The Truth About Fixed Indexed Annuities: Reality vs. The Sales Pitch

Fixed Indexed Annuities (FIAs) have exploded in popularity, continuously setting record-breaking sales volumes. Unfortunately, this surge in popularity has been accompanied by a massive wave of exaggerated sales pitches and unrealistic illustrations. If you have been cornered by an advisor promising "all of the market's upside with none of the downside," it is time to look past the marketing and read the fine print.

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[Listen to this Podcast Episode here]

Designed for Bonds, Not Stocks

Fixed Indexed Annuities were introduced in 1995 for a very specific reason: to compete with bank CDs and government bonds. Over the long term, that is exactly how they perform.

An FIA is an insurance product, not a stock market security. While they do offer genuine principal protection, they are not a "too-good-to-be-true" retirement miracle. They are designed to deliver conservative, bond-like returns with a safety net—not stock market-like growth.

How the Insurance Company Limits Your Upside

To offer you protection against market losses, the insurance company buys one-year call options on an index (most commonly the S&P 500). If the market goes up, you receive a portion of the gains. If the market drops, your principal remains safe.

However, the insurance company uses three major structural levers to heavily restrict how much interest you can actually earn:

• The Dividend Exclusion: FIAs completely track price returns and exclude dividends. Because dividends historically make up a massive chunk of the S&P 500's total return, you are starting behind the market from day one.

  
  

• Cap Rates: This is the absolute maximum interest rate the annuity can credit you in a single year. If your cap rate is 5% and the S&P 500 jumps 12%, your account is only credited 5%.

  
  

• Participation Rates: This dictates what percentage of the index's growth you actually get to keep. If your participation rate is 70% and the market goes up 10%, your growth is capped at 7%.

  
  

• Spreads: This is simply an internal fee deducted directly from the index's performance. If the market grows 8% and your contract has a 3% spread, your net credit drops to 5%.

When an annuity company combines a 70% participation rate, a 1% spread, and a 1% optional income rider fee, a 10% market gain quickly shrinks down to a 5% net return for the client.

The First-Year Mirage and the Renewal Rate Trap

The single most dangerous trap in the FIA market is the renewal rate. Many insurance companies bait the hook by offering highly attractive, uncommonly high caps and participation rates during the very first year of the contract.

What many retirees do not realize is that you are only buying a one-year guarantee on those growth limits. Because these are typically 7-year surrender charge contracts, you are locked in for the remaining six years at the total mercy of the insurance company. They retain the right to adjust your caps, participation rates, and spreads every single year based on market conditions. If they drop your cap rate to 3% in year two, you cannot leave without facing massive surrender penalties that can run as high as 7.5%.

The Fiduciary Verdict

Because I operate as a flat-fee financial planner, I do not sell products or accept insurance commissions. This independence allows me to look at these tools objectively. Traditional commission-based FIAs pay the selling agent a massive upfront commission ranging from 4% to 7.5%, which is precisely why they are pushed so aggressively.

If your core goal in retirement is securing a guaranteed lifetime income stream with the highest possible payout rate, you should directly compare a simple Single Premium Immediate Annuity (SPIA) against an FIA with a lifetime income rider.

However, if you are simply looking for principal protection and bond-like returns to anchor your portfolio, the current interest rate environment means that individual government bonds, Multi-Year Guaranteed Annuities (MYGAs), and traditional bank CDs will often provide a cleaner, safer, and far less complex solution without the hidden renewal traps.

Next Steps for Your Retirement

Ready to take the next step? I’d love to help you build a retirement plan, investment plan, and tax strategy.

Visit us at CapitalWealthGroupSC.com to see how we work with the 50-to-60 crowd. If you’re ready to dive into your numbers, you can schedule a 30-minute Introductory Call right here.

Let’s make sure you're on the right track for the retirement you want.

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Full Podcast Transcript

Transcript: The Truth About Fixed Indexed Annuities

In today’s episode, we are talking about Fixed Index Annuities. I will explain how they work, how they have historically performed, what they were designed to do, the two main reasons retirees may consider buying one, what’s a “renewal rate” and why should they matter and my honest unbiased opinion on FIA’s. If you are interested in learning about other types of annuities, please check out my 2 previous Annuity episodes from last week.

