A few years ago, Jim Smith, a 63-year-old Midwesterner interested in burnishing his future retirement portfolio, heard on the grapevine that he should look into buying an annuity – specifically a fixed indexed annuity (FIA). He was told that it invested in the stock market indirectly and that – hard though it seemed to believe — it would not lose money in a year in which the stock market declined.
So Smith picked up the phone and chatted with a financial planning firm advertising FIAs. Sure enough, it told him that a FIA was an excellent investment that invested in a stock index and did not, in fact, lose money in a down market. The FIA would even provide a 10 percent upfront bonus on the “income base” of his annuity, his broker added, explaining that this was the foundation on which annual cash withdrawals are calculated.
Smith invested $200,000 in the annuity. He isn’t a studious man and didn’t know for a while that he didn’t get the whole story, largely because he didn’t ask good questions. After receiving quarterly and annual statements, he finally learned what he should have asked and may have steered him toward a more enticing annuity without being penalized by steep surrender fees – the reality for prematurely exiting the product once it is purchased. Smith might have opted instead for a variable annuity, which invests directly in the market, not in a market index, and pays 100 percent of market returns. Only with a lag did Smith learn that his FIA paid only 45 percent of the stock market’s annual return.
The Smith story is apocryphal. But it illustrates in one important way why the U.S. Department of Labor ultimately crafted new regulations, effective in January 2018, regarding the way FIAs and select other retirement products are sold. Since then, brokers have had to follow new fiduciary guidelines. Now, for instance, they are only able to sell FIAs to a client if they put a client’s needs ahead of the FIA’s generous commission. While this is obviously a plus, it remains questionable whether the purchase of a FIA today is a good idea. The biggest reason is that so-called index participation rates on the popular S&P 500 index have fallen even further – to 30% or 35% –than they were when Smith bought his FIA.
Nonetheless, FIAs — fixed annuities with a variable rate of return, pegged to an investment index such as the S&P 500. – are still worth talking about because they remain popular and, in fact, registered a strong increase last year. According to the Secure Retirement Institute, FIA sales reached $63.7 billion in 2021, up 15% from 2020 and the biggest spate of growth in three years.
To be sure, substantially more FIA buyers know the ins and outs of the product today and are happy about their purchase. For them, select FIAs are good buys. Now they typically invest in increasingly popular low volatility indexes, which invest in stock indexes but also other assets, enhancing stability, and typically offer an index participation rate about twice as good as the S&P 500 participation rate, sometimes higher. This is particularly attractive to financially conservative people, the majority of FIA buyers.
Still, many of them still fail to realize how limited their FIA returns may ultimately be. According to Fidelity Investments, the average annual return for the S&P 500 for the 10-year period ended October 2020 was 13%. By contrast, the average FIA returned only 3.5% annually, Fidelity says.
In addition to low index participation rates, FIAs often have various fees not limited to significant surrender fees. This also hurts returns, as does the fact that investment in a stock index precludes dividend payouts. This is why it’s important to ask your broker to explicitly define how the product works, FIA buyers should know up front any factors that may put a drag on their potential return.
The bottom line is that the purchase of an FIA may still ultimately make sense, with or without a lifetime income rider, depending on the preferences of the buyer. But shopping around is critical because many FIAs are mediocre buys or worse. If that is the case, it may be in the best interest of a FIA buyer to seriously consider buying a different type of annuity.
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