With retirement planning, there are too many financial products to consider spending money on that it might become challenging. The first alternative that usually comes to mind is the Fixed-Index Annuity or FIA. They might seem almost miraculous in the advertisements, sales pitches, you receive market-linked growth, principal protection and even lifetime income. But can they be as good as they are supposed to be? Or is there a catch?
Now that we have a closer look at what fixed-index annuities are, how they operate, their strengths and weaknesses and whether this type of retirement product can be a good fit in your retirement plan.
What Is a Fixed-Index Annuity?
Fixed-index annuity is a form of insurance contract which you purchase with an insurance company. It is not something that you can buy or sell on the open market like a savings account, or stock investment.
Here’s the big idea:
- Your money will not be lost in case the stock market declines.
- As your growth potential is correlated with a market index such as the S+P 500.
- You do not really own stocks, the insurance company just credits interest to your account depending on the performance of the index.
Think of it as a middle ground. It is not as safe and locked up as a fixed annuity, which has a fixed rate of interest. However it is not as risky as a variable annuity, where your money is literally invested in the market.
How Do Returns Work?
Here things become a little tricky. Fixed-index annuities do not provide you with the entire market performance. Rather, your development is limited to some rules embedded in the contract:
- Participation Rate – It is the amount of gain in the market that you are actually going to receive. In a nut shell, when the market increases by 10 percent and you take part by 50 percent, you will get 5 percent.
- Cap Rate – There is a limit on what amount of money you could make within a certain year. With a cap of 6 percent and the market increasing by 12 percent, you will only receive 6 percent.
- Spread or Margin – Some annuities charge a given percentage off of the market rather than capping it. Assuming it is 3 percent and the market rises 10 percent, you will get 7 percent.
On the other hand, when the market declines, you do not lose money. The annuity has a floor in it which gives you a 0% return over the period.
The Upside: Why Fixed-Index Annuities are popular with people
Many bring notable benefits, which help to understand why FIAs are a common thing, particularly among individuals who are nearing retirement:
- Principal Protection – Your starting amount will not be lost in the event that the market goes down. This state of tranquility is a major attraction.
- The chance of better growth than Fixed Annuities – Because your returns are pegged to an index, you may get a better payout than the low, guaranteed rates that standard fixed annuities yield.
- Tax-Deferred Growth – You do not pay taxes on your earnings until the money is withdrawn, thus allowing the effects of compounding to work in your favor.
- Income Options – Lots of FIAs include optional riders (at an additional fee) to assure a payout of lifetime income, similar to a pension. Others also come with death benefits of your beneficiaries.
These benefits may be quite attractive to a person who desires safety and an opportunity of modest growth.
The Bottom Line: What You should be careful of
Although FIAs are an excellent idea on paper, there are a few critical drawbacks that you should be aware of prior to purchase:
- Low Growth – Due to caps, participation rates and spreads, your returns will never achieve parity with the entire stock market. In the event that markets actually perform well, then you may be left behind.
- Complexity – The contracts are lengthy and laced with many incomprehensible words. Most customers are never certain of how their returns are going to be computed until they realize it is too late.
- Liquidity – Fixed-index annuities are long-term investments. When you attempt to withdraw money sooner than expected you can be charged huge surrender fees and in some cases up to 7-15 years.
- Fees and Costs – Although not all FIAs impose direct fees, many of them do when you include income or death benefit riders. The commissions may also be high to the agents which occasionally pushes them to sell instead of making a recommendation.
- Renewal Rate Risk – The company has the right to adjust the participation rates, caps and spreads after the initial period of the contract. That is, something that appears to be attractive at the beginning may not remain so.
- Issuer Risk – An issuer guarantee is as good as the insurance company insuring it. Your annuity would be at stake in case the company runs into financial trouble.
Who are fixed-index annuities?
FIAs might make sense to some individuals, and not others. They tend to work best for:
- Pre-retirees or retirees seeking to protect their savings, and who still have chance to beat inflation.
- Nervous conservative investors who do not want to leave their money in the stock market and yet would not accept CD-like returns.
- People that want income guarantees, have to know how much it costs to add riders.
They are not necessarily the right option when you are:
- An investor who is still young and has many decades to live to absorb market volatility.
- A person who believes in liquidity and does not want to fiddle with his or her money.
- An individual with a desire to be involved in the full stock market and is able to grow.
Are They Too Good to be true?
The thing is that fixed-index annuities are neither a scam, nor a miracle. It is just a set of financial instruments, which have certain advantages and certain disadvantages.
They insure your principal and have the potential to provide steady, tax-free growth. But they also cap your potential, tie up your finances over years, and are costly, depending on the agreement.
That is, they are not too good to be true–but not to everyone.
Tips Before You Buy
When you think about an FIA, this is how you can defend yourself:
- Read the fine print – Be sure to know the rates of participation, limits, spreads and surrender.
- Review the rating of the insurer – To minimize issuer risk, seek financially sound companies (rated A or above).
- Shop around – The terms offered by different insurers vary widely. When it comes to taking the first one, do not take it.
- Watch the riders – In this case, an extra benefit can be handy, but it might be very expensive. Add them only when you really require them.
- Talk with a fiduciary advisor – Unlike a commission-based sales agent, a fiduciary must serve your best interests.
Final Thoughts
The right person can use fixed-index annuities as a smart part of the puzzle. They provide a safety-growth balance that is attractive to a large number of retirees. And yet they are also complex, binding, and are occasionally oversold by agents looking to earn commissions.
The bottom line? Do not purchase an FIA because it sounds safe and exciting. Get familiar with how it operates, consider the advantages and disadvantages, and ensure that it aligns with your overall retirement plan. When you do so, you will be much better placed to determine whether this too good to be true product is really one that suits you.
