There is something special about a particular type of annuity you may or may not have heard of – a so-called fixed indexed annuity (FIA). Its sales were climbing faster than most other annuities for years until the advent of the Covid-19 pandemic, which brought interest rates down to nearly zero and pressured insurance companies to offer less generous payout rates.
So-called index participation rates, commonly as high as 50 percent in 2019, subsequently declined to as low as 25 percent.
But annuity shoppers are warming up to FIAs again, partly because payout rates are creeping up a bit and likely to continue doing so, perhaps more vigorously, as the Federal Reswerve increases interest rates in 2022. According to the Insured Retiremnet Institute (IRI), sales of FIAs in ther second quarter of 2021, the latest figure available, rose 15.8 percent to $15.4 billion. This occurred while other types of annuities, such as variable annuiites, were almost flat. IRI projects that FIA sales will increase more than 5 percent in 2021 overall.
It turns out that FIAs — while unlikely to offer payout rates as high as they were years ago unless soaring inflation persist longer than most economists expect — are the right product at the right time for many pre-retirees and retirees. They offer market exposure with no risk and, with a guanateed income rider, still-respetacle income payments. They are more generous than traditional fixed annuiites, offer some exposure to the stock market and guarantee no losses in a down market.
According to Morningstar Inc.,a case can also be made that FIAs may become more attractive than some traditional alternatives, such as the “4 percent rule,” because the stock market will be unable to maintain its robust returns of recent years in a period of rising interest rates and a pricey stock market that already sits at near-record highs.
The 4 percent rule, an alternative to annuities, says that retirees with a well-balanced stock and bond portfolio can withdraw 4 percent annually and still support a 30-year retirement. Morningstar questions this because of its expectation of lower stock market returns moving forward. “This will require strategies that can mitigate the impact of market downturn,” Morningstart says in its report, and that includes the embrace of solid FIAs.
FIAs appeal to pre-retirees and retirees who want principal protection and income guarantees and who also want to roll the dice, at least a bit, via some exposure to the equity market. But unlike the case with variable annuities, these people want to protect that exposer. And FIA income guarantees, while depressed, are still typically better than they are in variable annuities.
None of this should suggest that FIAs are a panacea. Equity returns are modest unless the market enjoys an unusually good year. This is because market index returns are not limited only to participation rates. Also common are caps, which limit the amount of the increase in the index investors can reap, and spreads, which further subtract market gains.
The impact of these so-called crediting methods has been highlighted by Fidelity Investments and others over the years. In 2019, the best performance for the S&P 500 in six years with a total return of nearly 32 percent, Fidelity says that a “representative” FIA with a monthly cap on upside returns credited investors only about 10 percent that year.
FIAs also tend to have longer surrender schedules than other annuities – the penalty paid for exiting the contract prematurely — and are harder to understand because they have a lot of components. These include riders, rider fees, participation rates, caps and spreads. “There are more moving parts, and so there is more confusion,” says one financial planner familiar with annuiites.
Also, unlike VAs, FIAs are not regulated securities, and so they may be misrepresented by brokers. Some, for example, may claim that these have as much upside potential as a VA, which is not the case.
The significance of these drawbacks depends on the sophistication of the buyer. Those who do their homework and are quick to ask questions will not be confused or come away with the mistaken notion that a FIA can be almost as lucrative as a VA under the right circumstance. These people know this is incorrect.
The fact that FIA owners cannot lose money in a down stock market hasn’t been much of a sales tool in recent years because the market has done little besides rise, typically briskly. This is highly unlikely to be the case moving forward because the market is very richly priced and due for a correction, if not worse, at some point.
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