All fixed index annuities are hybrid annuities – fact or fiction? Fiction!
Don’t let the sizzle fool you. You can get a fixed index annuity without an income rider. Why would you do that? Why pay a fee for a service you will never use?
Typically, you shouldn’t upgrade your annuity to a hybrid style unless you know you want the lifetime income **guarantee while still maintaining majority control.
A base FIA (fixed index annuity) offers the ability to grow based upon the performance of an index while not going backwards. Your principal is never at risk and to clear up a popular misconception – your money is never actually invested in the index itself. With a fixed index annuity, the insurance company assumes all investment risk and while you may be able to participate in the gains generated by an equities or commodities index your dollars were never invested in any of those securities.
Watch as the Annuity Guys® – Dick and Eric, report on the fixed index annuity to help you evaluate if this type of annuity would be a good fit for your portfolio.
**Guarantees, including optional benefits, are backed by the claims-paying ability of the issuer, and may contain limitations, including surrender charges, which may affect policy values. During this segment, Dick and Eric are referring to Fixed Annuities unless otherwise specified.
There are pros and cons to any financial product and fixed index annuities have their detraction’s, such as cap rate, participation rate, and surrender terms. But if you are looking for an option that allows for better than average safer interest growth with no investment risk, check out a fixed index annuity.
Worried about interest rates impacting your bond portfolio? Check out this article.
If you haven’t noticed, bond interest rates have been inching up over the past year. The U.S. Treasury 10-year index hit a 52-week high of 2.83% on Friday, up 1.29%, or 84%, from the 52-week low of 1.54% on Aug. 31, 2012.
Given the fact that market prices of bonds move inversely with interest rate changes, increasing interest rates generally translates to decreasing bond prices. An example of this is the Barclays U.S. Aggregate Bond Trust, which, after increasing 7.84% in 2011 and 4.21% in 2012, is down 3.27% year-to-date as of Friday.
Recent bond interest rate increases, combined with the prospect for continued interest rate hikes, have gotten the attention of investors, resulting in reduced bondholdings in many cases. Replacement investments have included dividend stocks. While this has provided an alternative source of income, i.e., dividends, it has also resulted in increased equity risk exposure, which may prove to be more problematic than simply remaining in bonds.
Many investors in the past few years have discovered a different strategy for a portion of their bond portfolio that retains the fixed income nature of bonds while offering protection from bond and equity market declines. It’s called fixed-index annuities, or “FIAs.”
What is a fixed-index annuity?
A fixed-index annuity is a fixed annuity that offers a minimum **guaranteed interest rate and potential for higher earnings than traditional fixed annuities based on the performance of one or more stock market indexes. When purchased with non-retirement plan funds, unlike bonds, earnings grow tax-deferred. If a minimum **guaranteed withdrawal benefit (“MGWB”) isn’t built into the contract, a FIA can be paired with an income rider to give the annuitant(s) the ability to activate a lifetime income stream.
There are two types of FIA’s — single premium and flexible premium. A single-premium FIA is a one-time investment whereas a flexible-premium FIA allows for subsequent investments after your initial investment. With both types, you need to allocate your premium, or investment, between a fixed account and one or more indexing strategies. The fixed account pays a fixed rate of return for one or more years that’s generally higher than a similar-duration CD.
Indexing strategies provide the opportunity to earn interest based on the performance of a defined stock market index each contract year, with the Standard & Poor’s 500 Index being the most prevalent offering. Unlike a direct investment in an index where you participate in gains as well as losses, there are two basic differences when you allocate funds to an indexing strategy within an FIA:
1. If the index’s return is negative, no loss is posted to your account.
2. If the index’s return is positive, interest is credited to your account subject to a cap.
In other words, unlike bond and equity investments, you won’t participate in losses, however, you also won’t fully participate in gains to the extent that the performance of a particular indexing strategy exceeds that of a defined cap.
When do fixed-index annuities make sense as a bondholding alternative?
FIA’s offer several distinct advantages over bonds, including protection from market declines, elimination of bond default risk, participation in positive performance of stock market indexes, tax deferral in non-retirement accounts, sustainable lifetime income with a MGWB or income rider, investment management simplification, and elimination of investment management fees on the portion of a managed portfolio that’s invested in FIA’s.
They aren’t without their disadvantages, however. [Read more from MarketWatch]
Dick: Hi I’m Dick.
Eric: And I’m Eric and we’re the annuity guys; and today we’re choosing a fixed indexed annuity.
Dick: Yes, and Eric that’s referred to all over the internet as a hybrid annuity.
Eric: No, no…
Dick: Nowadays, nowadays it is.
Eric: Fixed indexed annuity without an income rider is the purest sense. Now, to get a hybrid style you got to have the income rider.
Dick: Well, that’s where we tend to talk in terms of hybrid combining a whole bunch of things into one annuity and mostly its marketing hype… mostly it’s just a sizzle to sell the annuity talking about hybrid; but it is in all fairness, hybrid does mean the combination of several elements into one thing. So, I would say that it is a hybrid in that sense but let’s get into the specifics of the fixed indexed annuity and what’s good about it?
Eric: Yes and I think usually the first thing I start with when someone asked me… its breaking down what’s an index? You know, really when you talk about indexing for an annuity, the most common one out there is typically are the S&P 500.
Dick: Dow Jones…
Eric: Now most people say “I’m invested in the market right?”
Eric: What do you mean? It’s like an indexed mutual fund^ or…
Dick: And that’s the thing, it’s challenging to explain the folks is that you really are never invested in the market. You’re using that index just as an indicator.
