Market Gains without Market Losses?
Sounds Too Good To Be True. Let's Look Under the Hood of a Fixed Index Annuity.
You’ve probably heard some version of that promise used to describe a Fixed Index Annuity.
Truth? You can get SOME of the market’s upside without suffering the market’s downside.
More returns, linked to a market index, better than the bank, with no loss risk? Sounds great!
But how can an insurance company possibly do that?
Where does the money come from? Is your money actually invested in the index, such as the S&P 500? Is the insurance company absorbing all your stock market losses?
NO!
To understand a Fixed Index Annuity (FIA), we need to look under the hood. Fixed Index Annuities are used as tools for two different goals in retirement:
#1 Safe Accumulation: An alternative to a Bond Fund or Bank Account
#2 Guaranteed Lifetime Income: An alternative to a Life Annuity or Pension
This week: We’re talking about accumulation. Could it replace a bond fund in your portfolio? Could you earn more interest than the bank, and defer taxes on it?
Next week: We’ll talk about how an FIA can be structured to produce retirement income and perhaps assist with Long Term Care expenses.
In both newsletters, we’ll also go over The Good, The Bad, and The Ugly!
First Surprise: You’re NOT invested in the index!
If the FIA uses the S&P 500, the index is used to calculate interest credits. You don’t own the stocks in the S&P 500, and you generally don’t receive the dividends associated with owning those stocks.
Then HOW DO I get interest credited when the market goes up?
Here's the simplified version:
The insurance company invests primarily in its general account, which is largely composed of fixed-income assets such as bonds and mortgages. The return on those assets helps support the guarantees in the contract.
A portion of the interest available from those assets can then be used as an “option budget” to purchase derivatives, commonly options, linked to the index.
Those options create the opportunity for index-linked interest.
Let’s make it simple using hypothetical numbers to illustrate:
You deposit $100,000 into an FIA:
The insurance company doesn't take your $100,000 and buy $100,000 of the S&P 500.
Instead, think of the insurer as using its general-account assets to support the contractual guarantees, while allocating an option budget to create the index-linked crediting opportunity.
Suppose, purely for illustration, the economics allow $4,000 for that option strategy.
The insurer might use that $4,000 to purchase options tied to the S&P 500.
If the index falls, those options may expire with little or no value—but your contract isn't debited for the index's loss; however, you won’t have any interest credited. (because the interest purchased the option)
If the index rises, the option performs and can generate interest credited according to your contract's formula.
That's the magic trick explained.
There isn't really magic.
In simple terms, you’re giving up the fixed interest you might have earned for the opportunity to receive index-linked interest.
So why don’t I get ALL the market gain?
Because options aren’t free. The cost of obtaining a certain amount of index exposure varies with market conditions. That’s why you need to understand the contract terms.
There are three big terms in these contracts you need to understand:
CAP:
PARTICIPATION RATE
SPREAD
If you don’t get all the growth of the index, what’s so attractive?
The 0% floor:
That’s the tradeoff.
Note: You’ll never lose value from a market loss; however, a 0% index credit floor doesn’t mean the contract can never lose value under any circumstances…
Withdrawals, surrender charges, rider charges, and other contract provisions matter!
The “Lock In” Concept:
If the contract credits 6% at the end of an annual point-to-point term (usually 1 – 2 years), the next term usually starts from the resulting contract value, rather than requiring the contract to recover a stock market loss.
Let’s contrast: Market Investment to an FIA with no withdrawals or rider charges:
Let’s assume a ↓ 20% market followed by a 6% gain:
Market Investment:
$100,000
Index ↓ 20% = $80,000
6% growth on $80,000 = $84,800
(You needed 25% growth just to return to $100,000)
Versus the simplified FIA Concept:
$100,000
Index ↓ 20%
Index Credit = 0%
6% credit the next year = $106,000 (do not have to make up market losses)
The “Crediting Method”:
The simple One-Year Point-to-Point is the crediting method we used in the above illustration.
Two FIAs may look the same but…
Remember that there may be Cap/Participation/Spread formulas as described above.
Two FIAs tied to the exact same index can produce very different interest credits because of these additional formulas.
There are also even more complicated monthly strategies, multi-year strategies, volatility-controlled indices, proprietary indices, etc.
Caution:
The Cap You Get Today May Not Be the Cap You Get Forever
This is a major issue! Some non-guaranteed elements can be reset by the insurer, subject to contractual minimums/maximums. Specifically, some contracts allow changes to participation rates, caps, and other elements every time a term begins.
Protect yourself by asking:
Liquidity is the price people forget…
The FIA may provide principal protection from negative index performance, but…
Can you get all your money tomorrow?
Probably not without consequences because there are rules:
The good news…most FIAs (Not All) waive surrender charges and MVAs if you have a catastrophic illness or pass away. These products are specifically built for an older client who may face a catastrophic illness and need their money.
Safety and Liquidity are NOT the same thing!
Money can have protection from index losses and still be inappropriate for money someone may need next year.
We recently had a client, Marion age 73, who has been very happy owning an FIA call us and say, “We have too much money in the bank. We’re making very little, and don’t want to risk it in the market. Can you get us another annuity?”
Our answer? NO!
Why? Because we’re firm believers that liquidity as we age is extremely important. When they ask, “But what can we do? We’re not making anything on it?”
Our answer: “Marion, chase CD rates!” Then we may guide her on how to do that. Why? CD early withdrawal penalties are typically VERY LOW (usually no more than 6 mo. interest) vs. much higher surrender charges in an FIA, which could initially be 5-8% or more!
Remember, we’re “Agnostic to the Tool”. In other words, what is the problem you’re trying to solve?
