I recently met with a client, Bob, who is a 65-year-old doctor approaching retirement. He has a defined benefit pension and Social Security, but he really wants to grow his portfolio assets because they will provide not only additional retirement income but also an eventual legacy for his kids.

Bob finds that owning individual stocks is a little too risky with the market near an all-time high and the return offered by bonds just isn’t that impressive. He hears about the fixed-index annuity (FIA), a product that offers principal protection with market risk-free returns, but also the potential for additional contract credits if the stock market performs well. Should he buy one?

Understanding Fixed-Index Annuities

First, let’s point out the main features of an FIA. Unlike traditional fixed annuities, which offer a guaranteed interest rate over a given period of time, or variable annuities, which allow your premiums to fluctuate in stocks and bonds, FIAs act like a hybrid of the two. FIAs typically offer a guaranteed minimum credit each year but also the chance for higher returns if a linked market index, such as the S&P 500, attains a certain level of performance.   

Here’s an example. Let’s say Bob puts $100,000 into an FIA. This particular contract may offer him a guaranteed minimum annual credit of 2%. If the S&P 500 moves up 9% during the first contract year, though, he can get a 5% credit instead. At this point, Bob may be wondering: “If the market returned 9%, shouldn’t I get the full 9%”? Not exactly.

FIA contracts do not invest your funds directly in stock and bonds. Therefore, there is no risk of market loss. To give you that market exposure but still guarantee a positive return, insurance companies use complex financial instruments to mimic the market but also hedge the possibility of loss. The contract credit you receive can be a combination of the stock market return subject to participation rates, floor and cap rates, and fees. So if the S&P returned 9%, 5% may very well be the contract credit you receive. 

Another approach, which is more common today, is the uncapped approach. In this approach, interest crediting is based on a low-volatility index managed by a firm like Merrill Lynch, Morgan Stanley, or Barclays. The index has no cap, so interest is not limited by a cap of 4, 5 or 6%. Instead, there is a very reasonable spread of approximately 2%.

In this scenario, you are credited the index earnings minus the spread. If the index performs at 10%, you keep 8%. If it credits 12%, you keep 10%. If the index is flat or negative, you do not absorb that negative return, and no spread is charged. The insurance company only charges a spread when results are positive, unlike variable annuities or mutual funds, which charge fees regardless of the investment performance and further eroding your principal.

The spread approach puts the client and the insurance company at the same side of the table. The insurer wins when you do. The insurance company does not win at your expense. Many clients prefer this approach.

Like other types of annuities, FIAs have accumulation and distribution phases. The accumulation phase is when the contract owner deposits money into the contract, either all at once or through a series of purchase payments. The various credits to the contract occur during the accumulation phase and the longer you accumulate, the higher your eventual payout will be.

The distribution phase occurs when the contract owner decides it’s time to start receiving back his or her money – either for a certain number of years or for life. The lifetime income option has been a popular feature of late because it caters to a widespread concern about outliving one’s assets at a time when lifespans are increasing and market volatility has picked up.

Is a Fixed-Index Annuity Right for You?

Does this all sound too good to be true? Well, there are some drawbacks. Due to the complexity of these contracts, and the benefits they offer, the owner is often committed to  the arrangement  for at least 10 years. If you need to redeem your funds before the surrender period is up, you may be limited to an amount that the insurance company allows you called free withdrawals. Any amount over that may result in penalties. Besides liquidity, there is also the issue of understanding the terms and features of the contract. For example, as described earlier, FIAs typically have a cap or spread that applies regardless of what the market does. This may be frustrating to a buyer who sees the market rising but only gets limited participation. 

So why the appeal for this product right now? The main reasons are that interest rates are very low and the markets are very volatile and risky. Because of that, vehicles that might typically be used to generate income and conservative returns, such as savings accounts, CDs, and bonds, aren’t really doing the trick. At the same time, typical investments offer more risk than many clients are willing to accept as they approach retirement. FIAs offer a solution to both problems, offering market participation and upside potential but the reassurance that your contract value will never move down as a result of poor market performance.

At Howard Kaye, we want to help you find the solutions that allow you to retire comfortably and sleep well at night. As you’ve probably noticed, we strongly advocate guaranteed principal, market risk-free returns — the sort that insurance companies typically offer. While annuities are complex and not right for everyone, they often are suitable for a portion of your retirement funds. Call 800-DIE-RICH to speak to our experts today and start creating a plan that works for you.