Are annuities an “investment,” and that too an ideal one? Eh. You might probably be mis-selling the product or simply don’t know enough about good investments – you may say.
The general notion of the market is that annuities are probably low-return products and, often, only benefit the entity (intermediary) that sells them. Further, with the rise of finfluencers (financial influencers on social media), there is a new wave of pushing “long-term” investments like stocks, crypto, real estate, gold, or even fraudulent Ponzi schemes in your portfolio. This is wrong on many levels. Traditional products like annuities have a very specific and important use case, and with the increased competition among annuity providers, annuities have become more lucrative than ever.
“Long-term” Investments
“Long-term” investment, by definition, means a strategy that involves putting money into avenues with the expectation of generating positive returns over an extended period of time, usually several years or more. Stocks, real estate, bonds, etc., are a few of the most popular “long-term” investments. Probably, no one ever counts annuities as an investment, leave alone “long-term.” But one thing that they don’t tell you is how long is a long term. It’s because no one really knows!
Let’s now shift gears and move to “longest” term investments. One thing that we definitely know is that the “longest” term is the term that you live. So, what are the best longest-term investments? Reiterating our original definition, we can define longest-term investments as a strategy that involves putting money into avenues with the expectation of generating positive returns over a lifetime. Let’s figure out what makes an ideal longest-term investment and which plans for retirement.
Ideally, there are four critical requirements that are very important in retirement planning:
- Protection of Capital
- Growth of Capital
- Legacy Corpus
- Long-term Care
Now, let’s compare different asset classes to assess which investment can prove to be the best longest-term investment and, at the same time, an ideal one to plan for retirement.
| Stocks | Real Estate | Bonds | Annuities | Crypto | |
| Protection of Capital | ❌ | ❌ | ✅✅✅ | ✅✅✅✅ | ❌ |
| Potential Growth of Capital | ✅✅✅✅✅ | ✅✅✅✅ | ✅✅✅ | ✅✅ | ✅✅✅✅ |
| Liquidity | ✅✅✅✅ | ❌ | ✅✅✅ | ✅✅ | ❌ |
| Legacy Corpus | ✅✅✅ | ✅✅✅✅ | ✅✅✅ | ✅✅✅ | ❌ |
| Long-term Care | ❌ | ❌ | ❌ | ✅✅✅✅ | ❌ |
| Lifetime Income | ❌ | ❌ | ❌ | ✅✅✅✅ | ❌ |
| Tax Deferral Benefits | 𑁋 | 𑁋 | 𑁋 | ✅✅✅ | ❌ |
From the above table, we can come to the point that annuities are an ideal “Investment” when it comes to investing for a lifetime. No other asset class comes close to an annuity when we talk about how many features an investment covers.
In the technical sense, an annuity is insurance and not an investment. They say that you should never mix insurance with investment, but in specific cases, such as planning for retirement, it might be a good option to do so. The only two things in which annuities fall behind other asset classes are 1) Growth Potential and 2) Liquidity. Obviously, it is not possible to have the best of all worlds, but we will still see how we can even make up for growth and liquidity by choosing the right type of annuity.
The Right Type of Annuity
Annuties are of different types, from immediate to deferred and from fixed to variable. You can learn about different types of annuities in a blog we wrote earlier. In a separate blog, we also wrote about how to choose an ideal type of annuity for yourself. But, this article will particularly focus on Fixed Indexed Annuities, where I will be making a case to see if they can prove to be an ideal longest-term investment. If you don’t already know about Fixed Indexed Annuities, let’s quickly have a refresher.
Fixed Indexed Annuity
Fixed indexed annuities (FIAs) have become an increasingly popular option for those saving for retirement. These annuities provide a unique combination of potential growth and protection from market downturns, making them an attractive option for those looking to secure their financial future.
When investing in traditional stock market-based retirement products, such as mutual funds or individual stocks, it’s possible to lose money if the market performs poorly. This risk can be especially pronounced for those nearing or in retirement, as a significant downturn in the market can have a significant impact on their retirement savings. With an FIA, the investor is protected from this downside risk, as their principal investment is guaranteed by the insurance company issuing the annuity.
One of the primary advantages of FIAs is that they offer the potential for growth while also providing a measure of safety. The growth of an FIA is tied to the performance of a market index, such as the S&P 500, rather than being directly invested in the market. This means that the value of the annuity can rise in line with the market, but it also means that the investor is protected from the downside of market crashes.
It’s also worth mentioning that FIAs provide tax-deferred growth, which can be a significant benefit for those saving for retirement. By deferring taxes on the growth of their investment until they begin to withdraw their funds in retirement, investors can potentially accumulate more savings than they would with a taxable investment.
Growth and Liquidity
Let’s now address the elephant in the room! The two areas in which annuities are considered to lag a lot, in comparison to popular asset classes such as stocks, are growth and liquidity.
It is true and obvious that an annuity does not have as much growth opportunity as stocks (less the risk, less the return), but it is also true that if you do proper research and choose the right fixed indexed annuities, you can still earn a decent income on your annuity.
