Since the development of Modern Portfolio Theory by Harry Markowitz in 1952, and later the 60/40 model portfolio (60% stocks/40% bonds), little has changed in the realm of portfolio risk management and diversification over the past 70 years. Add the fact that over the past 20 years we have seen interest rates at or near historic lows, and people have been looking for new ways to shore up the bond allocation. One popular option for this challenge has been annuities, issued by insurance companies. Whether it’s a Multi-Year Guaranteed Annuity (MYGA) or Fixed-Indexed Annuity (FIA), investors have been using these tools to lock in a guaranteed rate for a certain period (MYGAs) or to put a return limit (or floor) on their money while still participating in upside of the markets pegged to an index (FIAs). I will explain why the use of FIA’s has increased in popularity over the past decade. 

Fixed Indexed Annuities have a unique feature that makes them attractive to investors looking to protect a portion of their money and invest in a tax-deferred manner. This feature is called a “floor.” The floor is a 0% downside protection that comes with every FIA. In other words, if the stock market goes down for the year of the contract, the FIA will not post a negative return –– it would cap the downside at 0% return. This does not include any administrative fees related to the insurance, but those fees are normally around 0.5% yearly, depending upon the carrier and contract. In a down year for equities, you will lose only the administrative cost and be ahead of your peers that do not have this protection 

“Now interest rates are back on the rise, and this rise in interest rates is causing most bond prices to decline alongside many stock prices. This can create challenges for those who rely solely on bonds to be the stabilizing component of a balanced portfolio.” 

-Global Atlantic Financial Group

Another benefit of a FIA is the ability to participate in some of the upside of the market index. There are two options that can be chosen. One is a “capped” option of different indexed choices. These caps, currently are in the range of 7.0%-8.5%. The other option can be “uncapped” but with participation rates ranging from 35%-60% of the index of your choice, such as Large Cap US Equities, Small Cap US Equities, or others. This means you would enjoy that percentage rate of gain from the index, but not the entire upside. Another feature allows you the ability to change your indexed options every year on the anniversary of the contract. This gives you flexibility to use more aggressive or less aggressive index options. 

The last major benefit of a FIA is the ability to use them as a pension-like payment system or create regular income. Once an investor has declared to the insurance company that they want to convert from tax-deferred accumulation to an income stream and selected how long they will need the income for, the investor selects income on an annual, quarterly or monthly basis. Once that change is made, the annuity is “annuitized,” which is permanent and cannot be changed. If the lifetime income option is chosen, the money will be paid out even if there is no more left in the balance. 

Insurance company’s use mortality assumptions, so if someone lives beyond life expectancy, the insurance company is contractually bound to continue payment until death. This makes it a great option to use for income planning purposes, but one needs to consider the estate planning and legacy aspects to make the right choices. If the funds in the annuity are non-qualified, meaning not sourced from tax-deferred accounts such as a 401k or IRA, when the contract is annuitized, the income recipient would have an “exclusion ratio.” An exclusion ratio means that part of the income is tax free as a return of principal and part would be taxable for the interest earned. 

There are cons to FIAs as well, one of them being that your money is tied up for several years with limited liquidity or subject to surrender charges. Annuities can be part of a prudent planning and solving process for how much money you will need for secured income. Use of a financial consultant can help investors find the right balance or help create a financial plan as a roadmap to the right solution. 

FIAs are insurance contracts that are not registered securities and are not invested directly in the market. The index choices replicate the performance of some popular indices and can provide downside protection in in negative years. In short, they offer alternatives to the ups and downs of equities in a retirement strategy. When investors have a declining risk appetite and still want to participate in market-like returns, a FIA could be part of the solution. 

By Gregory P. Killilea, Insurance Manager 

Greg is a Financial Consultant for Asset Strategy