FIAs: Equity Or Fixed Income, Or Something Else Entirely?

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.