In my last article, I looked at immediate fixed-income annuities and discussed whether I might want to include them as a part of my overall retirement income plan.

Guaranteed payments for life are their strong suit (helps mitigate “longevity risk”). But, as I noted, one of my major concerns about immediate fixed-income annuities is that the payouts are, well, fixed—for life!

I am reluctant to get “locked-in” to a smaller payout due to the current low-interest environment. More importantly, I am hesitant due to the lack of an “upside”—fixed-income annuities don’t increase with inflation (unless you can find one that is inflation-adjusted). Therefore, they could lose value (in terms of purchasing power) over time.

So, at least for now, I have decided not to pull the trigger on an immediate annuity. If I choose to purchase one in the future, I would probably look for the inflation-adjusted variety. But, unfortunately, those based on the Consumer Price Index (CPI) are relatively rare. An alternative would be to purchase one with a fixed cost of living increase of 2 to 4 percent a year.

What about other types of annuities?

But what about the more sophisticated and “feature-rich” fixed index and variable annuities? Could one of them be a better solution, perhaps by providing lifetime income along with some upside to help with inflation?

Both of these types of annuities are selling like hotcakes. One insurance group’s study projects indexed annuity sales to increase by 38% over the next five years; variable annuities are expected to increase at a slower rate (10%). Some reasons for this are the increasing numbers of baby boomers reaching retirement age, distrust of the stock markets, and rising concerns over longevity risk.

I think it also has to do with the armies of insurance salespeople who are being incentivized by high sales commissions.

These annuities have traditionally had a pretty bad reputation, owing mainly to over-zealous salespeople, the products’ inherent complexity, and sometimes high (and occasionally, hidden) fees. Some of these criticisms were certainly warranted in the past, and may still be appropriate for certain products today.

FIAs are unique and sophisticated products that are not appropriate for everyone. To make matters worse, they are sometimes sold with misleading claims. For example, some product literature and earnest salespeople say things like: “Get stock market returns with no downside risk.” But as we shall see, these statements aren’t totally accurate.

The proposal that I recently looked at for my friend was for a fixed index annuity (FIA). After reviewing it, my overall reaction to it was that it was not too bad; in fact, it was probably better than most. It seemed to offer a greater upside than most fixed-income investments (such as CDs and bonds), while also protecting principal.

I have read that FIAs have gotten better (greater transparency, better rates, lower fees, etc.). So, for these reasons and others, I thought it would be prudent to take a fresh look. And because they are so popular, I have decided to also do a deeper dive on variable annuities, which will be the third (and final) post in this series.

Understanding fixed index annuities

Fixed-index annuities (FIAs) can be challenging to understand. FIAs are a type of deferred-income annuity that is intended to help you grow your principal during an “accumulation period” until you start using it for retirement income (the “distribution period”).

This growth happens in a couple of ways. FIAs have a guaranteed minimum interest rate, but their overall performance is tied to the price of a stock market index. The growth of your principal is based on the price of a selected stock market index price, which can fluctuate (sometimes significantly) from year-to-year.

Although there are many index options to choose from, one of the most commonly used is the S&P 500 Stock Market Index.

The index you select is used by the insurance company as a stock price index, not as a total return index. The total return for the S&P 500 includes both dividends and capital gains. But your principal gains (or losses) will be calculated based only on the price change of the index over a specific period, not total return.

This provision is important because, historically, S&P 500 dividends have averaged between 2 and 3 percent, and have at times been more than 4 percent. Since you don’t actually own a mutual fund that replicates the chosen index (such as Vanguard’s S&P 500 Index Fund—VFINX), you won’t directly receive those dividends payouts as income.

The price percentage changes to your chosen index, either up or down, are applied to your account by the insurance company using a formula to calculate the applicable percentage rate. The result is that you will not only not receive the total return (price appreciation plus dividends), but there will typically be a limit to how much your account will be credited.

Insurers use a variety of limiting factors, such as a cap rate, participation rate, or spread rate (margin). The proposal that my friend received used a cap rate. It was for a one-year S&P 500 Cap-Indexed annuity. That means it was based on the S&P 500, the rate would be calculated annually, and a contractual rate cap would limit it.

