Retirement used to be a lot simpler. You relied on pensions and Social Security to carry you through your golden years. Nowadays, market volatility, rising living costs and fears about outliving savings are pushing retirees and pre-retirees to search for financial solutions that offer both security and growth potential.
One increasingly popular solution: Fixed index annuities (FIAs). “They let you earn more interest than traditional annuities or certificates of deposit (CDs) when a stock index or other index does well but also protect your money against losses,” says top wealth advisor and retirement expert Bob Carlson. According to the Life Insurance Marketing and Research Association, FIA sales reached a record $128.2 billion last year, accounting for nearly one-third of all individual annuity sales in the US.
But FIAs can be complicated products with lots of trade-offs. Bottom Line Personal spoke to Bob Carlson, editor of Retirement Watch, to find out the key benefits and features of FIAs and how they compare to other annuities and the critical questions you should ask to get the best deal for your circumstances.
What Is a Fixed Index Annuity (FIA)?
An FIA is a contract sold by an insurance company. It is designed to give you the potential to earn higher, long-term returns on your investment money than interest-based vehicles such as bonds and CDs. FIAs do this by using the returns of a stock index or other investment benchmark to calculate the interest credited to your account each year. Your money grows tax-deferred, and you are guaranteed not to lose money even if the stock index or other benchmark declines.
| Pros | Cons |
| Protection from losses | Limited upside in strong bull markets |
| Potential for higher returns than other income investments | Complexity |
| Protection from creditors | Inflation risk |
| Avoid probate after your death | Insurer credit risk |
| Tax benefits once you reach early 70s | Agents’ misleading sales practices |
How Do FIAs Work?
You deposit a lump sum (or a series of payments) in an account with your insurer. During a defined period (typically one year), the insurer credits interest based on the performance of an external market index such as the S&P 500. “This is known as the accumulation phase,” says Carlson. Your account has a guaranteed floor, so you never lose principal due to market declines. If the index is negative for the year, you get a 0% return for that period. If the index rises, your account is credited for part of that gain, subject to the rules of your contract. Once interest is credited, it is permanently locked in and added to your protected base.
To compare different FIAs, you need to understand the formula for calculating the returns credited to your account. Insurers use various calculation methods…
Cap rate. This is the most popular formula. The insurer sets a maximum ceiling, commonly 5% to 12% annually, limiting your upside. Example: The index returns 18%. Your cap rate is 12%, so you are credited 12%.
Participation rate. This allows you a certain percentage of the index’s increase. Example: The index goes up 18%. Your participation rate is 60%, so you earn 10.8%.
Spread. In addition, insurers may apply a spread, which is a percentage ranging from 0.5% to 3.5% that is deducted from index gains before interest is credited. Example: The index is up 2%, but the spread is 2%…so you would receive a 0% credit.
It is not unusual for more than one of these limits to be used by the same FIA.
Important: Insurers can adjust caps, participation rates and spreads at the time of each annual contract renewal. Some reserve the right to make adjustments at any time. “So a product sold with an attractive 10% cap today could be renewed at 5% next year,” says Carlson. “You need to be aware of absolute minimum guarantees in your contract, which often are very low.” Insurers also can change the indexes used to calculate an FIA’s interest.
Once you start accessing the income from your account, you begin the distribution phase of your FIA. You generally have two choices for distribution…
Direct withdrawals. Most contracts tie up your money for a surrender period that can last between five and 14 years. You are typically allowed penalty-free withdrawals of up to 10% of the account value per year. If you withdraw more than that amount, you face surrender charges. Once the surrender period is over, you are free to access the full account value.
Create a personal pension. “You can buy a rider to your contract that pays you a guaranteed percentage annually from your FIA for the rest of your life,” says Carlson. Important: The amount you get in each paycheck isn’t based on the actual cash value of your account, but rather on the “income value” or “benefit base” of the account. Your benefit base grows at an annual rate stipulated by the insurer regardless of how the stock market does. It is relevant only if you decide to turn your FIA into guaranteed lifetime income.
Key Features of FIAs
Index selection. Most FIAs offer a menu of different major indexes to allocate your premium, as well as blended indexes, which can include equities, bonds and commodities. You generally can choose the index but not always.
Tax deferral. You pay no income tax on gains until you withdraw money from your annuity account. Withdrawals are typically taxed as ordinary income on the earnings portion. Withdrawals taken before age 59½ may incur a 10% IRS early-withdrawal penalty.
Riders: A rider to an FIA is an optional add-on to a basic policy for an additional cost. A rider customizes, expands or restricts coverage to fit your specific needs. Examples…
Guaranteed Lifetime Withdrawal Benefit (GLWB). This rider allows you to take a set percentage of a “benefit base” as annual income for life.
Joint GLWB. If you pass away, the same payments (or a specific percentage, such as 50% or 75%, depending on what you select) continues uninterrupted for your spouse’s lifetime.
Pros and Cons of FIAs
As with most financial investments, there are pros and cons to FIAs. Here are the pros…
Protection from market losses.
Potential for higher returns than other conservative investments.
Creditor protection—in many states, annuity assets are protected from creditors.
Probate avoidance—when you pass away, the account balance in your FIA on the date of your death usually passes directly to named beneficiaries.
