As well, we have discussed an FIA as providing annual terms. Interest is credited and new parameters are announced at each anniversary date. But there is no particular reason for the FIA term to be one year. It could be longer. The potential appeal of using an FIA with a longer term is that it may be able to provide more upside potential than rolling shorter-term periods. Though the costs of call options increases with the term length, it is not a linear increase. A call option with a two-year term does not cost double of an option that otherwise has the same features but with a one-year term.
Also, less bonds can be purchased because they have more time to grow before needing to match the floor value on interest. This can allow for more participation in the upside after protecting a floor. The other potential attraction for a longer term is that current FIA parameters will be locked in for a longer period before subsequent adjustments take place. This would help if economic trends drive toward less attractive upside opportunities (lower interest rates and more expensive call options). But if conditions improve through higher interest rates and less expensive call options, one would also miss out for longer on taking advantage of these better terms.
Another important caveat about longer terms is that interest is not credited until the end of each term. Any distributions taken before the end of the term, including the death benefit, may not be credited with any partial interest for the term. For instance, an owner who takes a distribution five-years and 364 days into an FIA contract with a six-year term would not receive any credited interest for this period, even if, for example, interest that would credit the account value with 90 percent growth could have been received just one day later on the anniversary date. The contract value would still be the same as at the start of the term.
This aspect requires extra caution when choosing a longer term. One also misses out on the annual reset opportunities to lock in a gain and protect it from subsequent index losses. Some contracts may provide exceptions and credit partial interest in the case the owner seeks to annuitize the contract or if the owner dies and the death benefit is distributed. But this is not the case with all contracts.
Regarding the death benefit, it is typically the remaining contract value or the minimum guaranteed value, whichever is larger. The standard death benefit may be enhanced with optional riders to support a larger amount.
An FIA may also offer a premium bonus providing an immediate increase of several percentage points to the initial contract value of assets. One reason this may be offered is to help the insurance company to obtain a longer-term commitment from the consumer, as the bonus will be recaptured for early withdrawals. Bonuses may also be a salient feature that draws attention from consumers. With a premium bonus, individuals must remember that there is no free lunch, as other less salient features would be adjusted in adverse directions in order to support the bonus.
Though this book is focused on retirement income, FIAs are not always used primarily for their income generating optional benefits. Rather, they may be used as an accumulation tool. Fixed index annuities provide protection from interest rate risk and other sources of investment volatility. Unlike a bond fund or individual bonds not held to maturity, they do not experience losses if interest rates rise.
Principal is protected and secured. This can provide powerful behavioral benefits. Fixed index annuities also offer tax deferral, unlike investment assets held in taxable accounts that face ongoing taxes on their growth. Upside may be limited, but protecting principal is where the index annuity has an opportunity to shine relative to other accumulation tools.
FIAs can function as an asset class within an accumulation portfolio to better manage downside risks while still providing participation in the market upside. The ability to better manage downside risks can lay a foundation for either needing less assets to successfully retire, or to be able to enjoy a higher standard of living from a given asset base.
Risk averse households will seek a high probability of success that their financial plan will work, which implicitly leads them to assume a lower rate of return from their investments. By managing downside risks through a more structured approach that creates a floor in which the asset return cannot be negative, a fixed index annuity used within an accumulation portfolio can allow for greater wealth accumulation at lower percentiles of the distribution of outcomes when markets perform poorly. This protection makes it easier to retire successfully in down market environments.
The FIA may serve as a suitable replacement for bonds or other asset classes with a low correlation to the stock market within an accumulation portfolio. Even if the overall portfolio standard deviation increases with the inclusion of an index annuity, the ability to protect from downside losses may serve to reduce risk for the distribution of wealth outcomes. Returns for the index annuity do not follow a traditional bell-shaped distribution.
One final point to include in the general discussion of FIAs is a philosophical question regarding whether we should think about FIAs as a stock-like asset or as a bond-like asset. With a 0 percent floor it has less downside risk than either, but can enough upside be captured with the FIA to beat either stocks or bonds on a risk-adjusted basis? Though the interest they credit is linked to the S&P 500, the returns on FIAs will be closer to bonds than to stocks. However, they are not exactly like bonds either, since principal is protected for FIAs, while bonds can experience capital losses when interest rates rise.
Owners should not think about FIAs as an alternative to owning stocks but rather as another option for fixed-income assets that protects principal and has the potential to outperform bonds when considered net of taxes and fees. With their principal protection, retirees may even consider increasing their stock allocation when replacing bonds with an FIA. One might occasionally observe that the cumulative returns from an FIA exceed the cumulative returns from its corresponding index, but this would have to be triggered by a large market loss in one year that the FIA protects so that its limited upside allows it to jump ahead. This will not be common outcome.
This article originally appeared on Forbes.
