“In simulation, we wanted to see as fairly as possible how would today’s contracts have performed over time,” he explains. “How would they stack up against stocks and bonds? We modeled what we believed to be a generic structure—an FIA based upon the S&P 500 price index. In simulation, the FIA outperformed government bonds with comparable if not better risk characteristics.”
That’s the good news. But then things get thorny. “FIAs are longer-term investments—i.e., nine to 12 years in the accumulation phase. Although insurance companies offer liquidity during this phase, it comes at a cost,” he says. “FIAs are also more complicated than stocks, bonds and mutual funds. As a result, it is very important for investors to work with a trusted advisor and a reputable insurance provider.”
Complex Insurance Products
To be clear, FIAs are not registered with the SEC or backed by the FDIC. They are insurance products backed only by the issuing insurance companies. They do not invest in equities or indexes. The performance of whatever index they are tied to is merely one factor in determining how much interest, if any, is credited to each account.
Furthermore, uncapped does not mean unlimited. The insurance companies have formulas that limit interest credits even in up markets. These formulas may factor in participation rates, spreads, margins or other measures to effectively collect from stakeholders. If a traditional FIA cap is a “hard” limit, the multifaceted, varying considerations levied on uncapped FIAs are considered “soft” limits.
“During each term, the insurer sets what’s called a participation rate,” says Ibbotson. “For example, during a three-year term, the insurer might offer a 60% uncapped participation rate on the S&P 500 index price. In a capped structure, the insurer might offer a higher participation rate but with a cap.” Perhaps a 65% participation rate with an 8% cap, he says. So if the index is up 20% on an annualized basis over that three-year period, “in an uncapped structure you would receive 12%—60% times 20%—[but] in a capped structure you would receive 8%.”
Make sure your clients understand in advance exactly what’s to be taken off the top when interest is credited. Whatever the formula, no deduction will be taken from the principal when the index is down.
Annual Variations
Whether uncapped FIAs are appropriate for a client may depend partly on one’s view of the applicable index. “They will normally outperform FIAs with caps when the equity markets are generating a very high return, and underperform in other years,” cautions Joe Heider, president of Cirrus Wealth Management in Cleveland.
Yet supporters insist that you can’t argue with success. “The use of a spread or fee, as opposed to a cap, allows well-designed FIAs to offer much greater upside potential to the client,” says Don Dady, co-founder of Annexus, a Scottsdale, Ariz.-based retirement-products developer and one of the forces behind the creation of uncapped FIAs, “and the real-world performance of our products for more than a decade has shown this to be true.”