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How Does a Fixed Index Annuity Work?

Stan Haithcock
May 26, 2024
How Does a Fixed Index Annuity Work?

Hi there. Stan The Annuity Man, America's annuity agent licensed in all 50 states. I am glad you joined me today. This is a hot topic, not the clothing line for you youngsters out there. How does a Fixed Indexed Annuity work? The Panacea product, the too good to be true, the bad chicken dinner seminar, the good steak dinner seminar where you get the filet mignon. The person stands up there and says, "Oh, this is the greatest product since sliced bread. It's a Fixed Indexed Annuity." Now what you're saying is, "Wait a minute, Stan The Annuity Man, America's annuity agent, I need to know the facts about Fixed Indexed Annuities, and I need to know how they work." Let's get right into it.

The typical call I get every single day of my life is, "Stan The Annuity Man, I went to this seminar. I got this really nice invitation in the mail, and we went there, along with the missus and me, and we got the steak dinners, which were really good. They had the filet, we had the potato, we had the Caesar salad. It was fantastic. Then the agent got up there, and the advisor talked about a Fixed Indexed Annuity. Now, what they said sounds so good, Stan The Annuity Man, that we're like, we should get that. That's great. If it's that good, that's what the FEDs should buy, right?" The answer is no.

The History

Let's talk about the history of Fixed Indexed Annuities (FIAs). FIAs used to be called Equity Indexed Annuities, but not anymore. In 1995, when they were designed and introduced to compete with CDs, typical, normal CD returns were not the time of this blog, but MYGA returns, Multi-Year Guarantee returns in the two to four % range. That's 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 with the bad sales pitch.

Let's talk about how they work from a 30,000-foot view, but understand that you can visit The Annuity Man . I have written a book on Indexed Annuities. It's called the Fixed Indexed Annuity Owner's Manual. It's about 70 pages of the truth, the brutal facts, and you can download it for free. But in essence, a Fixed Indexed Annuity is a Fixed Annuity. It's issued and approved at the state level and life insurance companies. And the growth story, which is the whole sales pitch's problem, revolves around a call option.

Call Options

In English, a call option is saying, "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, just really betting on, it's not a bet, but you're saying, I think that the market is going to go X from the S&P from this point to this point, and I'm going to share in some of the gains. That's where the story gets a little muddled because the annuity companies aren't going to give all of that upside away, period. There are levers that limit the upside. They can be called caps, participation rates, or spreads. It gets very, very complicated. But understand this: when you buy an Indexed Annuity, and let's just say it's the S&P 500 index, and let's just say that's the bogey, that's what you're using, and a lot of the Indexed Annuities use that.

The S&P index that you're buying the call option on, that's what the Indexed Annuity is doing, does not include dividends. Now, why is that important, Stan The Annuity Man? Excellent question. The reason is the S&P 500 index, over 50% of the historical returns of an S&P500 index includes dividends. Indexed Annuities, and that point-to-point or whatever options you choose, does not include dividends. Now, the other thing that you need to understand about Indexed Annuities is that the annuity company that issues the annuity, the Indexed Annuity, can change the rules at their discretion. Some are very favorable with these renewal rates, and some companies are not. You have to be very, very careful about what you're choosing.

Client Example

I told a guy who called the other day, and he said, "I bought this ten-year Indexed Annuity as a one-year call option." I went, "Okay. You do understand, though, that you bought a ten-year surrender charge product with a one-year guarantee. Every single year, that annuity company is going to give you renewal rates based on those caps, spreads, and participation rates." Indexed 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'll hear things that sound so good to be true that you think the world's 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 blog, look at the date; there are over 750 index option choices in the Indexed Annuity world. That is a lot. That is an absolute ton.

The good news about Indexed Annuities is that when you do have a gain, it's going to be limited, it's not going to be market-type returns, and 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 that says, "Hey, you're going to get market returns, and there's no downside. 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.

