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.”

First « 1 2 3 » Next