Eric: It’s a benchmark…
Dick: A benchmark to know how much interest will be credited to your account. So, this is a completely safe, investment free product..
Eric: All risk-free.
Dick: Yes, yes it is.
Eric: And I always laugh because what I try to do is explain that you know; we can use the weather as that same index and say we start with the this time at eight o’clock today and at eight o’clock tomorrow we’re going to look at the same time… and if we’re up to two degrees, we’re going to credit you two percent. You can just use any kind a benchmark. In fact, there are indexes out there that use interest rates…
Eric: Commodities, gold.
Dick: Right. So, if somebody comes to you with an annuity, with this amazing new index; don’t get too excited because first of all even if that particular index could soar, you’re going to be limited on the upside up of it. That’s how these indexed fixed indexed annuities work is they give you the upside but they give you no downside. So you don’t get all of the upside.
Eric: And really, if you kind of peel back the layers of how an indexed annuity really works; the insurance company has something usually that it can purchase options on. They’re looking at options contracts something they can buy for pennies on the dollar;
Dick: If it doesn’t hit, it expires and throw it away; and when it hits…
Eric: It’s very good for everybody.
Dick: It brings some money in.
Eric: And they are willing to share some of those benefits.
Eric: So, like you were describing, what’s the negatives here? You don’t get the full upside typically that you’re going to get from a market participation; if you were just truly invested in one of those yourself but then also the inverse of that is you don’t go back…
Dick: Completely safe, completely secure. And when we say risk free, we have to qualify that a little bit. What we’re really saying is, it is a market risk free; and you know, there’s risk in anything we do. If it’s a US Treasury, there’s risk in it. So, in terms of measuring risk, it’s one of the least risky things you can do with your money.
Eric: Right. In explaining some other things that limits some of the upside; this is part of the conversation that if you ever look at an indexed style annuity, that there boards caps typically associated which is usually…
Dick: Limits your upside.
Eric: You may say you got the S&P 500 index with a cap of 5 percent. Well, that typically means the most you’re going to make in a year is
5 percent – so that’s your cap. The market may make up to twenty percent while you’re only going to get up to your cap.
Eric: And, there’s the participation rate which is how much of that index…
Dick: So, that if the market goes up 20 percent and I have a 10 percent participation rate, I’m at ten-percent of what the market went up or spread which in that case you agree that the first portion of what’s earned; it could be one percent or 5 percent, goes to the insurance company or is not paid to you. Let’s put it that way. And so consequently, you get anything above that. If you had a 10 percent spread, the market did 20 percent; you get 10 percent.
Eric: And those are really kind of need aspects to say… I can still participate in the upside I know I’m not going to go backwards. And as long as there’s no fee associated with the contract, you’ll never go… you never will back up and that’s what’s very attractive. And who would be interested in these types of annuities? It’s usually somebody who wants some growth but they’re just not willing to go backwards. If we look at the charts over the last ten years; and this is where indexed annuity companies are really putting those charts out, because if you remember back in 2008 when that market went boom…
Dick: Or 2009.
Eric: Well guess what your indexed annuities do?
Dick: No loss.
Eric: We did not go back thirty-eight percent…
Dick: A nice place to start from when the market started coming back up… stair steps up.
Eric: And that’s what’s nice. It locks in typically it resets if it’s an annual reset. Every year you started that new benchmark and all you do is…
Dick: Now Eric, one of the things; I am going to switch our subject here on this a little bit – and that is; that we see all the time and it kind of gets our higher up a little bit, 8 percent returns you know on indexed annuities; and pretty misleading is it?
Eric: Well, and that’s when people are typically selling the rider; they’re selling the piece that you’re going to pay a fee for usually, but it’s that sizzle portion that people want because they want that market-style return. So, eight percent **guaranteed… for future income
Dick: Or income account – it’s a kind of a virtual type account, does what it’s supposed to do – an excellent feature, excellent benefit, but consumers are generally confused and misled many times by that statement of getting an eight percent return on their money; safe, secure, **guaranteed; when that’s just factually not true or at least not the whole picture.
Eric: In effect, most people – and this is the conversation you have to have – that if you’re not looking at FIA or fixed indexed annuity for income you can buy it without the income rider. You don’t need that income rider…
Dick: No fees.
Eric: No fees, no charges. Now you’re not going to get that **guaranteed roll up for future income but you still have the option of receiving lifetime income from these annuities because you can annuitize.
Dick: Annuitize, right. So, when we start looking at the fixed indexed annuity and the benefits that that annuity will give as compared to other annuities – variable annuities#, immediate annuities. We start to look at we’ve got the upside; we’ve got safety and **guarantees. So the upside would be kind of similar to the variable annuity# that you’ve got some upside here. You don’t have the unlimited upside of the variable but you do have upside for a little better than normal growth should be; and then you’ve got the safety and security of the fixed annuity because there really is no investment for a fixed index annuity. Income – you’ve got the potential of what the immediate annuity has in two ways – you can annuitize or you can use the rider for lifetime income; and the beauty of using the rider for the lifetime income is back to what we call majority control of your money where you can actually not get your lump sum away like the immediate annuity, keep control of that money either to go on to the heirs or for a future use if there was an emergency.
Eric: So, I think we’ve broken down the fixed indexed annuity giving you some tidbits as to how the hybrid might be a part or add on to that that base chassis. I think we’ve got it covered all.
Dick: We’ve done it. Thank you.