How a Fixed Indexed Annuity Really Works

Published August 20, 2017
Fixed indexed annuities are complicated products that don’t do everything they promise. Here’s what a fixed indexed annuity looks like in real life.
  • 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
  • Fixed indexed annuities generate less income than an income annuity, reducing your guaranteed income for retirement

How do you compare a fixed indexed annuity to other options available? The best way is to look at an example that compares these options over a historical period.

To start off, let’s talk about two of the options available if you want a retirement portfolio that includes both a lifelong source of income and has money invested in the market:

For this analysis, Option 1 will be based on the Voya Quest 7 with the Voya myIncome Withdrawal Benefit (Guaranteed Income Rider) with rates as of 2/2/2017. Option 2 uses the Mutual of Omaha Deferred Income Protector with Cash Refund with rates as of 2/2/2017, along with the Vanguard 500 Funds which tracks the S&P 500 and charges a 0.05% annual fee. For both scenarios, the first 15 years will be based on historical S&P 500 performance between 2002-2016, after which a conservative assumption of 4% growth is used.

To compare these two options, let’s use Adam as an example. Adam, 45-years-old, is considering investing $100,000 in a fixed indexed annuity. His goals are to (1) create a guaranteed income stream starting at age 60, and (2) grow his funds by participating in the market.

Option 1: Buy a $100,000 fixed indexed annuity with a guaranteed lifetime income rider starting at age 60. This rider will produce an income benefit of $7,000 per year.

Option 2: Spend $75,000 to buy a longevity annuity that produces an identical income stream, and leave the rest of his money in the market.

So how did each of these strategies do over time?

Income Benefit

First, let’s compare the income benefit available. The guaranteed income generated by each of these two strategies is exactly the same: $7,000 per year starting at age 60 and continuing for as long as he’s alive.

For the longevity annuity in Option 2, there is absolutely nothing he can do to risk or lose this benefit. But, for the fixed indexed annuity in Option 1, any withdrawals made above the allowable amount will substantially reduce the guaranteed income benefit and cancel the guarantee that it continues for life.

For the fixed indexed annuity in Option 1, there is also an opportunity for the income benefit to increase if the accumulation value grows to be greater than the guaranteed withdrawal base. If this is the case on a policy anniversary, the guaranteed withdrawal base would “ratchet” up to meet the accumulation value. This would also mean a higher income benefit. This is extremely unlikely to happen.

Market Upside

Next, let’s look at the growth of the assets. For Option 1, this is the same $100,000 that’s invested in the fixed indexed annuity, which is supposed to provide access to market upside and produce a guaranteed income stream. For Option 2, this is the $25,000 leftover from the longevity annuity purchase that can be invested directly in the market.

The following chart shows the annual return for the funds invested from ages 45 to 60, using historical S&P performance from 2002 to 2016.

Fixed Indexed Annuity performance modeled using the Voya Quest 7 with the Voya myIncome Withdrawal Benefit using historical S&P performance from 2002-2016. Market Portfolio modeled using the Vanguard 500 Funds which tracks the S&P 500 and charges a 0.05% annual fee.

The performance of the S&P market portfolio was strong, while volatile, averaging an 8.3% annual return. While much steadier, the fixed indexed annuity accumulation value grew only 0.9% per year during this period. The vast majority of growth was not captured by the fixed indexed annuity due to the mixture of participation rates, caps, spreads, and fees. While the fixed indexed annuity did not experience any decline in value during bad years, a significant amount of market upside was lost over the 15-year period.

Value and Liquidity

And lastly, let’s take a look at how the fixed indexed annuity accumulation value compares to the market portfolio. The chart below compares the two accounts using historical returns for the first 15 years (accumulation phase of the fixed indexed annuity), and projected returns thereafter (withdrawal phase for the fixed indexed annuity).

Fixed indexed annuity performance modeled using the Voya Quest 7 with the Voya myIncome Withdrawal Benefit. Market Portfolio modeled using the Vanguard 500 Funds which tracks the S&P 500 and charges a 0.05% annual fee. Both use historical S&P performance from 2002-2016 and a conservative assumption of 4% thereafter.

The market portfolio more than doubled in the first 15 years, benefiting fully from the index’s growth (offset only by a minimal 0.05% investment fee). In comparison, the fixed indexed annuity accumulation value, which was invested in the same underlying index, experienced growth of only 14% after applying the participation rates, caps, spreads, and fees.

The market portfolio continues to grow indefinitely, whereas the fixed indexed annuity accumulation value begins to decline once income benefits begin at age 60. From that point forward, there’s no potential for growth. Instead, there will just be charges against the account for each withdrawal and for rider fees. In this example, all of the fixed indexed annuity accumulation value is depleted by age 75.

So what’s the right approach?

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

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

  • Generating Income: For the same investment, fixed indexed annuities generate less income than a pure income annuity.
  • Market Upside: Fixed indexed annuities limit your gains through participation rates, spreads, fees, and caps. In comparison, investing directly in an S&P index costs as little as 0.05% per year.
  • Maintaining Some Liquidity: Fixed 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 comparison, the money saved by purchasing an income annuity can be invested such that it’s fully liquid.

In trying to cover three objectives into one product, the Fixed Indexed Annuity winds up being costly, complicated and suboptimal.

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.