What is a Fixed Indexed Annuity?

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In previous articles we have talked about the different kinds of annuities that you may have seen on TV, in the paper, or had a financial advisor recommend you use. This article will talk about the pros an cons of a fixed indexed annuity (FIA).

Outside of the Variable Annuity (VA), this is probably the most misunderstood of all the options and variations. The basic idea is that this is a fixed annuity, which means the principal is guaranteed, that earns interest based on the movement of a market index. The thinking is that, given how low guaranteed interest rates have been, linking your interest earnings to a market index can provide the opportunity for higher interest earnings.

The key is that you are not exposing your investment to the ups and downs of the market. Your money isn’t in the markets at all. You are just using the movement of a market index to calculate the interest you earn. Once interest is earned and credited to the account, you cannot lose that money in the future, regardless of what happens to the index.

For example, if I earned 5% on my money, and the contract “reset”, my earnings would be locked in. If the next period the market dropped by, say, 20%, I would not lose anything, my value would remain the same! Each earning period is its own, if the index is up during the period, then you make money. If it is down, then I earn zero and just start over for the next period!

I know this may sound too good to be true, and we will examine some of the good and bad characteristics for this option. Given the broad variety of choices and options, this discussion is really intended to be an overview. In future posts I will provide more detail and information on all of the products and options mentioned in this entry.

What Makes Up a Fixed Index Annuity (FIA)?

These contracts all share certain characteristics. Then there are options that can be accessed, depending on what you are trying to accomplish.

First, there is a time commitment. Surrender charges can vary from 5 years up to 14 or more years, depending on contract terms. Most of the contracts allow for “free” access to at least some of your money each year, generally 7-10% of the value of the contract.

Second, different contracts will offer different indices. The most common index found is the S&P 500. However, today there are wide varieties of index offerings; from precious metals to bonds to international market index options. Additionally, we also have a host of “hybrid” index options. These involve rules based asset allocation and rebalancing strategies. The idea is to reduce the volatility that an index like the S&P 500 experiences, so that an investor enjoys more consistent returns, especially during years where there are significant market drops like during 2007-2009. Because of the dynamic rebalancing, driven by an algorithm, many of these indexes returned 4-8% per year during that period, while many stock market indices were dropping by 60% or more!

All Market Indexes are not Created Equal

Now that you know more about the different types of annuities, you need to be aware of how your index options are being calculated and managed.

Some of the new hybrid indexes are designed to “back test” but will not perform well in the future. Many of these have only come out in the last couple of years, yet illustrate performance through a process called “back testing.” This is done all the time in the financial services industry to help analyze how a strategy might work in the future. But since “past performance is no indication of future results,” one must go beyond the numbers in order to figure out how an index might work in the future. This is a topic we will come back to in the future.

The Crediting Method

The most common crediting method is called “point to point.” This is calculated by taking the value of the index at the start of a period (one year, two years, three years, etc.) and subtracting that number from the ending index value. If the number is positive, then you calculate the percentage of gain and that is the percentage you earn on your investment. This method is sometimes “capped” at a specific amount. Therefore, if the cap is 5% for a year and the index returns 7%, you will earn 5%, since that is your cap. Other times there is a “spread” or asset fee applied. So if you had a spread of 1% and the index returned 7%, then you would be credited with 6% interest.

A second crediting method is “monthly sum.” This method caps monthly performance. The percentage change for the month is calculated and at the end of the period (usually one year) you add up the capped pluses and subtract the minus months and you will earn the total percentage, if positive, on your balance.

Finally, there is something called “averaging.” This will take the index value either daily or monthly, then add up the index values for the year and divide by the number of months or days to get the average index value. Then you subtract the original index value from the average and that is the amount you earn. Sometimes this method will have a cap, sometimes a spread and sometimes a “participation rate” which is the percentage of the performance you will earn. Sometimes that percentage is over 100%, it depends on the index and the time frame.

In addition, you can add optional features to many of these annuities. Guaranteed Withdrawal Benefits (also known as “income riders”) which guarantee minimum lifetime income, increasing death benefits, liquidity options and the ability to add premium deposits over time are some of the options that might be valuable to an investor.

Here are some of the pros to consider:

• Ability to earn high interest based on index movements
• Guarantees of principal
• You cannot lose interest once earned
• You can access some of your account penalty free during the surrender charge period
• Options are available to create guaranteed income for life, or a period of years.
• Won’t lose money, even if the index goes down
• Full disclosure of costs, benefits and options are available before investing
• Low maintenance due to guarantees

Here are some of the cons to consider:

• Surrender charges can limit liquidity
• Some new indexes have very limited upside
• Riders can add costs
• Future renewal rates might be lower
• Can be hard to compare options and costs
• Some crediting options can be confusing

As you can see, annuities come in a wide variety of options, choices and strategies. There are many tax benefits in the right situation and can be designed and customized to accomplish many financial objectives.

They are not a perfect asset, I don’t think one exists. But if you take the time to understand your options, and objectives, many of the options offer unique benefits that can work powerfully to help secure your financial future.

Whether it is starting a business, investing in stocks or real estate, or just opening a bank account, there are many options to choose from. Annuities are no different. What is important to remember is to keep in mind what you are trying to accomplish and how much fluctuation you are willing to experience when making any financial decision.

Usually, the more you guarantee, the lower your potential gain is, but the lower the time commitment to maintain the investment. That is why determining and understanding your priorities is critical when making any financial decision. There are always tradeoffs to consider. If we can help with that process, give us a call, we stand ready to help.

Annuities can be a complex topic and we understand that working with someone that can explain them to you in ‘plain english’ can be a good thing. Giving us a call at our downtown San Rafael office is the first step. We’ll be happy to schedule your free, no obligation introductory meeting so we can start answering any questions you have.
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