Investors always want the best of both worlds: strong returns during bull markets without the risk of big declines during bear markets. The annuity industry has traditionally sought to give investors what they want, and increasingly, annuity customers are turning to a particular type of insurance product to get the exposure they want.
Although traditional variable annuities remain the most popular product among customers, fixed indexed annuities are gaining in importance, and the way they behave in down markets could be extremely attractive to many would-be annuity buyers. Let's take a look at some of the trends in the annuity market that could boost the use of fixed indexed annuities in the future.
How fixed indexed annuities are selling
The market for fixed indexed annuities is growing rapidly. According to a recent report (opens PDF) from the Insured Retirement Institute, sales of fixed indexed annuities jumped by nearly a quarter in 2014 to $48 billion, making up more than a fifth of all annuity sales. Moreover, among those annuity distributors that the study surveyed, half believe that fixed indexed annuities will make up an even larger percentage of their overall annuity sales in the future.
It's true that fixed indexed annuities offer a combination of attractive features to customers. Because traditional fixed annuity rates are based on conditions in the bond market, they've been extremely low lately, making fixed indexed annuities compare more favorably because of the possibility of better performance when stock market indexes perform well. The ability to get lifetime income and to protect against loss of principal is worth the typical trade-offs of accepting capped gains or only partial participation in market gains. When both the stock market and bond market are in danger of losses, as many people believe they are now, insurance products with protection against falling markets get the attention of investors looking to reduce their risk.
Yet the report acknowledges that there are challenges with fixed indexed annuities. It characterizes the annuity products as "complex and difficult to understand," and in response, some annuity distributors have come up with training programs and suitability review processes in part to make sure that professional advisors know and understand the products they're selling to their customers. More than half of distributors rely heavily on annuity wholesalers to support their sales teams, calling them extremely or very important to the process and sometimes even participating directly in larger cases or those that are more complex. If advisors are having trouble understanding these annuities, you can imagine how difficult it can be for annuity buyers to know exactly what they're getting into with a fixed indexed annuity.
Moreover, surrender charges can make these products very expensive for those who change their mind once markets recover. Around eight out of 10 annuity distributors allow sales of products with surrender charges that last up to nine or 10 years. The report notes that that's an improvement over the 20-year surrender charge periods that used to prevail in the industry, as are gross commissions that for more than 60% of the industry amount to 5% or less of the initial premium.
Are fixed indexed annuities really a fixed-income substitute?
One interesting part of the survey dealt with consumer perception of fixed indexed annuities. Even though the returns on these products are linked to stock market returns, customers consistently said that their status as a fixed-income substitute without interest rate risk was an important consideration in their purchase decision, with more than half saying that factor was extremely or very important. Safety of principal was by far the most dominant reason supporting use of fixed indexed annuities, while participation in stock market gains was far less important.
The thing that would-be annuity customers need to remember is that at times of market turbulence, financial industry sales professionals often emphasize the value of strategies that protect against loss of principal, even when losses in the stock market have already happened. In many cases, protection that would have been useful before a market swoon is far less valuable after the market has already fallen. Despite the rise in popularity of fixed indexed annuities, investors need to be extremely careful about buying them even if the recent declines in the stock market turn out to last longer than most would hope.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.