How Does A Fixed Index Annuity Work

Hot topic. How does a Fixed Indexed Annuity work? Some people think it is the too good to be true product. I’m here to set the facts straight.

A typical call I get is, "Hey, Stan, The Annuity Man®, I went to this seminar. I got this nice invitation in the mail, and we got the steak dinner. It was really good. And then the agent got up there, and the advisor talked about a Fixed Index Annuity. What they said sounds so good, Stan The Annuity Man, that we were like, 'We should get that. That's great. I mean, if it's that good, that's what the Fed should buy, right?'" No.

Fixed Index Annuity Basics

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Let's talk about Fixed Index Annuities. The history of a Fixed Index Annuity, it used to be called equity index annuities but not anymore, is in 1995, they were designed and introduced to compete with typical, normal CD returns. Not at the time of this taping, but MYGA returns, Multi-Year Guarantee Returns, that two to 4% range, that kind of normal, that's what they were put on the planet to do.

They are not securities. They do not provide market growth, even though that's what you’ll hear on the bad sales pitch. So let's talk about how they work in a 30,000-foot view. In essence, a Fixed Index Annuity is a fixed annuity; it’s issued and approved at the state level, a life insurance company issues it, and the growth story, which is the problem of the whole sales pitch, revolves around what's called a call option. In English, a call option says, "Okay, I'm going to buy it at this date, and at this date a year later, I'm going to get a portion of the gains."

I know that's a 30,000-foot view, but a call option is betting on... It's not a bet, but you're saying, "I think the market will go X. The S&P from this point to this point, and I will share some of the gains." That's where the story gets a little chaotic because the annuity companies aren't going to give all of that upside away. Period. Some levers limit the upside, they can be called caps, and participation rates spread. It gets very complicated, but understand this: when you buy an index annuity, and let's just say it's the S&P 500 index, let's just say that's the bogie, that's what you're using, and a lot of the index annuities use that, that S&P Index that you're buying the call option on, that's what the index annuity is doing, does not include dividends. Now, "Why is that important, Stan The Annuity Man?" Very good question.

Be careful. If it sounds too good to be true, it is every single time.

The reason is the S&P 500 I; over 50% of the historical returns of an S&P 500 index include dividends. Index annuities and that point-to-point or options do not include dividends. Now, the other thing you need to understand about index annuities is that the annuity company that issues the index annuity can change the rules at its discretion. All right? Some are favorable to these renewal rights, and some companies are not, so you must be careful about your choices. I told a guy who called in the other day; he said, "I bought this ten-year index annuity as a one-year call option," and I went, "Okay, do you do understand, though, you bought a ten-year surrender charge product with a one year guarantee? Because every year, that annuity company will give you renewal rates on what those caps and spreads and participation rates are."

So index annuities, we love them, we use them as a CD product, and we use them as an efficient delivery system for income riders. But be very careful out there. You're going to hear things that sound so good to be true that you think the world is solved by buying this product. It is not a one-size-fits-all product. You can attach income riders for future income guarantees at the time of application, but also understand that at the time of this taping, look at the date; there are over 750 index option choices in the index annuity world. That is a lot. I mean, that is an absolute ton. Now, the good news about index annuities is when you do have a gain, and it's going to be limited, it's not going to be market-type returns; it’s going to lock in permanently. That's a good thing. But the bad thing is the agents and advisors will push that greed in the back of your head, saying, "Hey, you're going to get market returns, and there's no downside."

Too Good to Be True

"Market upside with no downside? Sounds great! Where do I sign up?" Be careful. If it sounds too good to be true, it is every single time. Now, I have a saying with upfront bonuses. Please don't get offended by this, but I call upfront bonuses candy for the stupid. And please don't be that stupid person out there who thinks an annuity company is giving money away for free. They're not. There are a hundred pennies in the dollar, and an upfront bonus is part of that hundred pennies, so if they're giving an upfront bonus, they're taking something away somewhere in that policy. That's just a fact. I mean, you can't even argue about that.

So if someone says, "Well, if you sign up, I'll give you a 25% bonus," the annuity company, there's not a philanthropist in an annuity company going, "You know what? I'm going to give money away. I just want to give money away to the people." No. It's an attractive piece of candy for the stupid, for you to sign up. Now, in some cases, does it work out contractually? Yes. In some cases, no. When you have me look at an index annuity or index annuity with an attached income rider, we’ll quote all carriers with bonuses or without bonuses. We show you the highest contractual guarantee for your specific situation. Hey, just to clarify, everyone was yelling at me when I said something to the effect that you buy the call options, and you don't buy them; the index annuity company buys them on your behalf.

Can I Loose Money?

Let’s discuss, "Can you lose money with a Fixed Index Annuity?" No. No. It's a fixed annuity, so there's not going to be any downside if the market goes down. That's a good thing, but let's get a little semantic about, "Can you lose money in a Fixed Index Annuity?" Let's just say you attach an income rider to an index annuity at the time of application. Again, "Stan, what's an income rider?" First, I’ve done many videos on income riders; you can hit the playlist, see it, But an income rider is an attached benefit for future income that you can start a pension income at a future date. The index annuity is a delivery system for that guaranteed income, but that rider typically comes with a fee.

So semantically, if the markets did zero and your index annuity got zero, and the annuity company is taking that income rider fee from the index annuity, you could have less money. Has that happened historically? No, not really, but I'm just saying that there is a lifetime fee annually for that income rider if you decide or if we decide on the phone that an income rider makes sense for you. Hey, one less thing: “Can you lose money with a Fixed Index Annuity?" If you surrender the policy during that surrender charge time period... And typically, that time period's going to rise from five years, seven years, ten years surrender charge. Suppose you have a ten year charge on your index annuity, and you surrender it in year five. In that case, you’ll lose money because there will be a surrender charge penalty on that index annuity.

What's the Downside?

People always ask me, "Stan, what's the downside of an index annuity?" The downside of an index annuity is you're not going to get market returns consistently. You might get it one year, but you're just not. That's not what they're designed to do. They are typically long-term products, and you must ensure you’re buying them for the right reason. If you're buying it for market returns, you're buying it for the wrong reason. If you're buying it for principle protection and normal CD-type growth, then that's fantastic. The other downside typically is the sales pitch. You buy the sales pitch and then get the contractual realities in the mail and the policy. But there are upsides, too; let’s talk about that. The upsides are it's principal-protected; gains are locked in; even though they're limited gains, they are locked in permanently, and you can attach an income rider for future pension needs.

Where Does It Fit?

"So Stan, how does it fit into my retirement portfolio? How does an index annuity fit? Where does it fit?" I'll tell you where it doesn't fit: it doesn't fit for market growth. If you want market growth, real rates of return, never, ever, buy an index annuity for that, okay? But where it fits in your portfolio, we have two places: number one is principal protection. If you do not want to lose any money with market downturns, that is a good product to go to. It's a, remember CD-type, normal CD-type returns. Also, in your portfolio, it could fit for income. When you need future income, I ask people two questions, "What do you want the money to do contractually? When do you want those contractual guarantees to start?" If you said, "Hey, we need income to start in seven years," then we might attach an income rider so it could solve lifetime income needs.

So in your portfolio, it could be a lifetime income guarantee pension-type product to combine with your pension if you're fortunate and your social security. Or it could be a principle protection product. In closing, here's the deal with index annuities: they aren't too good to be true, but they're pretty darn good if you understand the truths and the facts and how they were developed and designed in 1995 for principle protection, CD returns, and providing a lifetime income stream if you want to attach an income rider.

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.