For Marion, she was confused, thinking that the problem was her low return. The problem was being prepared for an unexpected event, such as incapacitation, loss of her spouse, etc., and needing immediate larger sums of money.
Before I give you the “Good, Bad and Ugly”, let me address my preferences after many years of experience with FIAs.
First, I believe in the indices of the broad market that have a history you can view and are easy to track, such as the S&P 500, the Russell 2000, etc. Not those that are the S&P with “volatility control” and a myriad of other S&P versions, or other indices that are “proprietary”.
Why?
Are they all bad? Probably not; I just want to know exactly what to expect. I can look at the index, the rules in my contracts, and know what to expect. Even then, you need to know what you’re looking at.
The S&P Price Index is your measurement, not the S&P Total Return Index, because you’re not getting dividends since you don’t own the stocks.
That said, we’ve seen decent returns in the FIAs with the simple broad index options. Remember, I started out saying this newsletter is about:
#1 Safe Accumulation: An alternative to a Bond Fund or Bank Account
That’s the real job of this tool, NOT to replace your investments in the market!
There are certain exceptions that may occasionally earn 8-20% in a year, but that is an anomaly!
The average returns we’ve seen for a good FIA are usually between 4-6%, similar to a bond fund, and a good alternative for your “safe money”, while you have other investments in the market.
The 12% returns I see in “illustrations” based on newer proprietary or volatility-controlled FIA indices rely heavily on hypothetical back-tested data from before they’re launched.
The truth? The new indices have cheaper “options,” allowing more participation and higher caps, but what if the index simply doesn’t perform because of its complexity?
Unfortunately, my clients and I have “been burned” by these “new” proprietary and “volatility-controlled” indices. It’s getting harder and harder to find the old-fashioned “simple” FIAs we started out with, but there are some out there!
Here’s an example of an FIA with a different crediting strategy—one I’ve long preferred. It disappeared about 15 years ago, returned two years ago, and has since become one of our primary FIA accumulation tools.
It’s called a “Trigger Annuity”.
The crediting is simple. If you choose the broad S&P 500 Price Index, and the index is “0%” or better for your anniversary year, you get the “Trigger” return applied.
The “Trigger” return may be guaranteed for the entire length of the contract (The BEST!) or may change from year to year, with a minimum guaranteed percentage.
Joann came to us, frightened about investing, because her husband had passed, and he had done all the investing. She was willing to trust our tactical manager with half of the money, $1M, but wanted security for the other half, $1M.
Two years ago, we deposited her $1M into a “Trigger Annuity” that has a 10-year term and a 9% trigger. The annuity has triggered both of the last 2 years. That was $90,000 the first year, and $98,100 the 2nd year. Do we expect it to “trigger” every year?
No!
Will she lose money if the index is down? No!
The market is flat or up an average of 7 out of every 10 years, but even that’s not a guarantee. The bad news is that the annuity has now changed its rules so that the “trigger” can change each year (but it won’t for her, because she has a contractual guarantee of the terms).
Even with the new rules, the “trigger” annuity is an excellent accumulation tool that also offers a very attractive option for fixed interest each year on part or all of our money.
Now…The Good, The Bad and the Ugly!
THE GOOD:
– Principal/account-value protection from negative index performance, subject to contract terms.
– Opportunity for index-linked interest.
– Previously credited interest generally becomes part of the contract value rather than being lost because the index subsequently declines.
– Tax deferral for nonqualified money.
– Potentially more growth opportunity than a traditional fixed-rate annuity, but not necessarily.
THE BAD:
– You don't receive the full return of the stock market.
– No direct ownership of the index.
– Caps/participation rates/spreads can limit credits.
– Some terms can change.
– No dividends from simply being linked to a price index.
– Surrender period limits liquidity.
– Complexity.
THE UGLY:
A perfectly legitimate tool can be sold badly:
– “Market returns without market risk!”
– “10% bonus!”
– “12% growth!”
– “Can't lose!”
– Those phrases may leave out crucial details.
So, can a Fixed Index Annuity (FIA) let you benefit when a market index goes up, without exposing you to that index’s losses?
Yes, subject to the contract’s terms (which I hope you better understand now!)
You’re not getting “something for nothing”!
You trade some potential upside and liquidity for protection from market losses. Whether that’s a good trade depends on the job this money needs to do. But we’ve only talked about one job today…Accumulation!
Next week we’ll address what happens when you retire and want that pile of money to start writing you a paycheck. That’s where FIAs get considerably more interesting, and considerably MORE CONFUSING!
We’re going to encounter something that sounds like an account growing at 7%, 8% or even 10%...while your actual money may not be growing at that rate at all!
Welcome to the world of Income Riders!
Next Week:
The 10% Return That Isn’t a Return
Understanding the number that may determine your Retirement Paycheck… even though you can’t cash it in!
Retire Plugged In Community Update
We have more details on Social Security in our community, “Retire Plugged In.” And it is much easier to find what you need!
Instead of jumping back to previous newsletters, all the short videos where I teach about taxes, Social Security, income planning, how to avoid scams and fraud, etc. are right at your fingertips!
When laws change, when things are happening that can affect your retirement, I’ll be able to send “Alerts”, so you don’t get caught by what is happening.
PLUS, our community will connect you with new friends, exciting updates on health issues, and even some fun ideas for your retirement!
We look forward to educating and entertaining you with this newsletter…and you’re exactly the group of people we’d like to help us shape this new Community!
If you’d like to know more about helping us shape this to give you a “home” where you feel safe asking questions, getting help, and making new friends…
Here’s a link where you can join the list of those who’ll be notified when we’re ready to start this founding beta group…
Okay, I’ll leave you with that for now. Have a great rest of your day, and I look forward to seeing you next week.
Take care, Nora