Understanding the Pros and Cons of Fixed-Indexed Annuities

Insurance companies often make fixed annuities out to be synonymous with “safety.” Typically, fixed annuities guarantee you a fixed or minimum return over a certain period of time. But suppose you simultaneously desire some exposure to specific market benchmarks—this is where Fixed-Indexed Annuities (FIAs), also known as indexed annuities, are supposed to come in. Fixed-indexed annuities contain features of both fixed and variable annuities, offering investors a return based on charges in a specific market benchmark. While your broker might be waving them around as a possibility, be careful where you tread. FIAs might sound better on paper than in practice. Make sure you know about fixed-indexed annuities’ pros and cons before you invest.

Your broker might have claimed FIAs provide the peace of mind supposedly offered by fixed annuities, while still providing market-like growth offered by variable annuities (products that deliver periodic payments with the amount varying based on the performance of the investment). However, this isn’t always the case. The gains you might be hoping for could end up being a lot lower due to fees and caps on your return. For instance, an FIA might have a “performance cap” that specifies a maximum percentage increase you’d be allowed. Also, FIAs often simply track the price of an index like the S&P 500, but without delivering the dividend payments you’d receive if you actually invested in the stocks. In the long run, FIAs are complex products that may not provide the peace of mind or the types of returns investors expect.

What Are Annuities?

Before focusing on fixed-indexed annuities’ pros and cons, it is important to understand how annuities work. All annuities have the same two-part structure:

  • Accumulation period. You make a deposit and the custodian (generally an insurance company) invests it.
  • At the end of the accumulation phase, as spelled out in the contract, your annuity investment is converted into a series of periodic payments for the rest of your life (or a fixed period, depending on the annuity’s structure). Upon annuitization, your investment usually becomes the property of the insurer and it can be difficult and expensive (or downright impossible) to recover your money in a manner other than the periodic payments set out in the contract.

For more on understanding annuities, we encourage you to read our guide, 9 Annuity Insights: Questions Every Investor Should Ask.

Fixed Index Annuity Characteristics

The so-called “pros” of FIAs are generally limited in context and only qualify as positives when you compare them against other types of annuities. FIAs are often pitched with the guarantee of a fixed “floor” interest rate, with claims that there is no risk of losing principal. They’re also marketed as an opportunity for growth, and come in a variety of flavors.

The Dangers: Know What You Are Getting Into

When it comes to FIAs, however, the pros are limited and there is a long list of cons. FIAs are complex investment products that often sound too good to be true. Your broker or advisor probably didn’t spend as much time on the cons as the pros. Also, they may not have gone over the “Statements of Understanding” contracts that are part of every FIA and, according to the Financial Industry Regulatory Authority, often difficult to understand. Here are a number of good reasons to be skeptical about fixed-indexed annuities’ pros and cons:

Loss of Value. One myth about FIAs is they provide a “floor” rate preventing you from losing money. The floor is the minimum rate of return you will earn, typically tied to the long-term annualized average return of the market index underlying an indexed annuity.  Simply put, floors are meant to protect investors from losing too much when the market is down a lot. But it’s more complex than that. While an FIA can provide a floor, it might be below the rate of inflation or even as low as 0%. With inflation averaging roughly 3% since 19251, this means you could lose value even if your account doesn’t actually go down. Keep in mind that preventing a loss in dollar value doesn’t mean the dollars you have left necessarily carry the same value they once did.

Stunted Growth. Investors sometimes get excited about FIAs because they think they simultaneously protect and grow their money, unlike a traditional fixed annuity. That isn’t necessarily the case, however. You may hear an FIA can deliver a return similar to the return of the underlying index. But keep in mind that caps and/or restrictions often limit how much growth passes along to you, the investor. Limits to growth include:

  • FIAs typically set a maximum rate of return, and even if the market performs better than that, the cap doesn’t go up.
  • Participation rates. These rates set the percentage of the index’s performance that gets passed along to you. For example, if your FIA has a 70% participation rate, and the index rises 10%, your rate of return would be 7%.

Fees. Another factor holding back FIA growth is fees, which are often charged as a percentage of the assets in an annuity and referred to as spread or margin fees. For instance, you might have to pay a surrender fee for withdrawing funds early. FIA fees can be especially problematic if you select a “rider” as their additional fees can quickly add up—another example of fixed-indexed annuities’ pros and cons. Such riders, which can include lifetime pay-out, joint lifetime pay-out, and minimum income guarantees, appear to provide additional protection, but in many cases, their cost doesn’t make them worth the benefit. At the end of the day, fees of all kinds can take a huge bite out of your returns.

Lack of Liquidity. Lack of access to your money is a common issue with almost any type of annuity. FIAs and other annuities often come with high surrender fees and withdrawal limits that can make it very difficult to extract your money should you need to access it before the contract is annuitized. The annuity custodian might assess a surrender charge to prevent you from canceling before the custodian can recoup its commission costs. A surrender fee is generally a percentage of the withdrawal amount and typically declines over time. For example, the fee may be 7% for a withdrawal in year one, 6% the second year, and so on*.

If you need money before age 59 ½, that can also be a problem. Similar to most retirement accounts, many qualified or tax-deferred annuities have restrictions on taking withdrawals before that age, and your withdrawals may be subject to an additional 10% tax levy from the Internal Revenue Service. If you buy an FIA or other type of annuity through a retirement plan like a 401(k) or an IRA, the annuity might also inherit the account’s withdrawal restrictions. Finally, death benefits might not be guaranteed. Make sure to check if a death benefit is provided in your contract, because once you annuitize, your money belongs to the insurer. You might be able to get a death benefit as a rider, but that adds to all the other fees we discussed. In other words, it is important to understand that if you are looking for liquidity, FIAs or other annuities may not be the answer.

Does a Fixed Indexed Annuity Ever Make Sense?

After that long list of cons, you may be wondering why anyone would ever buy an FIA. There may be some cases where an FIA could be appropriate. But most of the time, there are better alternatives that offer more flexibility, liquidity and potential growth.

Although your broker might try to sell you an FIA by touting its fixed rate as a way to hedge in the case of a market downturn or correction, the protection an FIA offers during those times doesn’t make up for the growth limitations you are likely to experience during the longer and more frequent bull markets. This means that over longer time horizons, investments in stocks, or even bonds, can significantly outperform investments in an FIA.

Compare Fixed Index Annuities With Alternatives

Ultimately, the most important outcome is that you reach your investing goals. On the surface, annuities may seem like a safe bet, especially amid market volatility. However, they often have significant drawbacks that aren’t readily apparent during the sale.

If you are a qualified investor** and you have questions about your annuity or would like a second opinion on the pros and cons of an annuity you are considering, request an appointment with us now. Fisher Investments has Annuity Counselors on staff to help you understand what your annuities offer and how they might fit in with other retirement investment alternatives. We also encourage you to look at our selection of annuity guides for additional insights into these products.

*This example is provided for illustrative purposes only. It is not intended to predict actual expenses, which will vary.

**For qualified investors only with at least $500,000 in investable assets. Nothing infers any right on any person to become a client of Fisher Investments, and Fisher Investments reserves the right to refuse or terminate any person as a client for any reason. Fisher Investments reserves the right to cancel, suspend or modify its financial planning services at any time and for any reason without notice. There is no guarantee that any accounts managed by Fisher Investments will achieve any specified level of performance. Investing in securities involves the risk of loss. Past performance is no guarantee of future results.

1Global Financial Data, as of 2/11/2014. The Consumer Price Index (CPI) averaged 2.9% over the period 12/31/1925 - 12/31/2013.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns.
Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations.