Maybe you're a conservative investor, but today's low interest rates have even you looking to punch up your investment returns. You're not alone.
It's not surprising then, that Fixed Indexed Annuities (FIA)s are growing in popularity. Sales of these products hit a record high in 2012 – $33.9 billion, according to LIMRA, an insurance industry research firm.
In case you're wondering what a FIA is, to try to make it simple, an FIA is an insurance product designed to protect a person's savings from the risk associated with the stock market, explains financial advisor Stephen Cagnassola of The Safe Money Umpire. Their intent is to provide a return that is linked to a stock market index, such as the S&P 500 index. "At no time is an individual's money 'in' the market. The return (if any) is calculated based on a formula (pre-determined) on a year to year basis," he says.
When there is a positive gain in the underlying index, then the individual policy holder would be credited with a rate of return that, in many cases, is higher than what a similar fixed interest product, such as a certificate of deposit (CD) would provide. If the stock market index is negative, then the person's account would not be credited with any interest. However, he says, they would not lose any interest or principal either.
Why FIAs are attractive
"FIAs fit a middle ground between CDs and the stock market. Many people want to place their money where it is not subject to the ups and downs of the stock and bond markets. Traditionally, this has been CDs or Money Market accounts at banks. But in recent years these accounts have paid very little interest, not even keeping up with inflation," says David Shucavage, president of Carolina Estate Planners.
What are some upsides of FIAs? "An advantage they have over bonds is protection from market declines due to rising interest rates, elimination of bond default risk, and participation in an advancing stock market. FIAs guarantee you a base interest rate, plus earnings from whatever stock market index you select," says James Comes, a wealth advisor with Carson Wealth Management Group.
However, most contracts cap the annual upside at about 4-5% of what the market index does, so it pays to do your homework and check around, cautions Comes.
What you need to know
Like all investments, FIAs have downsides. "You generally have to to commit for 5-10 years. The longer you commit, the higher the cap rate," explains Comes. If you choose to withdraw your money early, surrender fees can be 10% and up.
Since you have a "contract" with an insurance company, you want to be sure you are dealing with a top flight organization that is highly rated by Best, Standard & Poors and Moody's.
Realize too, that you can't run from Uncle Sam forever, your earnings will be taxed ordinary income tax rates at some point in the future when you withdraw from non-IRA accounts, says Comes.
Buyer beware. There are literally hundreds of products and index strategies out there today. "This has caused a great amount of confusion to those who buy them, as well as inexperienced sales people who do not understand them," points out Cagnassola.
These products can pay "nice" commissions and therefore can be mis-sold, says Comes. Translation – because there is a financial incentive, the person selling you the FIA could sell you what pays them the highest commission versus what's best for you.
Who is ideally suited for an FIA?
"They are especially good for the Millennial crowd because there is so much uncertainty swirling around social security and pensions, and 401(k)s are not enough to balance out a retirement plan. Millennials need to prepare for the fact that retirement funding that used to be around may not be available when they retire in a few decades," says Ellie Kay, author of The Little Book of Big Savings, who works with the Indexed Annuity Leadership Council, a consortium of life insurance companies, www.fiainsights.org.
They can also be ideal for older people. Cagnassola says his average aged client for an FIA is someone 55 and up to age 72. "Although others would argue that they are suitable for anyone. I disagree, because an average surrender period (period of time that money is unavailable for a full withdrawal) for an FIA is 5-7 years. That would mean that a person aged 55 would have full liquidity after 5 years, thus getting them past the penalty for early withdrawal at age 59 ½. And on the higher age of 72, a 5-year FIA would give them full liquidity at age 77."
The bottom line, FIAs can be complicated. You can study up on them here:
- Behind the indexed annuity curtain
- Equity-Indexed Annuities—A Complex Choice
- Fixed Indexed Annuities Merit Caution
- Annuity Industry Gets Name Makeover
Says Shucavage, "Fixed Indexed Annuities are considered to be very safe. Each state monitors the financial health of resident insurance companies and their assets. Most states have an insurance guarantee association that provides additional protection for policies."