Adviser Jo-Ann Holst's client, a woman in her mid-60s with $440,000 in savings, didn't want to sink her entire retirement nest egg into the stock market. And because she doesn't have a pension, she was looking for a predictable monthly income stream.
Ms. Holst recommended the client put some money in a fixed indexed annuity, or FIA. So two years ago, she took about half her nest egg — $200,000 — and split it evenly between two annuities. The client can expect $20,000 per year for life when she begins taking withdrawals at age 70. The remainder of her money is invested in dividend-paying stocks to provide growth, added income and liquidity.
“She wanted roughly half of her money to be safe and not in the market, so that's what we did,” said Ms. Holst, who operates an eponymous advisory firm.
Her client isn't alone. The principal protection offered by FIA contracts in the event of a market downturn has been a big selling point for these particular annuities, with the 2008 market crash still vivid in investors' memory, advisers say.
“I think people are fearful of when the next shoe's going to drop,” said Charlie Douglas, a financial adviser and editor of the Journal of Estate and Tax Planning, who uses FIAs with some clients.
In addition to market fears, a confluence of other factors, including current low interest rates, product evolution and distribution through channels such as independent broker-dealers that historically ignored these annuities, have led sales of FIAs to balloon over the past several years.
According to research firm Cerulli Associates, FIAs saw $48 billion in flows in 2014, up 45.5% from $33 billion in 2011, with flows increasing every year over that time span. Although variable annuities still outsell FIAs by almost a 3-to-1 margin, sales of VAs dipped 11.5% during the same 2011-14 period, Cerulli says.
FIAs notched their second-best quarter of all time in this year's second quarter, hitting $12.6 billion in sales, according to the Insured Retirement Institute. That's only slightly behind the $12.9 billion in sales in the second quarter of 2014.
FIAs are tied to a specific index, with the S&P 500 being the most popular. They offer investors a guaranteed minimum rate of return, usually from 0-2%, on the assets invested in the contract; they could deliver a higher return if the index performs strongly, but returns are generally capped on the upside, in the ballpark of 5-7%, advisers say.
For example, if an annuity has a 1% minimum guarantee and the S&P 500 returns 0% one year, an investor would still get a 1% return credited to the account. However, if the index returns 20% and the cap to the upside is 6%, the investor would get 6%.
Depending on the specific contract, investors can pay a lump-sum single premium or pay in installments. Investors can turn on the income stream derived from the assets in the contract, usually any time after the first year, and will receive a monthly check for life. Monthly income depends on factors such as age, account value and the payout rate — a 5% withdrawal rate, for example — and varies by carrier.
Amid persistent low interest rates, which have suppressed the returns on typical fixed-income instruments such as certificates of deposit and bonds, some advisers recommend FIAs because of their higher returns.
“The low-interest-rate environment has been a key driver of the increase in sales and their popularity,” said Frank O'Connor, IRI's vice president of research.
An FIA issued today would be expected to return approximately 3.8-4.8% on average over the life of the policy, according to annuity research firm Wink Inc.
Ms. Holst would be using bonds more with clients if interest rates were higher, she said. With the Federal Reserve expected to begin raising interest rates soon, being in bonds isn't an attractive proposition, because bond prices generally fall as interest rates rise, she added.
“As [interest rates] come up we'll be doing more with bonds, but right now we like FIAs to fill in some of that void,” she said.
Insurers say rising interest rates could allow them to raise the floors and caps on FIAs, making them more attractive for consumers.
FIA product design also has evolved for the better, beginning about four to five years ago, industry watchers say. While the contracts offer a lifetime income stream to investors as before, now investors have much more control and flexibility, according to Judson Forner, director of investment marketing at ValMark Securities Inc., an independent broker-dealer.
Before, turning assets into a lifetime stream of income was an “irrevocable decision,” in which the income stream couldn't be turned off, according to Mr. Forner. Now, the income stream can be turned off and investors can take the account value if they need to, assuming the contract's surrender period is over, he said. Surrender periods now are also shorter than they were historically on fixed indexed annuities, advisers say.
The income benefits come at an additional cost, currently an average of 84 basis points annually, according to Wink data.
These design evolutions put fixed indexed annuities more in line with VAs from a competitive standpoint, causing distribution channels that historically stuck to variable annuity sales to eye FIAs favorably, advisers and insurers say.
“On the distribution side, what we're seeing is more and more advisers that maybe didn't look at a fixed indexed annuity as a solution for retirement income planning are now starting to look at them, primarily in the broker-dealer community,” said Eric Thomes, senior vice president of sales at Allianz Life Insurance Co. of North America.
The independent broker-dealer channel's share of FIA sales grew from 2% in 2010 to 13% in 2014, according to LIMRA, an industry group.
WHEN TO USE
FIAs typically are meant for more risk-averse investors, those who like annuities but don't want exposure to all the peaks and troughs of the market, such as VAs provide, advisers say.
“It comes down to the person,” said Andy Tate, partner at Tate & Setterlund, a fee-based advisory practice. “[FIAs] are for my client who doesn't care about making more money; they care about not losing their money.”
The lifelong component of the withdrawals was especially important to Ms. Holst's client because of longevity in her family — she has a 95-year-old father.
Clients shouldn't lock up all their assets in an annuity because they usually can't touch the money for several years without hefty penalties, advisers say. Some contracts provide for a bit of liquidity, allowing around 10% of the account value to be tapped every year after the first year if needed without triggering penalties, Ms. Holst said.
Gregory Olsen, partner at Lenox Advisors Inc., said a conservative investor who's around 55, with about a 10-year horizon to retirement, and who's comfortable with a 2-4% rate of return, could fit the bill as an FIA candidate.
Someone who's younger, though — 45, for example — shouldn't use FIAs, because these investors shouldn't be capping their return to the upside, Mr. Olsen said. He often uses VAs with a rider that guarantees principal, which allows investors to capture all the market upside but protects to the downside.
“Younger clients have time on their side,” he said. “And time is the other minimizer of risk.”
Mr. Olsen bills these types of annuities as some of the most complex on the market as a result of subtle nuances in the contracts that investors and advisers may not be aware of.
For an adviser to tell a client that an FIA offers upside potential but protects to the downside, a common pitch, is a major oversimplification of how the products work, some advisers contend.
“It's not what people think it is,” said Erik Carter, senior financial planner at Financial Finesse Inc.
FIAs don't include dividends into the return on the contract, which “could add up to a decent percentage of the returns,” Mr. Carter added.
In addition, the way an insurer determines an investor's return can vary widely from contract to contract. Some contracts, for example, stipulate a “participation rate” in the index. For example, if the FIA had a participation rate of 80% and a cap of 6%, and the market returned 6%, an investor would only get a return of 4.8%.
Other contracts may have a “spread” associated. For example, a contract with a 2% spread means the insurer takes the first 2% of market gains and the investor keeps the rest, Mr. Forner said. Depending on the contract, an insurer could change the spread over time to be more disadvantageous, he added.
Because insurers aren't required to register FIAs with the Securities and Exchange Commission, often there isn't a prospectus investors and advisers can reference before signing a contract, advisers say.
Even though investors likely wouldn't read a 300-page prospectus, the length of the document might give them pause to more carefully consider a decision, Mr. Forner said. “With an indexed product, you don't really have that,” he said.