By the way, although the formula used for the calculation doesn’t change, the limiting rate used for the index calculation may be changed by the insurance company on each contract term anniversary date.

Here’s how my friend’s credited amount would be determined: The value of the S&P 500 at the end of the one-year indexed term would be compared to the value at the beginning of the indexed term. If the percentage change is positive, his account would be credited with the full percentage change—up to the indexed interest cap (the “upside”).

If, however, the difference is negative, then the account will be credited with a 0% (little or no “downside”), so there is no loss, and all previous earnings remain intact. (This is, in my opinion, one of an FIA’s most attractive features.)

The annuity proposed to my friend had a 6.35% interest rate cap. Based on my research, that is a pretty generous cap—most are in the 4% to 5% range, and very few are higher than that. It means that the most his account value can go up in a year is 6.35%, even if the S&P 500 is up 10 or 20% (which it is in some years).

Conversely, the least he would receive is 0%, even if the S&P 500 is down 10 or 20 percent (which it has been in some years). Overall, over the last several decades, the S&P 500 has “averaged” around 10%, so the insurance company is counting on it being close to that in the future (it lowers their risk).

Taking income from an FIA

Because FIAs are most appropriately set up initially as deferred annuities, consumers elect to start withdrawals at a later date. For example, you might purchase one at age 55 and not begin withdrawals until age 70. Your principal would grow based on the crediting mechanism described earlier; or, at the very least, you would not lose money in the unlikely event your chosen index has a net loss over the same period. (This is the bottom-side protection that is so attractive to many.)

It would be a mistake, however, to assume that you can withdraw your money at any time. FIA contract lengths vary anywhere from 5 to 10 years. The surrender charge—or penalty for early withdrawal—will vary with the length of the contract.

In my friend’s situation, there were some pretty steep surrender charges in the first five years (9%, 8%, 7%, 6%, 5%). In other words, after entering the contract, he would need to let the money “sit” for at least five years before taking any withdrawals—not a problem if he didn’t need it until later. But if he needed it for an emergency, it would cost him dearly.

Once you get beyond the “surrender penalty phase,” you can withdraw as much as you want whenever you want, similar to what you could do if you were drawing from an IRA. There are exceptions to the surrender charge that will vary from insurer to insurer.

With an FIA, no matter what your withdrawal rate, you are guaranteed to receive back at least the amount of your original principal. That is not the case with an immediate fixed-income annuity because you and your beneficiary could pass away before you reach your “break-even” point, which Is usually your actuarial life expectancy. Some annuities have a death benefit (similar to a life insurance payout), which would help mitigate that situation.

The other way to create an income stream would be to set up an “income for life” arrangement. This approach will require that you purchase an “income rider” (which is insurance-speak for “extra cost options”). Buying a rider enables an FIA holder to receive a guaranteed monthly benefit, even if turns out to be more than the amount of principal they originally put in. Understandably, this is one of an FIA’s more attractive features.

Income riders come in different flavors, but most purchasers prefer the “Guaranteed Lifetime Withdrawal Benefit” (GLWB). These are common add-ons to both fixed-index and variable annuities because they solve for the “guaranteed income for life” problem. But they do come at a cost.

So, what about costs?

One of the big knocks against fixed-index annuities is cost. They have a reputation for high fees and sales commission charges buried in them. By that, I mean that while the terms and fees should be fully disclosed in the product literature, they often are not and, therefore, can be hard to decipher.

The problem is that fees, no matter how they are assessed, reduce your returns. They are usually taken from future earnings, which is one of the main reasons that the majority of FIAs have earnings caps. With most FIAs, the company must make its money by investing your principal and via the cap/spread dynamic applied to index crediting. They calculate that, over the long run, they will earn more on your money than they credit to you.

The FIA I looked at for my friend had no stated base fees or up-front commissions in the product literature. That was a good thing because his principal wouldn’t be reduced from the start. However, that doesn’t mean that there weren’t any. As with most FIAs, they were probably “baked in” to the index cap/spread/crediting dynamic.

