How Does a Fixed Indexed Annuity Try to Do It All?

Published August 19, 2017
Don’t be fooled by the appeal of a fixed indexed annuity. We’ve broken down how FIAs really work here.

In short, a FIA doesn’t do it all. A fixed indexed annuity (or FIA) is an insurance product which produces a pension-like guaranteed income in retirement while also offering some liquidity and the opportunity to benefit from market growth. This product sounds like the best of both worlds — an income which doesn’t stop and the ability for that money to grow, as it would in the market. But, the insurance companies and brokers sell them for very high fees with lots of caveats, which significantly reduce the value that you could receive from your retirement savings.

Because they’re pitched as the ultimate financial products, we want to take you through each feature they offer, and how the insurance companies make it possible.

Gaining from market investment – without losing any savings

When you purchase a FIA, your premium is invested in different funds which track real or imagined market-based indices. How much your money grows depends on which indexes you choose. But, the returns you gain from the investments are severely limited by features like participation rates, caps, and spreads.

  • Participation Rates: This is the portion of the gain that you get to keep. If your participation rate is 80% and the index you chose grew 10% that year, you’ll only have access to 8% of the growth.
  • Caps: A cap sets the maximum amount of the gain you’re allowed to keep. If your cap is at 5% and then index grew 10%, you’d still only keep 5%.
  • Spread: A spread is the fee applied to any gain. If the index grew 10% and your spread is 1%, you’d only get the benefit of 9%.

Most FIAs use most, if not all, of these features. Meaning your cap, spread, and then participation rate on top of that severely limits how much you benefit from the market growth aspect.

Downside Protection

FIAs promise you won’t lose money. However, if you have any extra features (like turning the final accumulation into a guaranteed income), you’re still charged the management fee, regardless of the market’s performance.

Guaranteed Income Feature

FIAs have the option of turning your money into a guaranteed income in retirement. The payments are determined by multiplying a payout percentage (which is fixed when you start the policy) by the guaranteed benefit amount. There are a few factors to keep in mind:

  1. There is a fee to have this feature. This fee can be as much as 1.5% of the account balance per year!
  2. The income may not last your entire life. If you ever take a payment that’s higher than the income amount, your payments are no longer guaranteed for life. That means the market growth can only be accessed by sacrificing the lifetime income.
  3. The income reduces the amount of cash in your account. As you receive income payments, the amount of cash in the policy decreases, which also means less market growth. Although if it gets to $0 you will still receive income payments, that’s only possible if you haven’t had any extra payments before.

Liquidity

With an income annuity, your money is generally illiquid. This is a turnoff to some potential buyers. FIAs try to address it by providing access to that balance, but it comes with caveats.

  1. Early on, you pay large fees for withdrawals. Called surrender fees, if you withdraw any of the money from your FIA, you could be charged around 10% of your account value.
  2. Withdrawals erode the guaranteed income amount. If you withdraw money from your account, the amount of income you are guaranteed decreases, and sometimes could be cancelled all together.

In this example, we’ll show you why it’s better to keep your guaranteed income and market investments separate – lower cost, higher income, and less complicated!

Lauren Minches

Lauren Minches

Financial Planning Professional

Lauren is an actuary by training with expertise in retirement, finance, and risk. She writes about annuities to make them easier to understand and evaluate. Her goal is to help people create retirements with more time for living and less time thinking about money.