paying. That means with this type of annuity, the participation rates or crediting strategies may change from year-to-year. Each year the contract holder receives a notice in the mail stating what the rates or crediting strategies will be for the next year. If the annuity company is uncertain of what the near-term future holds, they have the ability to decrease their rates each year. When the economic uncertainty around COVID-19 began, some annuity companies lowered their rates.
Clearly, this is an issue that may give the studied consumer reason to pause before purchasing an annuity, and this is important because annuities are long-term contracts. Nobody wants to be stuck in an underperforming annuity. It could cost the annuity owner thousands of dollars.
A Different Option: Annuities with Participation Rates
A handful of companies have found a solution to the rate of renewal risk. They have developed annuities that guarantee what’s called a participation rate for the entire length of the contract. The participation rate limits an investor’s gains to a certain percentage of a given index’s return. For example, say you have an annuity with a participation rate of 70% and the index that it’s linked to gains 10% that year — your gain would be 7%. If the index finishes the year with a loss, you gain nothing (but you don’t lose anything, either). The annuity carrier can’t decrease the participation rates. This allows the fixed indexed annuity owner confidence that annuity rates can’t fluctuate.
So, if you’re considering using one of these annuities, it’s important to understand that, while the participation rate is guaranteed, you won’t necessarily earn a guaranteed return. The annuity is using an index as a mirror or gauge of how the economy is doing to determine how much the contract holder will earn. What the guaranteed participation rate means is that the annuity company guarantees you’ll receive a specific percentage of whatever the index returns.
Get the Details Before You Commit
This isn’t to say that traditional fixed indexed annuities that renew rates yearly are all bad, but it’s advisable to review the specific company’s rate renewal history to determine what you may expect to earn if you own that annuity.
Then ask for an illustration from the company or adviser assisting you. Normally, the illustration will demonstrate how the annuity would have performed over the last 10 years, the best 10 years and the worst 10 years. This information will help eliminate financial surprises with your annuity and may help you develop reasonable expectations for your annuity.
When you couple a guaranteed participation rate with a volatility control index, life gets even sweeter for the contract holder. In times past, indexed annuities primarily based their rates on the S&P 500. If the S&P 500 performs well, you might do well in the annuity. If the S&P 500 does poorly … well, you don’t lose anything, because your principal is protected. You may not earn anything that year, but remember – zero is better than a negative number any day of the week!
Several years ago, annuity companies began partnering with asset management companies, such as Janus Henderson, to develop indexes like the Janus SB Global Trends Index, which attempt to control the volatility in the index. The way companies such as Janus attempt to achieve this is by combining an equity component like the S&P 500 that most annuities use while adding bonds and commodities as well.
The thought process is that if the stock market were negative that year, then perhaps commodities would be up. It would allow the index to control the volatility and attempt to create more consistent and stable returns. I believe we will begin to see more annuity companies offering guaranteed rates and using customized indexes for the reasons outlined here.
A Hedge Against Market Volatility
While the stock market historically goes up over the long term, we know from the last few years that it may be a bumpy ride along the way. Using a fixed indexed annuity to mitigate against market gyrations may be a solution to consider for a portion of your portfolio as you approach retirement or are in retirement.
Historically speaking, we have seen it take a couple years for stock markets to come back from losses. While the market quickly came back from its lows in 2020, that isn’t always the case, and who’s basing what’s normal on 2020 anyway?
In retirement, if you are taking income off your savings and the stock market is down, that may be problematic. Drawing your assets down when they have taken a market hit is a double whammy. This is one of the key aspects that a fixed indexed annuity guards against. Using an index annuity for a portion of your portfolio may be worth considering.
This strategy may even allow you to take more risk in your equity positions because you know that the money in your annuity is safe from market losses. The fixed indexed annuity has an array of uses, but the best recommendation is to find a qualified adviser who’s knowledgeable about the evolving world of fixed indexed annuities. A qualified adviser can help you determine if an annuity is appropriate for your portfolio.
We are a financial services firm that utilizes insurance and investment products. Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and Clients Excel, LLC are not affiliated companies. All investments are subject to risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Any references to guarantees or lifetime income generally refer to fixed insurance products, never securities or investment products. Insurance and annuity product guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
David C. Treece is the president and founder of Clients Excel, an investment advisory firm in Spartanburg, S.C. David has helped many people understand the role annuities play in their financial planning since his start in the business 10 years ago. He writes a weekly financial newsletter that can be found on his firm’s website (www.clientsexcel.com). David is an Investment Adviser Representative, and he is insurance licensed.
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