In addition to obscure embedded fees and sales commissions, there are the more obvious ones associated with things like guaranteed income and death benefits, and even long-term care benefits if you want to pay for them. These rider fees can vary greatly in cost from one product to another, as can the benefits they purchase. On average, they will run in the one to three percent range.

Stock market returns, really?

Many FIAs are misrepresented as “investments” that can deliver stock market returns with no downside risk. But they are not investments—they are an insurance product with earnings tied to a stock market index. They do not deliver “stock market returns.” What they will do—and are contractually bound to do—is to provide reasonable returns in up-market conditions (but not actual market returns) while protecting principal during down-markets.

Whether this is good or bad depends on your individual needs and expectations. Over extended periods of market ups and downs, FIAs can be expected to deliver long-term CD or bond-like returns, perhaps a little better.

The models prepared for my friend by his advisor, which were based on real S&P performance during specific up and down periods, were a fair and reasonable characterization. For the “very favorable” period of Dec. 2008 to Dec. 2018, he would have averaged a gain of 4.44% per year. And for the “very unfavorable” period of Dec. 2000 to Dec. 2008, he would have averaged 3.83%.

But there was a problem. What my friend was not shown by his advisor was a similar model of how he would have fared during those same periods if he had his money invested in an S&P 500 Index Fund, such as VFINX. My analysis showed that he would have had average total returns (capital gains plus dividends) of 13.12% for the “very favorable” period, and 3.57% during the “very unfavorable” one. Therefore, for the entire 20-year period, he would have been better off investing in an S&P 500 Index Fund, assuming he could have stayed on the market roller coaster.

To be fair, in a worst-case scenario—several decades of net-negative S&P 500 returns—an FIA would be the better option since there would be no loss of principal. However, nothing like that has ever happened. The index has been down only eight out of the last thirty years.

Could things be very different over the next 20 or 30 years? Indeed they might, and if you believe they will be, then you may want to look somewhere other than the stock markets altogether.

Would I buy an FIA, and should you?

Overall, I think an FIA would be a reasonable choice for someone who: 1) doesn’t need access to any of their principal or at least 5 to 10 years and therefore would be a candidate for a deferred-income annuity; 2) doesn’t want to be at all concerned about stock market volatility; and, 3) will be happy with relatively low to mid-single-digit returns each year.

Because I am retired and in the “distribution phase,” I would prefer not to lock-up a significant part of my savings for the next 5 to 10 years as I need the income it generates now. And while I am concerned about market volatility, I am more interested in income from dividends and interest, which, though far from being immune from market conditions, are not directly tied to day-to-day market ups and downs.

I might be okay with low to mid-single-digit returns, especially with no downside risk, but I would prefer that I receive them as income while also having the potential for some investment gains that I could convert to income in the future.

As with immediate-income annuities, I won’t say that I would never purchase one, but I think it is unlikely at this point in my life. If I decide that I need an annuity, I would probably lean toward some kind of inflation-adjusted immediate annuity as I discussed in my last article.

Whether an FIA makes sense for you totally depends on your situation. If you meet all of the criteria I mention above and are comfortable handing over a big chunk of your savings to an insurance company, then give an FIA some serious consideration. But be sure to do your homework—make sure you fully all of the terms and conditions, what is contractually guaranteed and what isn’t, and especially what is in the fine print.

And finally, be sure you are dealing with a financial representative you can trust to have your best interests at heart.

Still standing pat, for now

Although I see some value in owning an annuity, I am going to stand-pat with my income-oriented stock/bond portfolio for the time being. But annuities are steadily improving, so there may be a product I don’t know about or something just beyond the horizon that I will find very compelling.

If you are convinced that an annuity is the right thing for you, I would say “go for it”— just make sure you understand exactly what you are getting into. And even then, my suggestion would be to allocate nor more than 30% to 40% of your retirement assets to one. That keeps other options open to you.

Having looked at immediate-income annuities and fixed index annuities, the third and final article in this series will be about variable annuities. As I have stated previously, these are the ones I am least interested in, but as it turns out, they have historically been more popular than their fixed-index cousins. On that basis alone, they warrant further treatment.