David Alison, CFP®, Certified Financial Fiduciary®, EA, dives into the innerworkings of fixed indexed annuities to provide an understanding of the impact of today’s volatile interest rates and marketing volatility on these products yield potential. His analysis provides a comparison of today’s yields between common fixed-income vehicles as well as income considerations and strategies for using FIAs in the best interest of clients.
Fixed indexed annuities have had explosive growth over the past decade. Academics, financial institutions, financial planners, and investment advisors have expanded the application of these products, which were once just seen as something “sold by insurance salespeople,” to become a valuable tool within a holistic financial plan. Even economist Roger Ibbotson, a 10-time recipient of the Graham and Dodd Award for financial research excellence and professor emeritus at the Yale School of Management, unveiled recent research analyzing the emerging potential of fixed index annuities as a bond alternative in retirement portfolios. However, the ability to objectively evaluate these products has been a challenge
The Mechanics of Fixed Indexed Annuities: Interest Rates & Option Costs
To understand how to evaluate these products, we must first understand the mechanics of how these products are designed. For every dollar of indexed annuity premium, the majority is used to support the product’s minimum interest guarantee. This minimum guarantee is the anchor that helps classify the product as a fixed annuity and supports one of the main reasons that clients purchase these products, and that is safety. The minimum guaranteed interest rate is established by the NAIC, the National Association of Insurance Commissioners. They have the ability to increase or decrease the rate, and carriers have to adjust accordingly.
The current economic environment we’re facing has been challenging for all fixed-income investments, and annuities are certainly not immune. If we remain in a very low-interest-rate environment like we are in right now, the NAIC might lower the minimum guaranteed interest rate. For an indexed annuity, this would potentially allow the insurance company to lower the MGIR on their products, ultimately freeing up more of the insurance company’s portfolio yield to help cover expenses and potentially allocate more money to the options budget. The more money allocated to the options budget, the more options they can buy. The more options they can buy, the higher the caps and the rates to your client.
Now, as with any fixed annuity, the funds used to back these guarantees are invested in bonds and other long-term instruments to generate a yield. The funds are part of the insurance company’s general account, and the policy owner does not have any interest in the underlying investments. This is a big reason that these products are fixed insurance products and not securities.
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