Indexed Annuities

What Is an Indexed Annuity?

An indexed annuity (a.k.a. fixed indexed annuity or FIA) is a tax-deferred retirement savings vehicle that provides the guarantee of a fixed return plus the potential for a higher variable return based on market performance. The structure of a FIA is based on that of a simple fixed annuity, known also as a multi-year guaranteed annuity (MYGA), so let’s start there.

Fixed annuities (a.k.a. multi-year guaranteed annuities or MYGAs) are very similar to CDs. With a fixed annuity, you can invest your savings over a specified time horizon (typically 3 to 10 years), earning a fixed return. Fixed annuities are issued by insurance companies instead of banks and typically offer higher guaranteed interest rates, as well as the ability to be converted into a lifelong stream of income. The latter is what makes a fixed annuity an annuity. Also differing from a CD, the interest earned in your fixed annuity is not taxed until withdrawn, but the withdrawal needs to happen at age 59½ or later. That’s because fixed annuities, along with all annuities, are meant for retirement. Current rates offered on fixed annuities can be found here.

The structure of an indexed annuity is based on that of a fixed annuity, as it also offers a guaranteed interest rate over a set period of time. In addition, it offers you the opportunity to participate in the market by investing your funds across various indices. So, if the market does well, your money could grow at a higher rate than the guarantee. But, if the market doesn’t do well, your money will still accumulate at the guarantee.

This upside potential and promise of not losing money comes at a cost. First, the guaranteed interest rate will likely be lower than that of a comparable fixed annuity. Second, the upside potential you’re offered by investing in indices is severely limited by “caps,” “spreads,” and “participation rates.” These are all ways the insurance company takes a portion of your account growth in the good years to cover the costs they incur in meeting their guarantees in the bad years. We’ll dive into these in more detail later on.

Indexed annuities also offer optional riders to create guaranteed income streams, like those available through income annuities. These are typically called Income Riders or Lifetime Withdrawal Benefits, and they come at a cost. In exchange for the potential to convert your assets into a permanent, lifelong income stream, you will be charged an annual fee and also essentially give up the liquidity that made an indexed annuity look attractive in the first place. We’ll also cover how this happens later.

One fixed annuity can look very different from another, as they vary by:

• the index;
• how you participate in gains and losses (in annuity jargon, these are defined as the participation rates, caps, and spreads);
• the credit rating of the insurer;
• bonuses that are offered at the time of purchase; and
• riders (that might provide income in the future or a death benefit).

Recently sales of indexed annuities have boomed. This has been led by a combination of several factors. First, those with fresh memories from the 2008 financial crisis liked the idea of a product where you can’t lose money. Second, low interest rates have made income annuities and fixed deferred annuities look relatively less attractive in recent years. Third, those who have witnessed the bull market from 2009 through today want to participate in the upside. Lastly, and quite importantly, they typically offer higher commissions to the distributor (agent, broker, financial adviser) than other annuities.

The Indexed Annuity Pitch

Indexed annuities are often pitched as products with upside potential, no downside, liquidity, and the option of guaranteed income for life. But how exactly do these products provide you with all of these promises?

When you choose to purchase an indexed annuity your premium is invested in different funds that track a stock market index (often the S&P 500). The growth of your accumulation value (i.e. your cash balance) is based on the underlying indexes that you choose. However, your upside is limited through features called participation rates, caps, and spreads.

• Participation Rate: This is the percentage to which you participate in the upside of the index. For example if your participation rate was 80% and the index was up 10% that year, your accumulation value would only have access to 8% of that growth.
• Cap: A cap sets the maximum amount of growth you can get for any increase in the index. For example if there is a 5% cap and the index was up 10% that year, you would only get the benefit of 5%.
• Spread: A spread is the fee applied to any growth in the index. For example if there is a 1% spread and the index was up 10% that year, you would only get the benefit of 9%.

One additional complication is that each index your money is invested in can have more than one of these features. Meaning you could be subject to participation rates, caps and spreads at the same time. The effect is a dramatic reduction in your upside potential.

If the market takes a tumble, many indexed annuity products promise that you won’t lose money. Generally that is the case but if you have any additional riders added to the policy (like a guaranteed income rider) your account is still charged that annual fee.

Indexed annuities generally have the option of adding a Guaranteed Income Rider that promises to pay you a fixed amount for as long as you live. The payments you receive are determined by multiplying a payout percentage (fixed at the outset of your policy for specific ages) by the guaranteed benefit amount in your policy. Often these products will have guaranteed growth rates that will be applied to your policy for the purpose of determining your benefit. However, there are a few important factors to keep in mind:

1. There is a fee associated with this rider. Depending on the insurance carrier, the fee to have this option can be as high as 1.5%, charged annually as a deduction to your account value.
2. The income may not last your entire life. If you ever take a distribution above the allowed amounts from your policy or decide you want to access the accumulation value once income has started, your payments are no longer guaranteed for life. That means that you can only access market-based growth in your policy by sacrificing your lifetime income stream.
3. The income reduces your accumulation value over time. Once your policy begins paying you guaranteed lifetime income, the accumulation value (i.e. how much cash you could access) reduces over time. Once your accumulation value has reached zero, assuming you have not made any extra withdrawals, your income would continue but you would have no other value in the policy.

The lack of access to the money you invest in an annuity is the biggest detractor for most people. So, the indexed annuity attempted to address it by providing access to the contract’s accumulation value. But, accessing your money winds up being a bad idea for two reasons:

1. During the early years, you’ll pay a surrender charge. Depending on the carrier and the year of your withdraw/surrender, you could be charged somewhere around 10% of your account value.
2. Withdrawals erode the Income Rider benefit. If you’ve added an income rider, it will never be financially advantageous to take withdrawals beyond the stipulated income amount. Doing so reduces your income benefit (which you’re paying for via an annual fee) and could mean that the income would no longer continue for life.

Choosing an Approach

So what’s the right approach?

In every category above, Option 1 underperforms Option 2, that is the indexed annuity provides an inferior outcome to using a longevity annuity and a market based portfolio.

In fact, no matter what the goal, indexed annuities are typically an inferior solution.

1. Generating Income – For the same investment, indexed annuity generate less income than a pure income annuity, like a longevity annuity.
2. Market Upside – Indexed annuities limit your gains through participation rates, fees, and caps. In comparison, investing directly in an S&P index costs as little as 0.05% per year.
3. Maintaining Some Liquidity – Indexed annuities limit your access to funds in early years, and all withdrawals won’t make sense because you’d substantially reduce, or even eliminate, your income benefit.

In trying to cover three objectives into one product, the indexed annuity winds up being costly, complicated and suboptimal. If you are looking for an income stream and market upside, in the long-run you’re better off purchasing an income annuity and leaving the rest in a low cost market portfolio.

At Blueprint Income, we only sell annuities for their guarantees, never for their potential. So stick with low-cost diversified funds for market upside and income annuities for a guaranteed paycheck for life.