One of the most popular investment products over the last 20 years is something called a ﬁxed index annuity (FIA), also known as an equity index annuity (EIA). The concept is simple: purchasing an FIA purportedly allows you to participate in market index gains and defer income tax, all while incurring no downside risk. Sound too good to be true? Following the Great Recession (2007-2009) and subsequent market downturn, many investors were looking for safer investments than the stock market and turned to FIAs.
Sales of FIAs have doubled in roughly the last 10 years, rising from $32.387 billion in 2011 to $65.513 billion in 2021.1 The amount being contributed to such annuities has also soared. The average FIA premium in the fourth quarter of 2011 was $66,758, while the average premium in 2021 was $147,860.2
What are fixed index annuities?
An FIA is a tax-deferred ﬁxed annuity that credits interest on a minimal guaranteed basis plus an amount based on the percentage change in the value of a broad market index (typically the S&P 500, which tracks the largest U.S. stocks), but which promises no losses if there is a decline in the market index.
How are returns calculated?
Calculations can be complex and are diﬃcult for many people to understand. The ﬁrst issue to understand is that the insurance company oﬀering the FIA is not actually investing in the index. Most insurance companies are limited by state law to investing primarily in bonds and other more conservative assets. The insurance company is simply crediting you interest based on the return of the market index, with some minimal guarantee. The interest is calculated using one of various formulas that determines how much of that percentage change in the index applies to the account value of the FIA. Insurers use various formulas, such as participation rates, caps, spreads and other techniques, to limit the amount of interest that can be credited based on the change in value of the underlying market index.
Example 1: An FIA has a participation rate of 75% of the change in the value of the S&P 500 index but not more than 7% in a policy year. If the index returns 12% in a policy year, 7% is credited to the account, as that is the cap.
Example 2: An FIA has a participation rate of 75% of the change in the value of the S&P 500 index but not more than 7% in a policy year. If the index loses 5% in a policy year, there are no losses in the account.
The calculation of how interest is credited in an FIA can be so confusing that the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization that regulates securities brokers and dealers, issued an investor alert because it was concerned investors didn’t understand the complexity of the product. FINRA’s alert points out that an investor may earn far less than the return of the underlying index in a good market and can even lose money, as most contracts only guarantee the return of 85% of the premiums paid plus 1%-3% per year.3
One provision of the policies that gets little attention is that insurance companies typically have the ﬂexibility to lower the participation rate, increase the spread or lower the cap, which lowers potential returns. In addition, it should be noted that an index return excludes dividends, so your return from an indexed annuity will also exclude the total return beneﬁts of dividend income. Unfortunately, many investors in an FIA may believe they’re getting full market index returns with no downside risk.
The misguided appeal of downside protection
A big appeal of FIAs is the downside protection when markets are declining. This is a sales pitch for those selling FIAs, and it’s fear that motivates those buying them. As can be seen from the above examples, a purchaser of an FIA is giving up full market return potential in exchange for downside market protection.
So, how valuable (or costly, in lost returns) is this protection? Stock markets have provided signiﬁcant returns over time. Since 1928, the S&P 500 Index has been positive roughly 75% of calendar years; only about 25% of those years have produced a loss. Yes, stock markets mostly go up, and over time they can go up a lot! Since 1928, U.S. stocks have produced an average annual return of about 11.8%, while, for comparison, U.S. Treasury bonds have returned a little more than 5%.4 The long-term average masks the fact that much of those gains are achieved in a lesser number of years where signiﬁcant gains occur.
If we look at the last 13 years, ending December 31, 2021, the S&P 500 average annual return was 16.36% (with dividends). During that time period, using year end values, there was only one year when an FIA provided protection against the negative returns in the U.S. equity markets: 2018 (-4.23%). However, there were 10 years where an FIA would have returned only a portion of the positive U.S. equity market returns. Most of those index returns were signiﬁcant (with dividends):5
Over the last 13 years, an investor in an FIA missed out on signiﬁcant positive returns in 10 years for the downside protection of one year of a small decline. One can argue that this 13-year period was a period of unusually high returns coming out of the Great Recession, but the fact that the sales of FIAs doubled during that time period doesn’t seem like a logical tradeoﬀ of risk and return! The fear of market downturns for those purchasing FIAs appears to far outweigh the reality of their actual investment experience, which was very positive during this time period.
The problem being “solved” with an fixed index annuity is a behavioral and educational issue — it shouldn’t be a product issue
With a little education, most investors should understand that risk and return are related. An investor can’t have returns above bonds or cash without taking some additional risk, which is deﬁned as market volatility. In fact, market corrections — sometimes severe corrections — are a feature of successful long-term investing, not a “bug” in the system that needs to be ﬁxed. If investors understood and accepted this fact about the markets, and got help in understanding this and maintaining discipline from competent advisors, they may likely be much less emotional about downturns and make better long-term decisions. A competent ﬁnancial advisor can help an investor develop an appropriate portfolio mix of stocks and bonds, or other assets classes, that meets the investor’s risk tolerance.
Keep in mind these other negative aspects of FIAs:
- While newer policies may allow for some limited annual access or shorter surrender periods, there may be a signiﬁcant surrender period of up to 10 years where a penalty applies for withdrawing funds. Given available alternatives discussed below, voluntarily creating an unnecessarily illiquid asset is likely a poor choice for most investors.
- Any interest credited to the account is taxed as ordinary income when distributed. Investments outside of an annuity or retirement plan may be taxed at lower capital gains or qualiﬁed dividend rates, and those in the lowest tax brackets may pay no capital gains taxes at all. Also, any withdrawals from tax-deferred annuities before age 59 ½ are generally subject to a 10% tax penalty.
- Salesmen often receive commissions on annuities. There are also administrative and other fees paid to the insurance company associated with maintaining the annuity contract. The purchaser of the annuity is paying for these commissions and fees through the reduced return under the contact cap or limited participation rate. Also, beware of “bonuses” and other incentives to boost returns during the ﬁrst couple of contract years. If you do decide to purchase an FIA (or any insurance product, for that matter), always review the prospectus very carefully and make sure you understand all the fees and costs involved. There is no free lunch!
- Given the expected returns with an FIA, consider whether most investors will achieve their long-term goals if they are expecting stock market-like returns in an FIA.
Is there a better approach to fixed index annuities for most people?
Given the concerns about FIAs outlined above, a strong argument can be made that there is a better alternative to FIAs for much of the investing public.
As scary as market downturns have been (or could be), the likely answer is not to lock up one’s funds in an FIA. To meet the desires of an investor who truly cannot stomach much market volatility and is willing to accept lower expected returns similar to those achieved in an FIA, a simple and understandable portfolio can be constructed with high-quality bonds and dividend-paying U.S. and foreign stocks that will achieve their objectives. With this portfolio, the investor has complete access to the funds at any time and is avoiding many of the negative concerns with FIAs outlined above. While the account isn’t fully tax deferred like an annuity, using tax-sensitive, low-cost mutual funds or exchange-traded funds with tax- exempt municipal bonds creates a portfolio with few ongoing income tax concerns. Finally, taking advantage of losses that should be expected (and are normal) through tax-loss harvesting could provide additional beneﬁt on an after- tax basis.
If you’re interested in learning additional ways to limit your market risk without an FIA, contact us to schedule a call with a member of our team. We look forward to getting to know you.