Understanding Fixed Index Annuities

Fixed Indexed Annuities (FIA) are very popular at this time. Let’s get to know the product.

These annuities are sold by insurance sales people and financial advisers. FIAs are an insurance product and they are a savings account rather than an investment account. Being a savings vehicle rather than an investment account allows financial people who do not have securities licenses to sell the product—most insurance sales people for example. Some sales people may pitch it as a safe investment to entice sales but it’s not an investment.

Like any financial product, it can be good or bad depending on your circumstance. We want to prevent buyer’s remorse when possible. Many features and benefits of any product sound good on the surface and only later when you realize how things really work, you realize you made a mistake—usually after the product doesn’t do something you thought it would in a given situation.

The FIA is a savings vehicle in the form of a deferred annuity. Deferred meaning you don’t have to make the annuity pay a stream of lifetime income until you choose to do so in the future—or not. Annuities are insurance companies’ savings or investment products that have guarantees (insurance) and some tax benefits. Some annuities can be considered a third-level of retirement account after employer plans (401ks, etc.) and IRAs.

The sizzle behind FIAs is the interest rate. The interest rate floats based on the performance of an outside measurement. Most use the S&P 500 Index (a stock portfolio) as their outside measurement to determine their rate of interest. You are not invested in the S&P 500 Index; it is just used as the basis of the interest rate paid to the account.

The typical FIA has a guaranteed minimum rate of interest like 1 or 2%–the floor you are guaranteed to earn. The upper limit of interest paid is a portion of the outside measurement. If the S&P 500 Index is used as the outside measurement, your interest rate is a portion of that Index’s rate. So as the sales pitch goes, you capture some of the stock market’s highs while being protected from the stock market’s lows.

Wow, that’s great! What’s the rest of the story? Best to think of these accounts as principal protection and not wealth creation. If this isn’t your objective, these are probably not for you.

You get a portion of the outside measurement’s return on the upside. The FIA has “cap rate” and a “participation rate” (terms may vary).

Cap rate is the most interest you can earn. Example…say the S&P 500 Index gains 15% in a year. Your cap rate may be 6%. In this case, you gave up 9% of the S&P 500 upside to insure your safety.

The cap rate can be decreased by the participation rate—limiting your interest rate even more. Let’s say you have a participation rate of 80%. Say the S&P 500 Index goes up 6% in a year. Your cap rate is 6% so you get the 6% right? Not so fast. In this case, your participation rate kicks in and limits you to 4.8%; 80% of the S&P500 return. The insurance company can’t pay you the same as the Index in this case. They are going to make their money.

So there you are, an interest bearing account that pays between 1 and 6% in this example.

Tax-wise, annuities are tax-deferred until withdrawal—your gains are not taxed as long as they sit in the annuity. You pay regular income tax rates upon withdrawal for all amounts that are not a return of principal. Your principal was already taxed money at the time of contribution. This means you will not get more favorable capital gains tax rates upon withdrawal. Even if you have a variable annuity (not an FIA) with investment options and capital gains, you pay regular income tax rates upon withdrawal.

Other issues are fees, surrender charges, whether you are limited to one lump-sum deposit or contributions over time, your need for a lifetime income option, liquidity options, your time horizon, your other interest rate account options, income needs, emergency withdrawal options, and your ability to close the account.

Carefully define the objectives and requirements for your money before you open a FIA. Your objective and requirements should help determine whether a FIA is right for you.