Last year was a banner year for fixed indexed annuities. Sales topped $50 billion in 2015, a 13 percent increase over the previous year and the eighth consecutive year of increased sales.
For Mike Morrone, associate vice president for fixed income strategy at Nationwide, this rush to security isn’t surprising, nor is it likely to end soon. “The financial crisis and recession of 2007-2009 are still fresh in people’s minds,” he says. “A fixed indexed annuity is essentially a principal-protection vehicle. Likewise, a product that offers such protection, along with guaranteed income for life, has appeal for many investors.”
Some upside potential and principle protection
A fixed indexed annuity is a contract with an insurance company that offers an opportunity to earn interest credits based on the performance of a particular market index, while protecting a client’s principal from loss. Fixed indexed annuities offer the potential for a higher return than that offered by other fixed asset alternatives, such as annuities that are not tied to equity performance.
Here’s how it works: An indexed annuity earns an annual credit equal to the performance of, say, the S&P Composite Stock Index (less any dividends and capital gains). For example, a particular annuity may offer credits in a range from 0 to 5 percent, meaning investors’ returns will be no more than 5 percent, even if the S&P return is higher.
At the same time, an investor’s principal can never lose ground, no matter how the market performs. For example, people with investments in such an annuity during the financial crisis were spared the nearly 57 percent drop in the S&P 500, from its peak in 2007 to its nadir in 2009.
Fixed indexed annuities’ interest credit caps are adjusted on an annual basis, but they often cannot adjust downward for a set number of years.
Like other annuity products, fixed indexed annuities also offer tax-deferred accumulation of wealth. In addition, they can deliver death benefits that include regular payments through the life of the surviving spouse. Those two points, coupled with principal protection, are key factors driving investors to indexed annuities.
Advisors must be clear about returns
Morrone stresses that while returns on these vehicles are based on an equity index, clients are not investing their money directly in the market. Rather, because fixed indexed annuities are contracts with an insurance company, their ultimate success is based on the strength of that company. It is the company that guarantees the principal. “That’s the assurance—and the insurance—an investor is seeking when they work with an advisor to partner with an insurance company,” he says.
Advisors must take the time to determine their clients’ risk tolerance, as well as what solution those clients are seeking to meet their investment and/or retirement needs. Most importantly, when it comes to fixed indexed annuities, advisors must properly manage clients’ expectations. “Clients must understand that these are fixed income products and they will not experience the variable returns, especially on the upside, of equity investments,” says Morrone.
Annuities have limitations. They are long-term vehicles designed for retirement purposes. They are not intended to replace emergency funds, to be used as income for day-to-day expenses, or to fund short-term savings goals. Investing involves risk.
A fixed indexed annuity is not a stock market investment and does not directly participate in any stock or equity investment. It may be appropriate for individuals who want guaranteed interest rates and the potential for lifetime income. Guarantees are subject to the claims-paying ability of the issuing insurance company.
Lifetime income may be provided through the purchase of an optional rider for an additional cost or through annuitization at no additional cost. If you take withdrawals before you're age 59½, you may have to pay a 10% early withdrawal federal tax penalty in addition to ordinary income taxes. Withdrawals may trigger early surrender charges, reduce your death benefit and contract value