“Beauty is in the eye of the beholder”, so the saying goes. So it is that with an article of this nature, it depends on who is writing it and that persons perspective as no two people will share the same opinion. So let us nail our colors firmly to the mast, so to speak, and share with you that we promote Fixed Index Annuities (FIAs) to our clients and are firm believers in their place in any Retirement strategy.
Now that we have our ‘disclaimer’ out of the way, let’s turn to the subject at hand. We will not even attempt to provide a comprehensive list here of all the pros and cons (in no particular order) but will merely touch on what we believe to be the major points and, again, these may differ from another person’s view.
Pros of Fixed Index Annuities
- The power of annual reset. What this means is that every year on the anniversary of the policy, any gains in the market (based on the strategy which you have chosen and an index such as the S&P 500) will be credited to your policy and then ‘locked in’. So if the market goes down in the next year, not only will your value not go down (you will stay level) but the gains made in the previous year that were locked in are yours as well. This can be compared to a ratchet on a jack for your car. As you move forward (up) you are protected from slipping backwards (down) by the ratchet (click here to learn more about annual reset).
- No downside risk. Following on from the first bullet, it follows that whilst you share in a portion of market gains (and these are locked in every year) you do not share in market losses. If the market goes down in any year, your prior year ‘locked-in’ value will stay level. That is, it will not go down or up, but will remain at the prior year’s value.
- Sharing in the market upside. What one has to remember with FIAs is that you are not invested directly into the market. As such, you do not get the full amount of any increase in the market, but share in the growth in any year. Your growth is limited by devices such as participation rates and caps so if the market goes up by 8% and you have a 100% Participation rate with a 5% cap, then you will get 5% growth in that year. Funds are not invested by the insurance company directly in the market, but they buy options in the market. If the market goes up then the insurance company exercises those options and pays you your percentage of the increase. If the market goes down then the insurance company essentially ‘burns’ the options and you get nothing.
- The power of zero. Getting a return of zero in a down year sounds, at first, like a con but it is a very significant pro. Take the example of a market that goes down by 20% in year one. In year two, you will need it to go up by 25% just to get back to where you were. So the power of staying level in that down year suddenly looks very compelling compared to taking a ‘hit’ and having to climb your way back up to where you were before you can start to show gains in your principal again.
- Safety of principal. This is again, partially, a rehash of bullet 1. Your principal is never at risk. It is guaranteed by the insurance company and, to the best of our knowledge, when many institutions were going to the wall back in 2008/9 there was no failure of any insurance company. If this is still a concern for you, then make sure that you are with a highly rated insurance company which will give some increased security and level of comfort. Should an insurance company go broke,, then you do have limited cover from the state and all insurance companies are state regulated. Very few investments are 100% safe as events in 2008 showed.
- The power of tax deferral. The principle here is that, because you only pay tax when taking the funds out as income, you get to use that deferred tax to grow your annuity. That means you are earning interest on the untaxed money, so interest on that higher amount – and so on every year. Because of the effectiveness of compound interest, over a period of years this amount can grow into a significant ‘profit’ on the tax deferred. Contrast this with mutual funds etc. where you have to pay tax on the growth every year and the advantage of deferral is another significant pro. One thing to bear in mind is that this assumes that tax rates remain at current levels. If you think that tax rates will go up significantly, then this deferral could be a con, again depending on where one sees tax rates going.
- Higher returns than CDs and bonds. There is always a trade-off of risk vs. reward. The fact that annuities can offer a better return than CDs means that you do have a product that has less liquidity than a CD. One would need to assess whether the funds would be needed in the short to medium term before investing in an annuity rather than putting it into a CD or similar vehicle.
- Unlimited contributions. Unlike IRAs and 401(k)s, where you have limitations on what you can invest each year, FIAs have no such limitation (provided the annuity is funded with after-tax Dollars). This makes it a very flexible retirement vehicle as you decide how much you want to invest each year. If you have excess funds in a particular year, then you can invest those without any restriction.
- Avoid probate. Annuities avoid probate at death and will pass directly to your beneficiaries who you have named in your contract. This can free up some cash for your heirs immediately upon your death similar to life insurance where heirs do not have to wait for a protracted period before being able to access funds from your estate.
