Take a look at index annuities

Steve Merrell |

Q: I went to a dinner recently hosted by someone who was trying to drum up interest in fixed index annuities. She said these kinds of annuities would allow me to benefit from the stock market’s upside while guaranteeing that I wouldn’t lose money if the market went down. It sounds too good to be true, but the products are offered by some very reputable insurance companies. What can you tell me about them?


A: Fixed index annuities (FIAs) are getting a lot of attention lately. Many newly retired people are drawn to them because they are afraid the bottom is going to fall out of the stock market just as they leave the workforce. However, before you buy an FIA, take time to understand how they work and how they will perform.

The interest rate you earn on an FIA is based on changes in the value of an underlying index like the S&P 500. Sometimes the index change is measured on a point-to-point basis, meaning between two specific points in time. Sometimes the change is measured on an average basis, meaning the average level of the index during a time period relative to a predetermined reference point.


The amount of interest you earn in each period is calculated using the annuity’s interest crediting formula. With some FIAs your interest rate is capped, meaning the interest you earn for that period will never go above a certain level. For example, if your FIA has a 6% cap and the index goes up 4% in the period, you get 4% interest. However, if the index goes up more than 6%, you still only get 6% interest.


Sometimes FIAs use participation rates when crediting interest. For example, if your FIA has a participation rate of 50% and the index goes up 10%, you get 5% interest. If the index goes up 30%, you get 15% interest. Participation rate FIAs usually do not have caps.


Finally, many FIAs have a spread or asset fee.  A spread is the minimum amount the index must change before you begin earning interest. For example, if your FIA has a spread of 2% and the index goes up 6%, you get 4% interest. If the index goes up 2% or less, you get no interest.


Typically, an insurance company will use derivatives to protect you against downside risk. The cap rate, participation rate, and spread help offset the cost of your protection. If market volatility is high, the cost of the derivatives will also be high and the insurance company will be forced to use lower cap rates and participation rates to offset the higher cost. On the other hand, if volatility drops, the cost of protection will be lower and the insurance company can afford to give you more upside.


At regular intervals, usually once each year, your FIA will have a reset date. On the reset date, interest will be credited to your account and the insurance company will set new cap rates, participation rates and spread rates. This is one of the most disconcerting aspects of this investment. Every year the insurance company gets to change the parameters of your investment. If you don’t like it, you can surrender your annuity. However, you may be subject to steep surrender penalties depending on how long you have owned the annuity.


Although some sales people may try to position it otherwise, a fixed index annuity is not a replacement for stock market investments. Several studies, including one by Yale professor Roger Ibbotson, show that FIAs produce returns more like long-term bonds. Unlike bonds, however, FIAs can be expensive, are illiquid, are less diversified and bear significant exposure to the derivatives market. Bonds are sounding better and better.



Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to smerrell@montereypw.com.