In the mid-1990s, insurance companies began to develop products to fit the space between CDs and mutual funds. Banks and brokerage companies quickly hopped on board the bandwagon by creating their own hybrid products.
Insurance companies developed the hybrid by taking the three elements of fixed annuities: safety of principal, a guaranteed fixed rate of return, and surrender/penalty charges for early withdrawal, and linking them to an external indices/stock index such as the S&P 500, creating the Fixed Index Annuity. This type of annuity can be designed for growth but not necessarily an income stream. Fixed Index Annuities (FIA) are also referred to as ratchet annuities because, like a ratchet, they can only go one way—up! So you can never lose your principal. However, hybrids usually cap your gain by setting a limit to the amount you can earn. For example, if you had invested money in an FIA with an 8 percent cap and the stock market soared to 14 percent during that year, you’d be limited to 8 percent of the 14 percent growth. This scenario assumes you are using an annual point-to-point strategy with a cap. Many different crediting strategies are available within these contracts, but this one is the easiest to understand, and the one I most
frequently recommend.
You’re probably thinking, “Well, that’s crummy. I want to earn the 14 percent.” But remember, you also can’t lose anything on a down year. So if the stock market goes down the next year, you stay at 0 percent growth and 0 percent loss.
Let’s assume you have an FIA with an 8 percent cap linked to the S&P 500, and during the course of one year, the S&P 500 increased by 10 percent; then your index annuity would credit you with an 8 percent interest rate for the year. The great thing about that 8 percent return is that it is now locked in, and you can’t lose that gain based on future stock market performance. So if you had $100,000 dollars invested in one of these hybrids, and you earned 8 percent based on the performance of the market at the end of the first contract year, you would have $108,000.
But the real power of the index annuity is displayed in years when the stock market declines. For example, let’s say in the second year of the contract, the S&P 500 fell by 10 percent. Remember, your annuity has grown to $108,000. In a year when the market declines by 10 percent, you don’t lose a penny. You don’t make anything in that year, but you don’t lose either. The hybrids are a good tool to help you fight inflation. Insurance companies offer Fixed Indexed Annuities. Banks offer equity linked CDs and brokerage companies offer indexed notes.
All these vehicles are similar because they are designed to protect your principal while giving you the opportunity to earn a rate of return greater than you might earn in a traditional fixed rate account. Of the three available, I believe the annuity version is best-suited for most retirees primarily because of the liquidity features and guaranteed returns available on the annuity versus the other instruments that are available.
In a recent study by Jack Marrion, Geoffrey VanderPal, and David Babbel from Wharton School of business, he argued that these hybrids/FIAs have performed favorably during the past ten years. Granted, the last ten years the stock market has had a bad run. But that’s precisely why these tools were created. Because we can’t begin to guess what the stock market will do, the hybrid is a way to have some upside exposure to the market while protecting
your principal.
Hybrids are an alternative to traditional fixed income/safe vehicles such as CDs or bonds, but they should not be a replacement for your equity/growth positions. As of this writing, the U.S. Federal Government has set the federal funds rate at essentially 0 percent. When interest rates begin to climb, bond holders could see a significant loss if they have to liquidate their bonds before maturity. But with an FIA, you always know the worst case position if you have to exit your contract early, whereas, with bonds you have more unknowns and more volatility. If the anticipated return for the fixed income portion of your portfolio is only somewhere between 4 and 6 percent, and if both a bond portfolio and a Fixed Indexed Annuity have performed within that range, shouldn’t you choose to use the safer of the two tools?