- Riders for Lifetime Income options. Whilst there are a number of riders available via your FIA, the one which is the most compelling for us is the Lifetime Income rider. Please note that most, if not all, of these riders come at an additional cost so one would have to weigh up whether the additional benefit would be worth the additional fee involved. The lifetime income rider will guarantee an Income for life irrespective of how long you live. Essentially, you would get certain guarantees on future growth on your Income rider ‘bucket’ which is separate from your accumulated funds bucket. You would never have the option to cash in your Rider bucket but could only annuitize this into a future income stream as the rider name would suggest. This rider is particularly attractive to those preparing for retirement i.e. where retirement is fairly imminent. The advantage is that the insurance company would guarantee you a particular rate of return on your rider bucket each year irrespective of what happens in the market. So if the rider guarantee was, say, 7%, then even if the market went down in a particular year, then even though your accumulated funds would remain level, your income rider bucket would increase by 7%. This is especially effective where one wants to lock in a rate of return so that one has the option to turn to the rider account on retirement rather than to one’s accumulated funds which might not have grown to the same extent. Essentially you are hedging your bets on the market and this is a particularly wise thing to do the closer you are to retirement, and the more you are depending on every nickel for your retirement income and have little to no ‘wiggle room’ for market fluctuations. Charges for this rider vary but are normally around 1% per annum. This fee is deducted from your accumulated funds so will reduce your cash value.
- Fees. The short answer to this is that there are no fees for a FIA. Where there are costs involved is where you have elected to include a particular rider which carries its own charge which is illustrated up-front. The only other charge as such, is the surrender charge should you elect to take funds out before the expiration of the surrender charge period. This surrender charge will vary according to the contract but is usually around 10% reducing over the term of the contract to 0%. Also the commissions which are paid to the advisor are never paid from your funds but by the insurance company. We constantly hear commissions being used as a negative which is rich considering that 401(k) fees are of the order of 3% pa and come directly out of the client’s funds every year. Similarly with funds under management where there is a fee each year based on the value of the portfolio.
Cons of Fixed Index Annuities
- You do not share in the full upside of the market. As mentioned in point 3 above, because you are not directly invested in the market, you ‘share’ in any gain in the index you have chosen. On balance though, we believe that this is a small price to pay for not sharing in ANY downside risk. If, however you can afford to lose a portion of your funds in a market slide without this affecting your retirement income, than you may well be better served investing directly into the market.
- Surrender costs. Again as mentioned in 11 above there are surrender costs involved in a FIA and these vary from contract to contract. As always this will depend on the product you have chosen and if you believe that you might need access to funds above the penalty free withdrawal amount then you would need to seek a product that has a shorter term. The penalty free withdrawal is the amount that the insurance company will allow you to withdraw each year without any penalty. There are exceptions but generally this is 10% of the accumulated value per annum after the first year of the contract.
- Tax implications, specifically the 59 ½ year rule. Any withdrawal from an annuity prior to this age will incur an additional ‘penalty’ tax of 10%. Thus, if you are younger than 59 ½ and you think you may need access to these funds before that age then this is something to bear in mind. Remember though that annuities are generally sold as a longer-term retirement vehicle so your advisor should not put you into this type of vehicle unless you are a match for it. This tax would apply to all withdrawals including the penalty free withdrawals. Taxes are also paid on a LIFO basis which means that earnings will be taxed first on withdrawal unless annuitization takes place in which case there may be an exclusion ratio.
From the above we can see that there are pros and cons to FIAs just as there to any retirement vehicle out there. The answer is to be informed and to be selective. There are choices by the hundred out there and you need to carefully weigh up which are the right ones for your particular circumstances. There are pundits out there who say that annuities are a bad choice but this lumps all annuities and all derivatives thereof into the same boat. As with any vehicle, there is a place for a FIA within any retirement strategy but properly chosen and structured.
To guide you in these choices you need the assistance of a professional who can both educate you on your options and, together with your input, pick the right combination of product. Even within the realm of FIAs there are literally hundreds to choose from, and this is where consultation and an understanding of your unique position is critical to making those right choices. Your advisor is there to advise only, the decision at the end of the day must be the clients, but education and consultation are key to this decision making process.
Choose your advisor wisely; he or she will be your retirement partner and your right hand in making these crucial decisions. You spend hours and get advice on every other major financial decision in your life such as the purchase of a new home. Your retirement, your biggest asset, is too important to be left to a faceless persona with whom you have little to no interaction. Take control of your retirement and surround yourself with people in whom you have the confidence to guide you to your goals whatever they may be.
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