Introduced in the 1990’s, an era of decreasing interest rates and increasing market volatility, fixed index annuities were designed to meet the growing demand for higher fixed rates by timid investors. Today their popularity continues to increase along with stock market volatility and diminishing interest rates. They have not been without some controversy over their complexity as an investment vehicle and their high costs. While they can be an excellent alternative for the right person, prudent investors should carefully consider the pros and cons of fixed annuities.
Fixed Index Annuity Basics
At their core, fixed index annuities offer investors the opportunity to participate in the gains of the stock market while limiting their downside risk. Offering a minimum rate guarantee, they provide investors with the assurance that, no matter how much the market may drop, they will still receive a positive return on their investment.
Unlike variable annuities in which funds are invested into the market via managed stock and bond accounts, fixed annuity returns are generated through participation in the increase of market indices year over year. For example, if the market index to which the annuity is tied increase by 15% over a year, the fixed annuity account will earn a portion of that. The actual amount earned is based on the participation rate and earnings cap (explained in more detail below) of the particular annuity.
As an annuity contract, they also enable investors to defer taxes on the accumulation and can be converted to a guaranteed stream of income for life. As with all annuities, they are structured with surrender periods and fees that discourage investors from withdrawing their funds in the first five to ten years of the contract. Withdrawals are allowed without a surrender fee as long as they don’t exceed 10% of the balance.
A Look Inside of Fixed Index Annuities
Up to this point, fixed index annuities would seem like not only a remarkable investment vehicle for the right investor, but also a great annuity innovation that offers the best of all worlds. The reality is that there are several components that go into a fixed index annuity that make it a bit more complex, and this is where an prospective investor really needs to understand the pros and cons of each.
Minimum Rate Guarantee
Not unlike most annuities, fixed index annuities include a minimum rate which is credited no matter if the stock market declines.
Pro: You can’t lose principle and you have a bare minimum expectation
Con: None to speak of especially considering that the alternative is to earn a negative return if the market falls.
Participation Rate
Investors will participate in only a portion of the index gain based on a percentage established by the insurer called a participation rate. The higher the rate, the greater the participation in the gain. For example, if the market gains 10%, and the participation rate is 70%, the percentage gain credited to your account is 7%.
Pro: The potential to earn returns greater than typical fixed annuities and participate in the growth of the market.
Con: Some participation rates can be somewhat low, 30 to 50%, and high participation rates are not usually guaranteed for a long period of time, so it’s easy to be lured by a high rate only to have it cut severely in the future.
Cap Rate
Fixed index annuity contracts include a cap on the amount of the gain that they will credit to the account. The cap rates are based on a formula or a fixed number and are determined at the issuance of the contract (but can be changed by the insurer). So, for example, if the market gains 20% and the cap rate is 10% the insurer will credit your account with 10%. Both the cap rate and the participation rate are used by the insurer to protect their downside when the market declines, and also, to create a “spread” that will ensure that they can make a profit.
Pro: Depends on your perspective and expectation. For timid investors who can’t stomach downside risk, a piece of the pie is better than none at all.
Con: Some cap rates can be low and high caps can be changed.
Annual Reset
One of the truly attractive features of an index annuity is the reset feature whereby the gains in the account value are locked in and form the new basis of the contract. Accounts are reset each year on the anniversary.
Pro: You have the assurance that your account values will not suffer a loss.
Con: None
Surrender Period
Surrender periods are common to annuity contracts. This is the period of time that the insurer requires that you keep your funds in the account or else be charged a surrender fee. Typically, the surrender periods last for the first seven to ten years of the contract and the fees are percent of the amount withdrawn in excess of 10%. The fee percentage declines by one point a year so it will eventually disappear.
Pro: You have some flexibility to access your funds, and eventually withdraw all of it without penalty (beware of the 10% IRS penalty for pre 59 ½ withdrawals).
Cons: Who likes to pay fees? But an investment in annuity should only be made with a long term time horizon. An early withdrawal could also affect your reset which could mean a loss of account values.
Summary
As with any investment there are going to be pros and cons that must be weighed in light of your specific financial situation. The common complaint about fixed index annuities is their limited upside potential. However, if your expectation is to be able to generate returns that are better than the ones you can get from fixed yield investments or savings with the same degree of safety, then fixed index annuities may be an attractive option.
