Fixed index annuities may seem complex. These hybrid savings vehicles have been growing in popularity, yet many advisors and their clients still wonder what to make of them. Are they equity or fixed-income assets?

The difference is important in terms of what you expect them to do, and how you characterize them in a portfolio or retirement plan. “It’s an important distinction because a client’s risk profile primarily determines how his or her portfolio should be apportioned,” says Noreen Phalon, head of product management at BMO Harris Financial Advisors in Chicago. “Each piece of the portfolio is expected to deliver certain characteristics.”

The conundrum arises because these annuities offer a minimum guaranteed return like traditional fixed annuities or bonds, combined with an interest rate that’s linked to a market index such as the S&P 500, like variable annuities or ETFs.

“Fixed index annuities do give you the ability to diversify a bond portfolio,” says Robert DeChellis, president of Minneapolis-based Allianz Life Financial Services. “But for those who are reluctant to enter the equity market and like the idea of downside protection with some upside opportunity, FIAs are not necessarily an equity replacement, but they are certainly a way for consumers to hedge themselves in equity markets.”

The Way FIAs Work
To better understand FIAs, it helps to recognize that they can be based on any number of market indexes. Some even allow investors to select more than one at a time. Moreover, they are typically structured with a one- or two-year call option on the index. That protects them somewhat from index declines. If the index loses value, the call option will expire worthless.

In this sense, they offer less risk—and less potential return—than a variable annuity. On the other hand, if the index value rises, FIAs can offer a higher return than a traditional fixed annuity. Any gains earned are locked in and will never decline.

“The primary pro is that they allow investors to partially participate in the upside of equities, unlike fixed annuities, and then lock in that upside, but with lower fees than variable annuities,” says Phalon. “An important con is that if markets don’t go up, clients forgo any added interest—they don’t lose money, but they might just have their principal and no interest.”

Multiple Purposes
One key reason clients purchase FIAs—also called indexed annuities or equity-indexed annuities—is to protect their retirement income from market loss. “They may be a good solution for clients seeking the guarantee of fixed annuities combined with the opportunity to earn interest based on changes in an external market index,” says DeChellis. “As the future of Social Security becomes more uncertain—and as fewer defined benefit plans are available—many clients are looking for additional sources of guaranteed income. FIAs are a great option to supplement income.”

As reliable sources of income, they resemble bonds more than stocks. “They can serve the purpose that bonds traditionally have in an asset allocation model, though FIAs do not participate in any stock, bond or other investment directly,” says DeChellis.

Legally speaking, FIAs are not regulated by the SEC, as equities are. Instead, they are treated as insurance products and regulated by state insurance agencies. You need an insurance license to sell them. Yet because they can be linked to an equity index, the distinction can grow fuzzy.

“FIAs were built to fit on the risk spectrum between fixed investments and equities and should be viewed as a solution that provides clients with the opportunity to receive higher interest credit than can currently be found on traditional deposit products,” says Brian Wilson, a vice president at Lincoln Financial Group in Hartford, Conn. “One of the core elements of the FIA value proposition is the opportunity to participate in market performance without putting principal at risk. It is not to receive the full return of the index.”

Tax Advantages
Another advantage of these products, besides the hedge against market downturns, is the fact that FIAs carry no annual fees (unless you attach riders). Gains are locked in annually on the contract anniversary date. And taxes on earnings are deferred until money is taken out.

This tax deferral can be an important planning tool. For clients in a high tax bracket—who may be paying the 3.8% Medicare tax on unearned income or the income-related monthly adjustment amount on Medicare Part B premiums (if their modified adjusted gross income exceeds a certain amount)—the strategy of moving funds to a tax-advantaged product such as an FIA can make a lot of sense.

“By putting the investment dollars into an FIA—or other annuity or life insurance product, for that matter—the income from this investment principal is sheltered from current taxation and may possibly be distributed at a later date when the client might face less tax on the earnings,” says G. Joseph Votava Jr., CEO of Seneca Financial Advisors, a multifamily office based in Rochester, N.Y., and Washington, D.C.

It’s important that retirees be able to manage their tax brackets in the future, he adds. Future tax rates and structures can’t be guaranteed. But if retirees can manage their tax brackets, they can have some control over their annual cash flow and some ability to preserve their investment base. They’ll also have some control over their Social Security and Medicare benefits, which may be partly based on income levels.

FIAs may also be a perfect fit for those who have maxed out contributions to IRAs and 401(k) plans and are seeking other tax-sheltered opportunities.

Adding Riders
In addition, riders can be added to expand benefits, for a fee. Some popular options include long-term care or confinement coverage and guaranteed death benefits. “Riders are great tools for the right client,” says Wilson of Lincoln Financial. “Typically, rider costs for FIAs are relatively low in comparison to VA riders. Rules vary greatly for how riders are appended to and removed from contracts at onset, as well as on existing contracts.”

Lincoln Financial, for example, has an optional guaranteed living withdrawal benefit that can be added at issue or on a contract anniversary, and it can be removed after the fifth anniversary.

Not For Every Client
Despite all their benefits, FIAs shouldn’t be recommended to all clients. They are complex contracts, and clients should understand fully how they work before deciding to purchase one. Even then, comparing one FIA with another is difficult because of the many variables. The way index gains are calculated, for instance, varies from product to product, affecting how much is credited to the annuity owner. Some FIAs use participation rates or may also use spread, margin or asset fees. Some cap the maximum interest the FIA can earn. “It is critically important that the client understands the various moving parts of the product,” says Phalon.

Furthermore, an FIA is a commitment. Early surrender charges can be steep and typically come with an additional tax penalty, wiping out the tax-deferral advantages and potentially eating into returns. “Surrender charges are applicable in earlier years, if funds must be accessed in greater amount than the contract provides,” notes Votava. “Contract provisions specify [the] amounts that can be distributed, giving rise to illiquidity of a substantial amount of the investment, unless high costs are paid.”

On the other hand, FIAs can be an important, even elegant, tool. “While some people might categorize these products as complicated, I prefer to use the word ‘sophisticated,’” says DeChellis. “What’s powerful about them is that they can serve various needs. Someone who is looking for asset accumulation might not want to buy an FIA that has a guaranteed income rider in it, if that’s not their primary objective. But someone who’s looking for guaranteed income and doesn’t have a real emphasis on liquidity, and doesn’t really have an emphasis on accumulation in terms of anticipating needing to walk away with a lump sum, but rather wants those assets to generate lifetime income, lots of innovation has taken place in FIAs around guaranteed lifetime income riders.”

Often Misrepresented?
Still, annuities can be sold inappropriately. “I do see this as a potential problem,” observes Phalon, “because some products have a variety of indices from which a client must select. Without the background that a securities license should provide, the salesperson may not adequately understand or be able to explain the different index options and how the markets might affect them.”

Yet exaggerated claims are less common for FIAs than for, say, variable annuities. In fact, the biggest risk with FIAs may be the solvency of the issuer. “FIAs are, in fact, insurance products, not investment products,” Votava emphasizes. “Unlike variable annuities, which keep the up/down market risk in the hands of the buyer, FIAs have the guaranteed principal and guaranteed minimum lifetime benefit provided by the contract, so the risk of market performance has been transferred from the buyer to the insurance company.”

The Future
With the aging population, and declining defined benefit plans, it stands to reason that demand for income replacement tools such as FIAs will continue expanding.

“There has been an average annual growth rate for FIAs of 17% since 2000,” says DeChellis. At the same time, he adds, the industry has “revolutionized product structures [and] crediting methods and created innovative indexes”—which no doubt only furthers their appeal and usefulness.