Fixed indexed annuities are often pegged as a safer way to invest in the market. As such, many financial advisers spurn the product due to its perceived inefficiencies in growing wealth when compared to straightforward investment strategies.
This is based on a huge misconception of the FIA product, which many people incorrectly view as nothing more than a tax-advantaged wrapper that allows insurance companies to take a cut off the top when they're actually just buying into the S&P or another underlying index security.
This is one of the biggest misconceptions that advisers have about the returns generated by the FIA. Most believe that the insurance company is keeping the difference between what the index generates and the cap. However, this isn't how the product works. In reality, FIAs result in interest growth being credited to the account based on market returns without actually buying underlying securities in the account.
FIAs should be compared to insurance products, not investment security products like mutual funds. They allow clients to protect the principal of their investment in the insurance product while letting the annuity be credited with growth based on certain indexes like the S&P.
1. Bond replacement
The data on using FIAs as a bond replacement in retirement income planning look very favorable. Research by academics like Roger Ibbotson has shown FIAs can outperform bonds, making them a solid bond alternative. With interest rates at extremely low levels, an FIA could be a better way to chase yields and provide return while protecting the investor's principal balance.
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2. Steady income for life
The other thing an FIA can do that most other investments, strategies or products cannot is provide a steady income for life. Incorporating lifetime income sources into a retirement income plan is valuable. Annuities — more specifically, FIAs — offer one such option.
Having a secure floor of income throughout retirement can allow investors to take more risk with the rest of their portfolio, which can even result in investors ending up with a higher total spending amount in retirement and a higher legacy amount.
Dave Alison, executive vice president at C2P Enterprises, said many FIAs also allow for a penalty-free withdrawal of up to 10% even in the early years of the contract. So the products don't completely lack liquidity even during the surrender charge period.
3. Tax-deferred growth
FIAs boast tax-deferred growth. Any interest gains earned inside the account aren't taxed until investors withdraw their money, providing them with tax-free growth. Moreover, when investors are taxed upon withdrawal, it's likely during retirement when they're earning less and therefore are in a lower tax bracket.
In addition, if the FIA is purchased outside of a retirement account and it is annuitized, the income will be taxed pro rata. This can be a helpful way to manage taxable income in retirement and a tax-efficient way to grow wealth.
FIAs allow investors to grow their principal up to a certain cap without the threat of market volatility. With an interest-rate floor, investors will never earn anything less than their investment. The security, safety and growth opportunity that FIAs offer investors makes them a solid option for a retirement.
Jamie Hopkins is director of retirement research and vice president of private client services at Carson Group.