If you're on the lookout for a stable revenue stream in retirement, you may have come across a type of annuity that's surging in popularity -- the fixed index annuity, or FIA.
FIAs combine the security of an annuity contract with the potential to increase the total payout the contract holder receives, depending on the movement in a stock or bond price index, such as the S&P 500 Index.
The concept (and accompanying insurer's sales pitch) is simple: Purchasing an FIA allows you to preserve your capital, and participate in gains if the underlying index advances, while incurring almost no downside risk.
In an extremely low-interest-rate environment, which in recent years has taken the sheen off bond and CD investments, who wouldn't at least entertain this offer?
It turns out that in practice, FIAs aren't always sure propositions and aren't as efficient a use of your money as they might seem at first blush. Let's look at some characteristics of FIAs you should consider when deciding whether to add one to your retirement arsenal.
How FIAs work
It's important to understand that the purchaser of a fixed index annuity isn't actually investing in anything. Rather, the annuity has the potential to be credited with interest based on the performance of an index. Suppose you purchase a $100,000 fixed index annuity that uses the S&P 500 as its underlying index and has a term of one year. And suppose that by the end of that year, the S&P 500 has gained 7%. In the absence of any limitations or fees, you'd be credited with 7% interest on your premium, matching the index gain.
In reality, you're highly unlikely to receive credited interest that exactly mirrors an index gain over a specified term. Insurance companies have a number of methods they employ to limit index-linked returns. The most common is known as the "participation rate." If the stated participation rate in your annuity contract is 75%, then your portion of the 7% index gain above will be only 5.25% (i.e., 75% x 7%).
Your FIA issuer can also institute a "cap," or maximum amount of index-linked gain used in the interest calculation. Suppose your contract calls for a 5% index gain cap. Continuing our example, your gain will be then be calculated at 5% times your participation rate of 75%, for a total credited interest of 3.5%.
Another limitation on enjoying index gains is the presence of administrative fees, which your insurance agent may present to you under the terms "spread" or "margin." A spread can take the place of a participation rate but often is assessed in addition to the participation rate.
In your favor, however, insurers often stipulate a minimum amount of index-linked gain, called a "floor." In most cases, the floor is equal to zero, which means that if the index declines during the term, the contract holder won't be credited negative interest or see his or her premium lose value.
Understanding the "no lose" proposition
Part of the allure of FIAs is the idea that you can't lose your premium. According to the National Association of Insurance Commissioners (NAIC), some FIAs guarantee the return of a percentage of your initial premium, while also guaranteeing a minimum interest rate. So even if the linked index loses value over the period, the annuitant can still come out ahead.
To illustrate using an oft-cited example from the NAIC, take a fixed index annuity which offers a guaranteed return of 87.5% of premium, coupled with at least a 3% guaranteed interest rate. Over a six-year term, this produces a total surrender value plus credited guaranteed interest equal to 101.43% of the initial premium. At minimum, a marginally positive payment stream is generated.
(An aside: In this minimum-case scenario characterized by a declining index, you do lose money in real terms, since the roughly 1.5% cumulative interest over five years doesn't come close to keeping up with inflation. By comparison, simply investing in certificates of deposit for six years, at a long-term interest rate of 2% -- current as of this writing -- with annual compounding, will return cumulative interest of 12.6% on your initial principal. Not great, but much better than 1.5%.)
Yet beware: Even with these guarantees, unless the annuitant follows all contract rules carefully, a loss of premium is still possible. Many FIAs carry provisions stating that interest isn't vested until the end of the contract term. Drawing money out of your annuity before full vesting could mean that only a portion, or worse, none of your gain is credited to you at the annuity's expiration. Further, you could also be subject to surrender charges against your premium in the case of early withdrawals -- so it's well worth the effort to read all the fine print in your contract before signing it into effect.
Why an FIA isn't the best use of your money
It's worth reiterating here that an FIA you purchase isn't an investment, but an insurance product that obligates the insurance company to return a specified amount to you in the future, in exchange for the premium you remit to the company now.
In this trade-off that can result in a 100% return of premium, much is sacrificed. Since the annuitant isn't investing in the market, in most cases he or she forgoes the benefit of dividends. The S&P 500 Index doesn't recognize dividends in its pricing, and thus, annuity contracts linked to this index won't, either.
And as we've discussed, performance can be both capped and diminished by fees. Over the past five years alone, the S&P 500 Index has returned over 17% annually, and an annuitant under an index cap, and further exposed to a spread, would have missed out on the majority of this return.
For some, the FIA route may not be the best use of money, but it may be the most pragmatic, depending on one's age, overall financial situation, and need for a reliable future payout. If this describes you, ask your insurance agent about purchasing an income rider to your contract, which will cost you a bit more in up-front premium but provide for a higher annuity stream.
As an alternative, consider investing a portion of your funds earmarked for an annuity, up to 25%-33%, in a balanced ETF or mutual fund that allocates its holdings between stocks and bonds. While the balanced equity/bond approach has been somewhat out of fashion during this long, multi-year bull market in stocks, it's a defensive strategy that can reward the risk-averse.
A solid example of such an investment is Vanguard Balanced Index Fund Investor Shares (NASDAQMUTFUND:VBINX). This mutual fund allocates approximately 60% of holdings to stocks and 40% to bonds. Since inception in 1992, it's provided an annual average return of 8.05%.
The fund's beta hovers around 0.60, meaning that on average it's only two-thirds (roughly) as volatile as the overall market. And the Balanced Index Fund Investor's expense ratio of just 0.22% is magnitudes less of expense than you'll incur on any FIA product, between participation rates, spreads, and other fees.
According to the NAIC, the average FIA term is six to seven years, so holding VBINX or a similar fund in lieu of an FIA, or even alongside an FIA purchase, can allow you to truly participate in the market over the long term, with risk reduction to boot. And in investing, it's often better to mitigate risk than to try to avoid it all together.