So, let’s get started! Fixed Indexed Annuities, also called FIA Annuities, are very complex and often sold using exaggerated claims. I will reveal what you didn't know about FIA annuities that no one has told you before. A lot of people have been asking me about FIAs lately, and many people are selling them often with unrealistic illustrations. Per Limra.com, In the first quarter 2023, fixed-indexed annuity (FIA) jumped 42% to $23.1 billion, setting a record for the third consecutive quarter. LIMRA expects FIA sales to grow as much as 10% in 2023.

Here's what to Remember, if it sounds too good to be true get a second opinion, no two FIA Annuities are exactly alike, and the contracts are only as good as the language used and the credit of the company backing them.

In addition, the insurance company can change the Cap rate, participation rate, and the spread every year. Before you buy, read, and understand the prospectus and check the historical rates to see how they've changed over time. It is critically important to read and be aware of the “fine print.”

FIAs can offer both principal protection and lifetime income, depending on the options you choose. If you chose an income rider, then the main use is lifetime income. If no rider is chosen a FIA is used to protect the principal and hopefully earn interest a little better than Fixed MYGA Annuities, CD’s and Govt bonds over the long-term.

Here are the basics you need to know about FIA Annuities: They were introduced in 1995 to compete with CD’s and bonds. And over the long term they have produced CD and bond like returns, not stock market like returns as some sales pitches may claim. You may wonder why they have had CD and Bond like returns? Well, that’s just how they were designed to perform. FIAs are insurance products, not stock market products or securities. They are not too good to be true and they're not a one-size-fits-all solution for retirement. They do not offer market upside with no downside. However, that is often how they are pitched.

How can a retiree use an FIA annuity? Like I mentioned earlier. It depends on the options chosen. They can be used for principal protection or lifetime income. If an annuity income rider is chosen, then the main use is lifetime income. Without a rider, it can be used to protect the principal and potentially earn a little more interest than CDs, Fixed MYGA Annuities, and Govt bonds. The key word is potentially over time they may earn interest a little better than fixed income.

How do FIA Annuities Work? The return is mainly based on a call option on an index like the S&P 500. The call option is generally a 1-year option and expires on the anniversary date. Note: There are lots of indexes used. but I personally would stick with the well-known indexes like the S&P 500. The option is a bet on where the price will go in the future.

The Insurance Co. pays a fee also known as a (premium) to buy the call option. If at the expiration date or (anniversary date), the asset's price is above the strike price, the Insurance Co. gets the difference between the original price and the price at expiration, minus the premium. As a result, the insurance company gives you a limited portion of those gains, and that return is locked in. The good news is that if the market crashes, the fixed index annuity doesn't lose. However, FIA Annuities have limits, often major ones, in the form of Cap rates, participation rates, and spreads.

So how is the return calculated? An indexed annuity return is linked to the performance of an index like the S&P 500, but with limited upside. If the index has a gain, your indexed annuity will also increase. But here's the thing: the insurance Co’s put some rules in place to limit how much your annuity can increase. What do they use to limit the returns, you may ask? First, Dividends are excluded. For example, if the S&P 500 index has a total return of 7% one year, but 2% of those returns are from dividends. (7% - 2% = 5%). So, your annuity only goes up 5% assuming no other features or fees.

Second, only a portion of an index is included. FIA annuities use one or more features that restrict your returns. The 3 Main Features are:

• Cap Rates: The Cap Rate is the max rate of return that your FIA can earn. For example, if your Cap is 4% and the index return is 12%, your annuity will only go up by 4%.

• Participation Rates: The participation rate determines the percentage of gain you FIA will get. For example, if the participation rate is 70% and the index return is 10%, your annuity would only go up 7% (10% x 70% = 7%).

• Spreads: Spreads is another name for a Fee. This fee subtracts a set percentage from any gain in the index. In the case of an annuity with a “spread” of 3%, if the index return is calculated to be 8%, your annuity would be up 5% (8% - 3% = 5%).

