Fixed indexed annuities (FIAs) are one of the hottest investments around. Sales amounted to $10.9 billion in the first quarter of 2014, up 39 percent from the same quarter a year ago. But before you sink a chunk of your retirement savings into one, make sure you ask whoever is pitching you this complicated financial product at least six questions.
First, a little background. Fixed indexed annuities were formerly called equity indexed annuities. They're often sold via free educational seminars offered by financial advisors, and the basic pitch is that you get guaranteed income for life with some of the upside potential of stocks.
But if you think that sounds a little too good to be true, you're not alone. Literature today is toned down from a decade ago when many producers promised stock market upside with no downside risk. Financial regulator FINRA issued an investor alert on the product, warning that losses are possible and some terms in the fine print may change.
Now market leader Allianz Life of North America merely defines an FIA as a contract between you and an insurance company that may help you reach your long-term financial goals.
A brochure (pdf) provided by Allianz says in exchange for your premium payment, the insurance company provides you with income, either starting immediately or at some time in the future after an "accumulation" phase. Benefits include tax-deferral, indexed interest potential, accumulation, guaranteed income and a death benefit. Accumulation means your initial investment can grow if an index the product is linked to, such as the S&P 500, moves up.
I've analyzed one of the Allianz products called the Allianz Core Income 7 Annuity (pdf), which is tied to external indexes like the S&P 500. Your account would grow by the same amount the S&P 500 gains over the year, up to a certain cap. The appeal is that you don't lose if the S&P 500 declines or even plunges, because Allianz guarantees you will at least get your money back if you wait the full seven years required.
As appealing as these features are, it's important to understand any financial product before plunking a portion of your retirement nest egg into it. Here are the six critical questions to ask before buying any FIA and some answers to those questions provided by Allianz:
1. What is the cap of the index return? For example, the Core Income 7 had a current cap of 4.5 percent (pdf) per year as of Sept. 2, according to one published report. That means you would get somewhere between zero and 4.5 percent over the next year depending on the performance of the S&P 500 index. The company did not respond to emails confirming this is the current cap.
2. Does the insurance company have the right to lower the cap in the future and, if so, by how much? The Core Income 7 reserves the right to lower the cap all the way down to 0.25 percent in future years. An Allianz spokesperson told me it would take a true economic catastrophe for the cap to be lowered to 0.25 percent.
3. Within the rate cap, will I get the total return of the index or only the price appreciation? If, for instance, an S&P 500 index fund like the Vanguard S&P 500 ETF (VOO) gained 4.5 percent over the next year, would you get that amount? Typically, I've found that the dividend portion is stripped out. If the 2 percent dividend yield is removed, a 4.5 percent total return would translate to a price increase of about 2.5 percent.
4. Will I pay less in taxes? While taxes on interest credited are deferred, it doesn't always translate to paying less in taxes. For example, if you cash out, all interest earned over several years is taxed in one year. If your income jumps up that year, this could push you into a higher marginal tax rate and give you a lower after-tax return.
5. Isn't some of the income just return of my own principal? The truthful answer will almost certainly be "yes." For example, a 6 percent annual income payment sounds great considering that certificates of deposit are yielding less than half this rate. But using a 6 percent payout as an example, one must live 16.7 years just to get principal returned. According to Social Security, a 65-year-old man has a 17.6 year life expectancy, while a woman has a 20.2 year life expectancy.
6. How much will I have to pay if I withdraw money from the account? Have the agent put it in dollar amounts by year. The Core Income 7 product has one of the lowest surrender penalties I've seen, starting at 8.5 percent in year one and declining to 3 percent by year seven. Like most FIAs, it offers a "free 10 percent surrender," but this means 90 percent is subject to this surrender fee between the first and second year. By comparison, the Barclays Bank five-year CD has an early withdrawal penalty equivalent to about 1.12 percent.
One final point to keep in mind: Annuity commissions are usually quite high. One third-party website I found lists the Core Income 7 commission to the agent as 4.5 percent, though Allianz would not confirm. Agents will often say you're not paying those commissions or any other fees of the insurance company, but don't believe it. Every insurance company must cover commissions paid, their own overhead and make a profit.
In short, asking at least these six questions is critical to understanding this technical product, and getting answers in writing is something I strongly recommend.