Tax benefits. When you reach your early 70s, your FIA is not subject to required minimum distributions (RMDs) if they were funded using after-tax dollars.
And here are the cons…
Limited upside in strong bull markets. “In flat or modestly up years for the stock market, FIA fees can wipe out nearly all credited interest,” warns Carlson. “Also, your FIA’s growth is based on price-only stock index returns, not total returns, which include dividends.” Interest also is limited by factors such as the cap, participation rate and spread, as discussed earlier.
Complexity. FIA contracts can employ multiple crediting methods and nonstandard market indexes to determine your returns, plus income-rider structures that are challenging to compare.
Inflation risk. FIAs with low cap rates may barely keep pace with inflation in moderate market environments after fees.
Insurer credit risk. FIAs are backed by the insurer, not the federal government. While defaults are rare, your guarantee is not protected by FDIC coverage and is only as strong as the annuity insurer’s financial health.
Aggressive sales practices from agents. Red flags in the FIA sales process include…
Urgency tactics—buy now before your rates drop.
Cherry-picked back-testing—showing only the best historical crediting period for a given strategy.
Misrepresenting the benefit base you earn for lifetime income with the actual cash value of the FIA account.
Common Fees and Charges
Most FIAs do not charge an annual maintenance fee on the base contract, but they do come with other fees…
Optional rider fees: A GLWB (cost: 0.5% to 1.25% annually)…Joint GLWB (cost: 0.90% to 1.5%). “Ask your insurance agent whether an annual GLWB fee is calculated based on your actual account value or on your benefit base,” says Carlson, “since it could greatly affect the amount of the check you receive.” Also, in most FIAs, this fee continues to be charged after you elect to start receiving income.
Surrender charges operate on a sliding scale. Example: For an FIA with a 10-year surrender period, the first year you might pay a 10% penalty on any amount you withdraw over the contractually allowed annual limit. The charge declines by one percentage point for each year until it drops to 0%.
FIAs vs. Other Annuities
“FIAs are designed to be a hybrid of fixed and variable annuity contracts,” says Carlson. “You get more growth potential than a fixed annuity and more protection than a variable annuity.” But there are other kinds of annuities…
Basic fixed annuities (also known as single premium income annuities) are more transparent and predictable and best for retirees or pre-retirees seeking guaranteed income to cover living expenses. In exchange for a lump sum, you receive guaranteed income that lasts for the rest of your life or a defined period you selected. Drawbacks: Once purchased, your fixed annuity is irreversible—you cannot cash it in, surrender it or get back your principal. Some annuities offer alternatives, such as a guaranteed return of principal to your beneficiary if you don’t live to life expectancy, but they will reduce the lifetime income.
Variable annuities carry greater risk than FIAs but also have the potential to provide larger payouts. These are best for people who want full market exposure inside a tax-deferred account with an option to tack on guarantees via riders. The insurer invests your premium directly into market-based subaccounts, essentially mutual funds held inside an insurance wrapper. Your account value rises and falls with actual market performance. Drawbacks: High fees that can run from 2.5% to 4.5% annually. Also, they can suffer investment losses.
Who Should Consider an FIA?
Near-retirees seeking protection. FIAs are often used by people five to 10 years from ending work who can’t afford a large market loss so close to retirement. They want to protect their principal but have the potential to earn more interest than a fixed-rate annuity or a certificate of deposit.
High-income earners who already have maxed out annual retirement contributions to accounts like 401(k)s and IRAs and who want to shelter additional money for tax-deferred growth. There are no contribution limits to how large an FIA you can purchase.
Retirees who want a guaranteed paycheck for life. Compare the income rider to the income available from single premium immediate annuities (SPIAs).
Important Considerations and Risks
Take the following steps to ensure you select the right annuity for your needs…
Comparison shop. Use an independent annuity broker who works with and has access to top FIA carriers such as Athene, Allianz, American Equity, North American, Nationwide and Pacific Life. “Ask the agent to run illustrations for your specific situation comparing at least three carriers,” says Carlson. Helpful resources to find annuity products and insurance brokers: AnnuityAdvantage.com and SafeMoney.com.
Be wary of putting an FIA inside your IRA. The IRA already provides tax deferral, so the annuity layer adds costs without adding any tax advantage. Also, FIAs held in traditional IRAs are subject to RMDs. Yet FIAs in an IRA can be a good idea if the IRA holds most of your retirement savings or you want to use an income rider to generate guaranteed retirement income.
Research the insurance company’s financial strength at organizations such as A.M. Best, Moody’s and S&P Global Ratings. Aim for a rating of at least A or higher (A3 for Moody’s).
Get an independent review of your FIAs from a financial advisor. “Your insurance agent is typically paid a commission for selling you an annuity,” says Carlson, “so his financial incentive does not always align with your best outcome.” A financial advisor can evaluate why the FIA is a better fit for your broader retirement goals than alternatives and how much of your nest egg should go into an FIA. Note: Every state requires a “free look” period (typically 10 to 30 days) after you sign an annuity contract during which you can cancel for a full refund.
Bottom Line Personal interviewed Bob Carlson is editor of the newsletter Retirement Watch. He is also a managing member of Carlson Wealth Advisors and former chairman of the board of trustees of the Fairfax County (Virginia) Employees’ Retirement System. RetirementWatch.com
