Fixed Index Annuities Caveat
In this discussion of fixed index annuities, which use to be called equity indexed annuities, I am mostly making an implicit assumption that the annuity is competitively priced. Internal costs reflect was is needed to support the guarantees provided by the insurance company and to keep the company reasonably profitable. But costs are not excessive such that the value to the consumer is eliminated. As well, I assume value is created because the annuity has a clear role to play in the financial plan and is not being sold by an unscrupulous financial advisor only to generate a commission.
It must be noted that not all fixed index annuities are created equal. As will be discussed, they are complex financial instruments, and that complexity can hide a lack of competitiveness in the pricing of individual products. A fixed index annuity that is pitched at a free dinner presentation is more likely not the type of financial product I have in mind, especially if it is misused.
One should tread carefully. Due diligence and a comparison with other annuity options is needed to make sure that the product is fairly priced and will behave in the way that the purchaser understands it to behave. I do not want the “bad” annuities out there to free-ride off of my explanations about the potential positives that can be created by “good” annuities.
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Fixed Index Annuity (FIA) vs. Variable Annuity (VA)
A fixed index annuity (FIA) with an optional guaranteed lifetime withdrawal benefit (GLWB) shares many similarities with its variable annuity (VA) counterpart. Both are deferred annuities that may take advantage of rollup rates and step-up opportunities to increase guaranteed income. Both provide guaranteed withdrawal rates. Both also provide tax deferral benefits outside of qualified retirement plans. FIAs may also have surrender charges on excess distributions taken in the early years of the contract beyond the free withdrawal allowances provided. The following discussion assumes familiarity with the content about variable annuities from the previous chapter because there are so many similarities between the two. Here I will emphasize the differences.
Where fixed index annuities are most different from variable annuities is the underlying mechanism for asset growth. VAs allow for the direct investment of premiums into subaccounts. FIA premiums are added to the general account of the insurance company and credit interest to the owner based either on a fixed return or on the performance of a linked market index. FIAs offer index-linked interest, but they are not invested directly into the underlying index. They simply pay interest to the owner using a formula linked to the performance of the index.
With FIAs, the credited interest (or returns) can be structured more precisely in terms of controlling downside and upside exposures. Many FIAs will protect principal in the sense that 0 percent interest is credited even if the underlying index declines significantly in value. To obtain this protection, FIA owners should expect to receive only a portion of any positive gains experienced by the index. These types of structured outcomes can lead to a different investing experience that could have implications for retirement income planning and sequence-of-returns risk. Overall, FIAs may generally reduce the potential volatility of the underlying contract value relative to a variable annuity. On the spectrum of risk, index-linked FIAs fall in between fixed annuities with a fixed interest rate and variable annuities with volatile subaccount investments.
FIAs also differ from VAs in that, as with an income annuity, FIA fees tend to be structured internally to the product such that there are no observable fees to reduce the contract value. Fees can be kept internal because they are based on a spread, like other banking products. The insurance company earns more from investing the premiums than it pays to the owner. As with income annuities, it is also possible to reverse engineer and estimate the internal costs for the FIA, though this process does get more complicated, as will be explained.
FIAs do not have mortality and expense charges and they do not invest in funds such that there are no investment fees. Internal fees are reflected through the limits placed on the upside growth potential. Of course, upside growth potential must be limited in order to support the downside risk protections. The internal fees for the FIA just mean that upside growth potential is less than it could have been if the insurance company did not need to cover its expenses and profit needs.
At the same time, though, households may not be able to earn the same rates of returns on their funds as an insurance company that obtains institutional pricing on trades, better diversification, and longer-term investment holding periods. It is not always the case that households could easily replicate on their own what the FIA provides as an accumulation tool.
The exceptions to the lack of external fees include that FIAs may still have a surrender charge schedule in the early years for excess distributions. This is done to allow the insurance company to invest the premium in longer-term assets and to cover the company’s fixed expenses for providing the annuity. These surrender charges will gradually disappear for long-term owners. As well, any optional lifetime income benefits or enhanced death benefits added to the contract have observable fees that will be deducted from the contract value. Though otherwise protected, the contract value of the FIA could decline on a net basis after accounting for optional rider expenses.
Another key difference from VAs is that, related to their potential to protect principal, fixed index annuities may also be emphasized as an accumulation tool in the preretirement transition years to help lock-in a wealth accumulation target at the retirement date with a high probability. The FIA can be treated as an asset class alongside stocks and bonds, but with the unique property that it protects from downside losses. After accounting for its tax deferral, the question becomes whether it provides enough upside exposure to compete with other fixed-income investment opportunities on a risk-adjusted basis. For these accumulation uses, the optional lifetime income benefit may not be emphasized.
In other applications, though, the FIA can be discussed alongside other annuities providing lifetime income as a tool to better manage longevity and market risk and to meet a retirement spending goal with less earmarked assets. For some FIAs, using an income rider may be required.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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