Every year since my wife and I began investing in fixed index annuities (FIAs) with income riders several years ago, we’ve received annual statements on the anniversary date of each contract. A reconciliation of the beginning- to the end-of-the-contract-year accumulation value is a key component of each statement. This includes additions, or premiums, premium bonuses, interest credits, withdrawals, surrender charges, and income rider charges.
Distinguishing Feature of Fixed Index Annuities
Interest credits and the methodology used to calculate them is a distinguishing feature of FIAs. The amount of interest credited is primarily dependent upon the performance of a stock market index associated with one or more selected indexing strategies during the previous contract year.
There’s generally a cap rate, or preset maximum amount of interest that will be credited for a particular strategy each year. No interest is credited in years where there is negative performance. The current interest rate of a fixed account also affects total interest credited to the extent that this has been selected as part of one’s overall allocation in a particular year.
The annual interest credits on my wife and my FIA contracts have exceeded our income rider charges as a result of the recent performance of the stock market. This has resulted in an increase in the accumulation value and death benefit of our contracts each year, ignoring additions and premium bonuses.
Protection from Stock Market Downturns
Although we’ve experienced, and are delighted by, the annual net increases in the value of our FIA contracts, my wife and I have yet to realize the unique benefit of owning a FIA compared to other types of investments, i.e., protection from inevitable stock market downturns. Unlike direct investments in mutual funds and exchange traded funds that decrease as well as increase in value, FIAs are insulated from market declines. This is sometimes referred to as the “power of zero.”
How is a FIA owner protected from market downturns? As previously stated, no interest is credited to individual indexing strategies in contract years when performance is negative. In other words, index credits will never be less than zero. This is very comforting when this occurs in a negative year, let alone in a prolonged bear market.
To appreciate this, let’s suppose that you invested in an exchange traded fund tied to the S&P 500 that experienced a decline of 20% in one year. You would need to realize a return of 25% just to break even. This turnaround could potentially take several years. On the other hand, the portion of a FIA tied to the same S&P 500 index would be unaffected by the 20% decline. This would simply be a non-event with no interest credited in the contract year in which this occurred.
In the foregoing example, assuming that 100% of your FIA was tied to the S&P 500 index and there were no additions or withdrawals, your end-of-the-contract-year accumulation value would be identical to what it was at the beginning of the year unless your contract includes an income rider. In this case, your contract’s accumulation value would be reduced by the income rider charge, which generally is 0.5% to 1% of the contract’s income account value. Although an income rider charge reduces a contract’s accumulation value, it has no affect on the amount of income distributions you will ultimately receive.
If you’re approaching, or are in, retirement, or if you’re more sensitive to loss than to gain, FIAs may be an appropriate choice for a portion of your investment portfolio. Don’t underestimate the power of zero.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.