The most recent type of annuity to be introduced, the fixed index annuity or FIA, has quickly become one of the top selling annuities in the marketplace today. It also has been the target of many in the financial services industry, as with its complexity, it has caught the attention of many skeptics.
Let’s go over the main features for now and tackle the in depth details in another post “What Determines The Returns in an Index Annuity.”
Context of an Indexed Annuity
Is a FIA a good investment? It all depends what the investor is looking for. The FIA is in the category of guaranteed principle safe investments, just like the fixed annuity. If an investor wants to have a portion of their portfolio in something that has very low risk, with solid guarantees, then this is where it fits. You could also put this in the category of bond type of investments for return comparison. Of course it is important that the company you’re using is solid with good ratings. That being said, the index annuity has proven itself over time to be a nice addition for the safe side of a balanced portfolio.
The FIA has been compared to index funds or pure equity investments, and many articles have been written showing the shortfall of the FIA when compared to these investments. That is really an apples to oranges comparison, as the FIA should never be compared to an equity type investment. This shows how important it is to put each investment in its proper context.
Variation of a Fixed Annuity
Most people don’t realize that a fixed index annuity is really just a variation of a fixed annuity, so it has all of the same safety features. What the insurance company is doing is instead of offering a fixed rate, they use those funds to purchase call options on various stock indexes, with the S&P 500 being the most common.
What is a call option? It is a financial instrument that allows the option owner to purchase the index at a later date (usually one year), at what is was at the date the option was originally purchased. For example if the S&P 500 was trading at 1750 when the option was purchased, and one year later the S&P 500 is 1850, then the option is in the money and will be exercised.
How They Work
The insurance company invests the majority of money deposited into a fixed or fixed index annuity into high grade government and corporate bonds of varying maturity dates that they usually hold to maturity. The interest from the bonds is what the company normally uses to credit as a fixed rate if a fixed rate annuity is purchased. With the fixed index annuity, the insurance companies will instead use those funds and purchase call options. With the amount of funds they have to work with, they cannot purchase the entire market upside within the call option. This is why the investor will only get a portion of the market gains, not all of the gain. With today’s rates we can expect an index annuity to average somewhere between 1 to 6% depending on the product being offered. This is a very important consideration among annuities and in the article “What Determines The Returns of an Index Annuity”, we will tell you what to look for. Overall index annuities have outperformed the fixed annuity since their inception, because of the upside potential of a market index.
The annuity owner will either lock in index gains, if the market goes up, or they will have zero gains if the market goes down. Depending upon the annuity and indexing method selected, the lock in will occur every 1 to 5 years. One of the best features about an index annuity, is if the market does sell off the investor doesn’t incur a loss, but a zero. In 2008 the index annuity didn’t lose any money, which gave many investors tremendous peace of mind in the face of the greatest financial crisis since the Great Depression.
This is where an index annuity can become complex very quickly and is where we see a very large difference between the top tier products and ones on the lower end. Unfortunately for the consumer most of them have no idea how this part works and what to look for.
Once again the insurance companies are purchasing call options and the vast majority we see are one year options. The better the option, the more money the client will make. See the article “What Determines The Returns of an Index Annuity”, for a complete breakdown on this so you can make sure your getting the best annuity out there.
The vast majority of index annuities today offer a first year bonus of 1 to 15%, which is usually immediately added to the account value. For the most part the bonus does help to jump start the annuity, as well as to offset penalties coming out of other annuities. The insurance companies are either offering the bonus within some type of rider, or they are simply crediting upfront what could have been made in the future if there wasn’t a bonus by being able to capture higher gains in the index. There is nothing wrong with a bonus as the majority of products add it to the account value immediately and it then compounds over time, and is available to take out as a free withdrawal.
Most index annuities today have surrender periods as low as 5 years and as long as 17 years. This is where the consumer does have to be careful, because this of course can affect one’s liquidity. Usually the annuity allows a once a year 10% percent free withdrawal, with most annuities allowing this after the first year. The surrender charges apply if the owner decides to liquidate that account in entirety. Normally the charges will go down over time. It is important to keep in mind that you should always have other funds available for liquidity, other than what you would put into an annuity.
In summary the FIA is a safe investment that helps to bring balance to an overall portfolio. It has been one of the best performing safe investments over the past decade and has proven itself as a solid choice for the right investor.\
To Learn More About Index Annuities and What to Look for, Read the following Article: