How Do Insurance Companies Make Money on Fixed Index Annuities?

Hi, Stan The Annuity Man. Today's topic is a wing-dinger. It’s about how annuity companies make money on Fixed Indexed Annuities. Boy, there’s a lot of misinformation out there. I will try to make it very simple for you to understand why the annuity companies have the big buildings. I mean, they’re smart, but some of the misconceptions and ideas people have about Indexed Annuities need to be covered. By the end, you’ll understand how they make money on Indexed Annuities, whether it's a good deal for you, and if you even need one.

What Is a Fixed Indexed Annuity?

We have a lot to cover on this topic. We’re talking about how annuity companies make money on Fixed Indexed Annuities. We’re going to cover a lot of things: What is a Fixed Indexed Annuity? What does it solve for? How does it work? Then, we’ll talk about how annuity companies generally make money on annuities. Why do they have the big buildings? Why do they have those big logos on jets? They’re smart; they know things. Life insurance companies know when you'll die—that’s why they have those big buildings. And Property and casualty companies don’t know when hurricanes will hit, for all you Floridians out there. So, you get it.

Then we’ll dive into how they make money—or not—on Fixed Indexed Annuities. Ultimately, we’ll discuss where they fit, the limitations, and the product's benefits. And hang in there because, at the very end, I’ll tell you how to get a free book I’ve written on Fixed Indexed Annuities.

The Basics of Fixed Indexed Annuities

So, what is a Fixed Indexed Annuity? If you’ve ever been to a bad chicken dinner seminar, where some guy in a bad leisure suit is talking about the product, it probably sounds too good to be true. Remember, if it sounds too good to be true, it is—every time, without exception, with annuities. And with Fixed Indexed Annuities, the hype is insane. “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.

So, what is a Fixed Indexed Annuity? It’s a Fixed Annuity. That’s the first word: Fixed. You’re never going to lose any money. That’s a good thing, right? It was introduced in 1995 to compete with CD returns. And guess what? It’s done exactly that. Historically, it’s competed with CD returns. All that hype about “market upside with no downside” and “market participation, principal protection”? That’s not reality. It doesn’t mean it’s a bad product; you just need to understand how it works. It’s designed to provide enhanced CD-type returns. That’s what a Fixed Indexed Annuity is.

How Fixed Indexed Annuities Work

Now, let’s talk about how Fixed Indexed Annuities work. Typically, when I start explaining this, I warn people that it's like showing paintings to blind people. No offense to blind people—it’s just tough. I try to simplify it to a nine-year-old level—no offense to nine-year-olds. But as I always say, you shouldn't buy or sell it if you don’t understand it or can’t explain it to a nine-year-old.

So, let’s talk about the basics of how Fixed Indexed Annuities work. Number one: it’s a Fixed Annuity. It protects your principal. Fixed. The gains? That’s where the hype comes in. The sales pitch is all about “market upside,” but the truth is that gains are based on a call option on an index. A call option is like a one-year bet saying, “I think the index will go up,” and if it does, you lock in that gain, but with a limit.

Here’s where the sales pitch can get misleading: annuity companies aren’t in the business of giving things away. No philanthropist at an annuity company says, “Let’s give stuff away.” They provide a good product, but you need to understand it for what it is. The basics of how Fixed Indexed Annuities work are simple: there’s a cap on the upside. There’s a limitation on the upside, and the carrier dictates those rules. They can change them at their discretion. You can also attach a lifetime benefit Income Rider to a Fixed Indexed Annuity at the time of application if you want income guarantees later. So, that’s how a Fixed Indexed Annuity works.

What Do Fixed Indexed Annuities Solve For?

What do Fixed Indexed Annuities solve for? First and foremost, principal protection. It provides enhanced CD-type returns historically. That’s what it’s designed for. It can also provide a lifetime income guarantee if you attach that Income Rider at the time of application, assuming the specific annuity offers that.

How Annuity Companies Make Money on Fixed Indexed Annuities

Alright, we’re about to get into the weeds. Bear with me—I’m going slow because I want you to understand how annuity companies make money on annuities. Let’s talk about this broadly: How do annuity companies make money? Here’s the basic breakdown:

When you give money to an annuity company for a Fixed Annuity of any type, the regulators require the annuity company to invest that money in bonds. On day one, they put your money into a bond portfolio, and the interest they earn from that portfolio is split: they give you some, and they keep some for their profit. That’s the 30,000-foot view of how annuity companies make money on your money, regardless of annuity type.

Remember when I said annuity companies invest in bonds and give you part of the interest, keeping the rest for profit? With Fixed Indexed Annuities, they buy a call option on the index instead of giving you that interest. This is what they do with that money: they use it to buy the index option for the Fixed Indexed Annuity. Let's go over some common misconceptions about Indexed Annuity carriers.

First, annuity companies do not make money by buying index options. They make no money buying them. Second, the carriers don’t make money on the index option participation. They don’t keep the difference between the caps and the spreads. They don’t keep that. Here’s what really happens: when they buy the index option, they typically buy it from a large investment bank, like the big firms with $3,000 suits. The annuity companies give them money to buy the option, and those investment banks absorb the risk of the performance of that option.

Why Are There Caps and Limitations?

So, why are there caps and limitations on the upside for Fixed Indexed Annuities? It’s because that’s all the annuity companies can buy with the money they allocate to buy the option. That’s all they can buy to protect your principal. At the end of the day, remember: Fixed Indexed Annuities are Fixed Annuities first. They protect your principal—they’re not market products. They’re CD-type products.

Income Benefit Riders and Profit

Let’s add one more thing. At the time of application with most Fixed Indexed Annuities, you have the option to attach an income benefit rider, which is a future income guarantee. If you do this, the annuity company holds onto your money longer because the income benefit payment is based on your life expectancy when you start taking it.

So, in addition to making money off your money through bonds, they also make money by holding onto your money longer if you use the income rider. This gives them more time to make money off the bond portfolio. They’re not hitting home runs with your money but hitting “bunt singles” for a long time. It’s a slow, steady process for them.

Key Points to Remember

Two final key points:

1. Annuity companies aren’t smarter than banks. They’re more regulated. When you give money to a Fixed Annuity company, the regulators require them to buy investment-grade bonds. They can’t do risky stuff with your money like banks can.
2. Surrender charges are high on Fixed Indexed Annuities. Why? Because there’s a built-in commission for the agent, and the annuity company needs to make up for the investment costs (buying options, administrative costs, etc.) if you withdraw early. They’re in the hole for the first few years.

Benefits and Limitations of Fixed Indexed Annuities

Let’s quickly go over the benefits and limitations.

Benefits: Principal protection, CD-type returns, and gains lock in permanently at the contract anniversary date. You can also attach an Income Rider for future income benefits.

Limitations: The over-hyped sales message of “market upside with no downside.” Remember, Fixed Indexed Annuities were introduced to compete with CD-type returns in 1995. Are there some anomaly years where they do a little better? Sure. But at the end of the day, expect CD or better-type returns.

Conclusion and Free Books Offer

Thanks for hanging in there with me. I hope you’ve learned a lot. Now, as promised, I’m offering you two free books. All you have to do is sign up for the Indexed Annuity Owner’s Manual and Income Riders Owner’s Manual. You can download them for free and read about Fixed Indexed Annuities and Income Riders. Thanks again for reading along with me.