Fixed index annuities (FIAs) have recently received bad press be-cause the stock brokerage community is not overjoyed with these products. They're popular because they provide attractive features not available from securities. FIAs guarantee that clients will earn an interest rate linked to a major market index, but they will not suffer a loss if the market plummets. Hence, FIAs are most appropriate for clients who do not want the possibility of downside risk.
But in almost every case cited as an example, the spotlight is on the worst FIA critics can find (often a payout two-tier annuity -- more on that later) being sold to a highly vulnerable or elderly person. What they fail to say is that such people should not buy any annuity or security. These consumers should really only consider highly liquid, low-yielding instruments such as money market funds and savings accounts.
FIAs are similar to traditional fixed annuities, except rather than being paid a fixed rate of interest, clients will earn a rate of interest determined by a stock or bond market index. For instance, the index to which your clients' earnings are linked might be the S&P 500 stock market index. Their interest may reflect less than 100 percent of the change in the index if it goes up, but if it declines, they will not share in the loss. (Changes in the index will not include dividends paid on the underlying stocks.) For example, if the index increased by 15 percent, your client might only get a return of 8 or 10 percent. But if the index sank by 15 percent, they would not suffer a loss. That's why FIAs are so appealing to those who are extremely concerned with losing money, even temporarily. The upside opportunity with no downside risk is very attractive to some savers who want the potential for a higher rate of return without the risk of loss.
When clients purchase a FIA, their money is not in the market or exposed to market risk. However, their rate of earnings is determined by the growth in the market index. FIAs have been characterized as a simple concept made complex by insurance companies -- but you and your clients don't have to be overwhelmed by the moving parts of some FIAs.
FIA interest crediting methods
At latest count, there were more than 100 different methods for computing how interest is earned from a FIA. The methods used to calculate the interest rate are at the center of this complication. These methods are mostly marketing sizzle used by insurance companies to make their products appear unlike all the others. So don't pay much attention to them when reviewing annuities with your clients. Of course, once you home in on the annuity that's right for them, make very sure they understand how the crediting works.
All crediting methods are designed by actuaries to give about the same results over time. So, there is no way to tell which method is going to best perform over the next several years. Whether your clients choose point-to-point, monthly averaging, daily average, S&P index, DJIA index, or others, their chances are about the same at the beginning, because that is how the actuaries designed the annuities. Once the annuity starts, each crediting method will perform differently, and some will be better than others. This will only come to light, however, after the fact.
The best approach is to hedge your clients' opportunity by dividing their money between two or three crediting methods rather than selecting only one. This diversification means that over time, the performance will average out and the overall result will be more stable. Think of comparable fixed annuities as commodities because, over the long run, they will all give you about the same results for equally rated insurance companies. Of course, there are always exceptions, such as payout two-tier annuities that can take unfair advantage of consumers. In the interest of full disclosure, you should give clients the history of how certain annuities have performed. But keep in mind that "back testing" an annuity can yield results that may not accurately reflect historical performance. There's an old saying in economics about getting the results you want: "Just torture the data until it confesses." Also, past performance is not a reliable indicator of future results.
Who bears the earnings risk of an FIA?
Again, the risk is borne by the insurance company. With a traditional fixed annuity, clients are guaranteed a fixed rate of return for the number of years selected, and the insurance company is obligated to pay that amount. With an FIA, the interest rate is tied to a market index that determines the interest rate that is earned. But if the index to which the annuity is linked goes down, your clients' account value will, at worst, earn nothing but lose nothing, as well. Think of this as a safety net on your clients' assets during a plummeting market. With FIAs, the worst case scenario is that your clients will earn the minimum interest rate guaranteed if they hold the contract to term. The minimum rate guaranteed by an insurance company varies by state. Generally, the rate is somewhere between 3 percent on 100 percent of the clients' money to as low as 1.5 percent on 87.5 percent of their money. Guaranteeing a minimum rate on less than 100 percent of their money can be very misleading. Here's an example: How much will your client earn if they are guaranteed 3 percent on 90 percent of their money? The obvious but wrong answer is 2.7 percent (3 percent times 90 percent = 2.7 percent). If you do the arithmetic, however, you'll find that 3 percent on 90 percent over five years is 0.8523 percent, and over 10 years, the rate is 1.9205 percent.
The danger of the two-tier annuity
Ironically, for the past several years, the best-selling fixed index annuity in America has been a payout two-tier annuity requiring clients to withdraw their money in installments.
This design may make such annuities unsuitable for some to own. So why are they so popular? Because the marketing is principally focused on the higher tier while the explanation of the lower tier is far less conspicuous.
With many payout two-tier annuities, earnings are reported as if clients will hold the annuity until the end of the contract term and then withdraw their money in installment payments over a certain number of years. If they don't take it in installment payments, earnings are computed in a very unfavorable fashion. With the typical payout two-tier, clients must withdraw their money over a period of at least 10 years to get the full account value reported on their annual annuity statement. Beneficiaries are generally permitted after the owner's death to obtain the full account value only if they withdraw the money in installments over five years. Should the owner or beneficiaries ever withdraw the money as a lump sum, a much lower rate of interest than the index-linked rate is paid for the entire life of the annuity -- going all the way back to the date the account was opened. What's more, any bonus added to the account, and interest it has earned, will be taken back if a lump sum withdrawal is made.
There is no guarantee with payout two-tier annuities that the client's money will earn a market rate of return during the installment payout period, typically a period of five to 10 years. With the payout two-tier annuity, they'll receive the interest credited during the accumulation period and the bonus added to the account only if they withdraw in installments. When the installment payments start, clients may receive a below-market rate of interest because the insurer is not obligated to pay a competitive interest rate.
On the other hand, if clients withdraw funds in a lump sum from a payout two-tier, they earn a much lower rate for the entire time they held the annuity and lose any bonuses received when they opened the account. Either way, they're likely to get smaller earnings from their money.
Shelby Smith is chief operations officer for BHC Marketing. This article is an excerpt from his "Is Your Annuity Good or Bad?" For the full article, email ssmith@bhcmarketing.com.
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