Today's topic is how annuity companies make money on fixed index annuities. There is a lot of misinformation out there, and I'm going to try to make it very simple for you to understand why the annuity companies have significant buildings. They're smart. But we need to cover some of the misconceptions and ideas people have about index annuities. At the end of this, you're going to understand how they make money on index annuities and if it's a good deal for you and if you even need one.
Boy, we have a lot to cover on this topic. I love this topic, which is how do annuity companies make money on fixed index annuities? Now, if you've been to the lousy chicken dinner seminar where the guys up there and a lousy leisure suit telling you about this product sounds too good to be true, it is. Never forget if it sounds too good to be accurate; it is every single time without exception with annuities. With fixed index annuities, the hype is crazy. This is the best thing since sliced bread. If you don't buy it, you're crazy. You and I both know there are limitations and benefits to all products. What is a fixed index annuity? It's a fixed annuity. That's the first word. Fixed annuity. You're never going to lose any money. That's a good thing.
Now, it was put on the planet in 1995 to compete with CD returns, and guess what it’s done historically? It's competed with CD returns. This hype of market upside with no downside, market participation, principal protection. If it sounds too good to be true, it is. That doesn't mean it's a wrong product. You just need to understand how it works to provide enhanced CD-type Returns. That's what a fixed indexed annuity is. Let's talk about how fixed index annuities work.
Typically, when I start this, I warn people, I always say if you can't explain it to a nine-year-old, you shouldn't buy it or sell it. Many people out there are pushing these fixed index annuities as a one-size-fits-all solution to your life; calm down, sparky. It doesn't work like that. These are contracts. It's not too good to be true. Let's talk about just the nuts and bolts of fixed index annuities.
Number one, it's a fixed annuity. It's protecting your principal, fixed. Now where people go crazy and say, "Hey, that sounds pretty good. Why wouldn't we get that? That's perfect." Ultimately, it's not, and the gains are based on a call option on an index. A call option is like a one-year bet saying that I think the index will go up. You get to lock in that gain with a limit if it does.
Now, this is where all of the sales stuff comes in, and you got to be real careful because annuity companies aren't in the business of giving anything away. There are no philanthropists at an annuity decision. They're going to provide a good product, but you have to understand what that product is and the basics of how fixed index annuities work. There's a cap on the upside. There's a limitation on the upside, and those rules are dictated by that carrier and can be changed at their discretion.
Also, understand you can attach a lifetime benefit income writer to a fixed indexed annuity at the time of application if you want income guarantees later. That's how a fixed indexed annuity works. What does fixed indexed annuity solve for? Once again, fixed principal protection provides enhanced CD-type returns historically. That's what it provides for. It can also provide a lifetime income guarantee if you attach that income writer at the time of application if that specific annuity offers that.
We're getting ready to get into the weeds, so just bear with me. I will go slow because I want you to understand how annuity companies make money on annuities. Let's talk about just from a broad standpoint, regardless of type, how do annuity companies make money? Here are the basics. When you give money to an annuity company for a fixed annuity of any time, the annuity company holds your money in a bond portfolio.
They give you some and keep some for their profit, a huge one, and the interests they get from that bond portfolio. From a 30,000-foot view, that's how annuity companies make money on your money regardless of annuity type. Now, remember, I told you that annuity companies invest in bonds, and they take some of that interest off, give it to you, and keep the rest for profits. Now, with fixed index annuities, instead of them giving you the interests, like on a multi-year guaranteed annuity, they take that interest, that portion, and buy the call option, that index option on the indexed annuity. That's what they're doing with that money.
Let's go over some common misconceptions people have about indexed annuity carriers, and I get calls like this all the time that are wrong, and I'm so happy to clear all of this up. The annuity companies do not make money buying the index options. They make no money buying them. That's the first thing you need to know. You need to know if the carriers; don't make any money on the index options. They're not making money on the index option participation. They do not keep the difference between the caps and the spreads, the limitations in place. They don't keep that.
What happens is when they buy the index option, when they bind that option, they typically buy it from one of these large investment banks. All of those blue blood guys with $3,000 suits. They give them the money to buy the option, and the investment bank is absorbing that risk of what happens with the performance of that index option. Once again, the index annuity companies buy the option from the investment bank.
They don't make any money on that, and they're transferring the risk to that investment banker, etc. to absorb that performance of the option. Also, understand that there are caps and limitations on the upside for index annuities is that's all the upside they can buy while protecting your principal. Remember, fixed index annuity is fixed protecting your principal.
If the question is, why is my limitation four percent or five percent on the upside for that option? It is because that's all they could buy with that money, that interests money that they allocated to buy the option. That's all they could buy to protect your principal. Because at the end of the day, fixed index annuities are fixed. They're the main protection products first; they’re not market products. They're CD-type products. They're fixed products.
Let's go over one more thing. At the time of application, with a most fixed index annuity, you have the option or the ability to attach what's called an income benefit writer, which is a future income guarantee. Now, if you do that, the annuity company will hold onto your money longer. Why? Because when you turn on that income benefit, that income benefit payment is based on your life expectancy when you take the payment.
In addition to them making money off your money from just buying bonds, they're also going to have a longer time to make money off your money buying bonds if you use the income writer for future income because you're going to stay in the policy longer. Again, you see how they're making money. Just baseball analogy, they're not hitting home runs with your money. But, they're hitting singles for a long time. They're just incrementally making small amounts with a bunch of money.
I think two final vital points are critical for you to know. Annuity companies are more innovative than banks. They're more regulated than banks. When you give money to a fixed annuity company for a fixed index annuity, the regulators require there's no option; they require the fixed indexed annuity company to buy bonds, investment-grade type bonds. They can't do risky stuff with your money like a bank. That doesn't mean they're better than banks.
They're handcuffed from the standpoint that the annuity carriers, from what they can invest in. It's got to be investment-grade bonds. Understand that. The other thing I think is essential to understand is that when you buy a fixed indexed annuity, the surrender charges are high. It’s because there's a built-in commission that goes to the agent. Second is because they buy the options and all this stuff, administrative costs for the first few years, then the annuity company is in the hole. I'm serious about that. I know you're crying tears for them, but it's true, and that's the reason that the surrender charges are so high. Because if you pivot and say, "I want my money back." Then they're going to have to make up for some of that money they've been investing in the options, etc. It's a long-term play for them as well.
Let's go over quickly the benefits and limitations of fixed index annuities. The benefits are principle protection. You get CD-type returns. You never lose a penny, and any type of gains do lock in permanently at that contract anniversary date. You can also attach an income writer for the future benefit for income. The negative revolves around the overhyping of the sales message. The market upside with no downside. Market participation with complete principal protection.
Remember, they were put on the planet fixed index annuity in 1995 to compete with CD-type returns. Are there some anomaly years where they do a little bit better? Yeah, sure, but at the end of the day, blended returns just go into a fixed indexed annuity if you buy one with the understanding that you will get CD or better type returns. If you do that, you will like the product but if you go into it thinking you're going to kill it with, gets 7, 9, 10 percent every single year, come on, you're smarter than that. You know better than that. It's not designed like that, and it doesn't work like that.
Never forget to live in reality, not the dream, with annuities and contractual guarantees! You can use our calculators, get all six of my books for free, and most importantly book a call with me so we can discuss what works best for your specific situation.