Fixed-income annuities (FIAs) with guaranteed lifetime withdrawal benefits can improve investor outcomes when used in retirement portfolios, but there are caveats, a new Morningstar study found.

“The products can provide richer benefits than other annuities for the right consumer who buys the annuity before retirement and doesn’t need income right away, so they delay withdrawals,” Spencer Look, author of the study and associate director of retirement studies and public policy at Morningstar Investment Management LLC, said in an interview.

FIAs are tax-deferred contracts and have a rate of return that is based on the performance of an external index, such as the S&P 500. Because of their guarantees, they’ve become one of the most popular annuities sold, with $112.1 billion in sales in 2022, more than double (111%) 2021 figures, LIMRA reported. Sales are projected to hit $174 billion in 2023.

They are commonly sold with guaranteed-lifetime income withdrawal riders. The riders allow the purchaser to take withdrawals that are guaranteed for life, even if the account balance drops to zero.

To find out if FIAs were worthy of the buzz, Morningstar created stress testing and simulations involving a number of different scenarios. In one scenario, the firm used a couple, both 55 years old, with a beginning balance of $1,350,000 and 10 years of annual contributions of $30,750, to compare strategies involving a partial allocation of 40% to two different FIAs with lifetime guarantee riders. The results were then compared to a portfolio-only strategy mirroring FIAs set at 90% bonds and 10% equities to show what income and bequest each strategy would generate at age of 65.

Of the two FIAs that Morningstar tested—one with a level-income guaranteed lifetime withdrawal benefit (GLWB) and one with a rising income GLWB—the FIA with a level-income GLWB outperformed the portfolio-only investment option by 2.65%, provided the insurer kept its pricing spread constant. This product left a bequest of $1,518,378. The FIA with a level-income GLWB outperformed the portfolio-only investment option by 2.34%, but left the highest bequest of the two FIAs—$1,582,505.

Morningstar also found that that FIAs with GLWB strategies provide more income than a portfolio-only strategy in cases in which the retiree runs short of money, as the product mitigates against market risk and longevity risk. However, FIAs with a GLWB only boosted bequests in cases where the insurer did not increase the pricing spread or only increased it slightly.

“FIAs with a GLWB can mitigate against portfolio shortfalls, but they may not always boost bequests,” Look noted.

Advisors and investors who want to assess the likelihood that an insurer will raise an FIA’s pricing spread should look at their historic pricing and spreads, Look said.

“You can request renewal rates, and get an idea of what an insurer has done historically. But it’s hard to know what an insurer will do since it does vary based on the economy and each insurer’s experience in their lines of business,” he added.

Investors should plan to delay drawdowns from FIAs with GLWB riders for 10 years or so, Look said.

“It does ultimately depend on someone’s own situation and their behavioral risk,” Look said. “Maybe they can begin withdrawals in seven to eight years or so, or should wait a little longer than 10 years. But I do think it’s a rule of thumb that every year you delay taking withdrawals, income increases because of shorter life expectancy. That’s why I emphasize buying FILAs well before retirement,” he said.

For investors who need income sooner and still want a guarantee, there are products that will work better, added Look, who noted that single-premium annuities could provide “much higher guaranteed income immediately for those who can’t delay withdrawals.”

Look also said that advisors should treat FLAs with GLWB riders as bond equivalents. “We found that the effective asset allocation of an FIA with GLWB over a longer time horizon was consistent with a 10% equity and 90% bond portfolio,” he said.

Although FIAs have become the shining stars of the annuity world, they do have their critics, Morningstar noted. “This may be due in part to consumers being misled by some salespeople,” the firm said. Further, managed volatility indexes are typically developed using back-tested returns, which may be used in product illustrations, setting unrealistic expectations for policyholders, the firm noted.

In one product illustration Morningstar reviewed, the annualized rate of return for a “low” market return scenario was over 12%.

Critics also cite the complexity of FIAs as a reason to avoid them, as many consumers will not understand the features and choices in a contract.

“One last criticism we observed frequently in our review is that FIA costs are opaque. Consumers do not have a surefire way to tell what they are paying, and some may not realize they are paying anything at all,” Morningstar said.