Some FIA’s combine these features. For example, if an indexed annuity uses both a participation rate of 70% and a “spread” of 3% and the S&P 500 index return is 10%, your annuity will get 4% (10% x 70% = 7%; 7% - 3% = 4%). These features can reduce your return in the same way that a direct fee would even if the annuity is called a “no fee” annuity.

You know, every policy for fixed indexed annuities is different. But the main thing is they limit how much your money can grow. If someone tells you that you'll get all the benefits of the S&P 500, they're not being honest. Here's another thing, some annuity companies give you a really high growth limit in the first year, making it look great. But then, they change it after that first year, and that can be a problem.

Renewal rates are crucial in indexed annuities. Let me explain with an example. Imagine you bought a 7-year surrender charge fixed index annuity. In the first year, they might give you a good return if the markets do well. But after that, it's not so great. The problem is, you're essentially buying a one-year guarantee on how much your money can grow. And for the other 6 years, you're at the mercy of the annuity company. They decide what limits they'll put on your money each year and you can't do anything about it.

That's why checking the renewal rate history of the annuity company is essential. Don't buy an indexed annuity based on the optimistic promises some agents might make. Those never come true. Indexed annuities are more like CDs and bonds, with maybe slightly better returns, but don't expect stock market-like gains. Before you sign up for any indexed annuity, take a good look at how the annuity company has changed the renewal rates in the past. That'll give you a better idea of what to expect in the future.

When researching FIAs, it was tough to find unbiased opinions. Two reasons: first, all FIA Annuities are different, and second, the information mainly came from annuity salespeople or investment managers with their own interests.

As a flat-fee financial planner, I don’t take commissions, so I can stay unbiased. Some insurance companies now offer non-commission FIA annuities, but most still are sold with commissions. The commission range for the all different 7 Year Surrender FIA Annuities that I looked up were between 4% to 7.5%, while the fee-based equivalent would be around 0.57% to a little over 1%.

I checked out a bunch of 7-year Fixed Index Annuities (FIA's), and the Cap rates linked to the S&P 500 ranged from 3% to 12%. Now, let's imagine the S&P 500 went up by 10% without considering dividends. If your Cap rate is 5%, you'd get credited with 5%, but that's assuming you have a 100% participation rate, no spreads, and no riders (which are usually around 1%). I know it sounds complicated. Now, let's take another scenario. If you have a Cap rate of 10% but a participation rate of 70%, and a 1% spread, and a rider with a 1% fee, and the S&P 500 goes up by 10%, your interest credit would be 5%. This is just looking at the point-to-point aspect. There are also averages, but we won't dive into that now.

The most crucial part to remember isn't the Cap rate you get in the first year. It's more about what happens in the following years, like year 2, 3, 4, and so on. This is where we get into the renewal rates part of an indexed annuity. The best thing you can do is look at the renewal rate history, which will at least give you an idea of how the rates and features change over time.

Let’s Recap: Retirees can use FIA annuities in different ways. Depending on the options you choose, they can offer principal protection and lifetime income. If you pick a lifetime income rider, it's mainly used for lifetime income. Without a rider, it protects the principal and hopefully earns slightly more interest than CDs, Fixed MYGA Annuities, and govt bonds over a long period of time. FIAs are like replacements for bonds that can give you lifetime income, but they will not give you stock market like returns like some may say.

The returns of FIAs are based on an index like the S&P 500, but they're limited because dividends are not included. There are also features like Cap Rate, Participation rates, and Spreads that restrict their potential returns, though they do offer principal protection.

In my opinion, if you want guaranteed lifetime income in retirement with the best rate, compare SPIA annuities to Fixed Index annuities with a Lifetime Income Rider. If you're looking for bond-like returns with principal protection a Fixed Index Annuities may fit into your retirement plan, but considering the current interest rate environment, Fixed MYGA Annuities, Govt Bonds, and CD’s might be a better choice today. Always be cautious and do your research because FIA annuities are very complex, often have high surrender fees, each one can be very different, and they can change the rules every year.

Disclaimer: The information discussed in this podcast is for general explanations and education only. It is not tax, legal, or investment advice. Before considering acting on any information heard here, first consult with your tax, legal, or investment advisor. Thank you and have a great day.