Upfront Bonuses

Let's talk about a couple of other things about Indexed Annuities that make the top of my head pop off, and you don't want to see that. When the agent talks about upfront bonuses. I have a saying about upfront bonuses. Please don't get offended by this, but I call upfront bonuses candy for the stupid. Please don't be that foolish person who thinks that annuity companies are giving money away for free. They're not. There are 100 pennies in a dollar, and an upfront bonus is part of those 100 pennies. So, if they give an upfront bonus, they're taking something away somewhere in that policy. That's just a fact. You can't even argue about that. If someone says, "Well, if you sign up, I'll give you a 25% bonus," the annuity company, there's not a philanthropist at 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 Indexed Annuity or Indexed Annuity with an attached Income Rider, we will quote all carriers with or without bonuses and show you the highest contractual guarantee for your specific situation.

To clarify, everyone's yelling at me when I said something to the effect that you buy the call options. You don't buy them; the Indexed Annuity company buys them on your behalf. So, just semantically, I was a little bit off there. But some people say, Stan, you're a little bit off anyway, but I digress.

Let's discuss whether you can lose money with a Fixed Indexed Annuity. No, no. It's a Fixed Annuity, so there's not going to be any downside if the market takes a big dump, a big crapola, as they say in Italy. Do they say that in Italy? I don't think so. Anyway, if it does, if it goes down, you're not going to lose any money. That's a good thing. But let's get a little semantic again: can you lose money in a Fixed Indexed Annuity?

Income Riders

At the time of application, let's just say you attach an Income Rider to an Indexed Annuity. Again, Stan, what's an Income Rider? First of all, I've written a book on it that you can download for free. But an Income Rider is an attached benefit for future income that you can start as a pension income at a future date, and the Indexed Annuity is a delivery system for that guaranteed income. But that rider comes with a fee, typically. So, semantically, if the markets did zero, and your Indexed Annuity got zero, and the annuity company's taking that Income Rider fee from the Indexed Annuity, technically, 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.

The Right Reasons

Hey, one last thing about whether you can lose money with a Fixed Indexed 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, 10 years, surrender charge. Suppose you have a 10-year surrender charge on your Indexed Annuity and surrender it in year five. In that case, you'll lose money because there will be a surrender charge penalty on that Indexed Annuity. People always ask me, they say, "Stan, what's the downside of an Indexed Annuity?" The downside of an Indexed Annuity is you won't get market returns consistently. You might get it one year, but you're just not. That's not what they're designed to do. Number two, they are typically long-term products, and you must ensure you buy 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 principal protection and normal CD-type growth, then that's fantastic.

The Upside

The other downside typically is the sales pitch. You're buying the sales pitch, and then you get the contractual realities in the mail, right? And the policy. But there's upsides, too. Let's talk about that. The upsides are that its principal is protected, and 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. "So, Stan The Annuity Man, how does it fit into my retirement portfolio? How does an Indexed 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 and real rates of return, never ever, ever, ever, ever, ever, ever, ever, ever buy an Indexed Annuity for that, okay?

But where it fits in your portfolio, it's two places; number one is principal protection. If you do not want to lose any money with market downturns, that is an excellent product to go to. It's, remember, a CD-type, normal CD-type returns. Also, in your portfolio, it could fit for income. "How's that, Stan The Annuity Man?" Excellent question. When you need future income, like you said, "You know what, Stan?" Because I always ask people two questions: what do you want the money to contractually do? When do you want those contractual guarantees to start? If you said, "Hey, Stan The Annuity Man, we need income to start in seven years," then we might attach an Income Rider so it could solve for 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 so fortunate, and your Social Security or it could be a principal protection product.

Hey, 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 principal protection, CD returns, and providing a lifetime income stream if you want to attach an Income Rider.

I encourage you to get my books at The Annuity Man and to schedule a call with us. We'll talk about Indexed Annuities and how they fit. There's not one that's better than the other, but if you're really looking into these as a potential addition to your portfolio, then we need to speak.

Hey, thanks for joining me. I will see you on the next Stan The Annuity Man blog.

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