Now, as we have discussed earlier, a fixed indexed annuity has no downside and an opportunity to earn market return. This is made possible by limiting the upside potential of market return by using limitations like Cap rates, participation rates, spreads, performance-trigger, volatility control, etc. Let’s quickly go through these terms again:
- Participation Rate (PR): Participation rate describes the annuitant’s participation percentage in a return of an index. For example, suppose the participation rate is 150%, and the index returned 4% over the agreed time. In that case, the annuitant will be eligible for 150% of the return, i.e., 6%. A higher participation rate benefits the annuitant.
- Cap Rates: It means at what rate your interest-earning capacity is capped. For example, if an index returned 12% but the contract’s cap rate is 6%. In this situation, the annuitant will be eligible for an interest credit of 6% only. It doesn’t matter how much the index goes above the cap rate; the maximum interest that can be earned is the cap rate. A higher cap rate benefits the annuitant.
- Spread: The amount of interest that the Company will credit is based on a declared spread on the selected index on an annual point-to-point basis. Once the index gain is determined (if any), the spread amount is subtracted. The remaining amount is what is credited to the contract for that term. For example, if the chosen index returned 10% in a year, but your strategy has a 4% spread, then you will get only 6% (10% – 4%) credited to your annuity account. A lower cap rate benefits the annuitant.
- Performance-Trigerred Index Option with Declared Rate: A flat or positive index return triggers the declared interest rate to be credited to the contract value. If the index return is negative, no interest is credited, but there will be no loss, and the contract value will remain the same. Suppose the change in the value of the index during that one year is zero or positive. In that case, the declared index gain interest rate is multiplied by the option’s account value to determine the index interest credits. The index interest credits pursuant to this option will never be less than zero.
Generally, the declared interest rate is set at contract issue and applies for the entire withdrawal charge period. For example, if the performance-triggered rate for the S&P 500 Index is 8.00%, it means that if S&P Index doesn’t go negative for a given 1-year period (even if the growth is 0% and not negative), the interest credited will be 8.00% irrespective of the S&P 500 actual return. A higher performance-triggered declared rate benefits the annuitant.
- Fixed Account Rate: If you opt for a fixed account rate, you simply earn the fixed rates for a particular period specified by the company before your policy begins. These rates usually tend to be low/at par as compared to other fixed avenues, such as CDs and MYGAs, so you should avoid fixed rates in a general scenario.
Now, it is not possible to match the return of stocks with these limiting factors in place, but you, as an annuitant, can perform basic due diligence to buy an annuity that offers the following:
| Limiting Factors | Favourable for Annuitant |
| Participation Rates | High |
| Cap Rates | High |
| Spreads | Low |
| Performance Triggered Declared Rates | High |
| Fixed Account Rates | High |
If you do your research well, it is possible that you may even get stock-like upside (with zero downsides intact). In some cases, you might even earn better returns than the stock market.
- Stock market-like returns – If you choose an indexing strategy that offers a high cap rate, it is possible that you might earn an almost stock-like return. For example, we recently did a review of the Lincoln Optiblend Fixed Indexed Annuity, an annuity that offers (at the time of review) a cap rate of 10.25% on the S&P 500 Index. It’s a known fact that, on average, the S&P 500 has returned over 10.60% annually, since it was incepted. Now, our example annuity with a high cap rate (10.25%) would have allowed you to earn almost as much return as S&P 500 index without facing any downside risk.
Although, you must clearly know that these companies are very smart. Your gain is their loss. So, they keep changing these rates to ensure that they win most of the time. Still, with some proper research and keeping yourself updated about the latest rates (most annuity companies do publish updated rates on their website regularly), you can try to extract the most out of your annuity.
- Better than stock market returns – In some cases, you can earn better returns than the stock market without having any downside risk. Some strategies that offer high performance-triggered declared rates can be used to achieve this. Again taking the example of the Lincoln Optiblend FIA, it is currently offering a 1-year performance-triggered rate of 9.25%. This is a very specific use case. Suppose the S&P 500 performed very bland in a particular year but just managed to be in green (very low return, but not negative), with a performance-triggered rate of 9.25% is very lucrative, beating the market return by many folds!
Besides the rates and costs, it is also important that you select the right index, right crediting strategy, riders, etc., to extract the best returns possible. The below table summarises what things you should take care of while choosing the variable factors while purchasing your annuity.
| Things to take care of | Recommended practice |
| Index Choice | Popular index like S&P 500, Russell Mid-cap, Dow Jones, etc. |
| Index Type | Market Index – Should NOT have a volatility control mechanism. Generally, you should avoid going with the indexes that are made specifically for that annuity. A rule of thumb, in case you don’t know much about indexes, is to go only with known and popular indexes, without any volatility control mechanism |
| Crediting Strategy | Point-to-point strategies are my preferred out of all |
| Riders | You should study the rider very carefully. Some riders just add to the cost and do not provide any material benefit, while some riders are extremely recommended to have |
To sum up, if you carefully select your indexing and interest crediting strategy, it is possible that you might earn decent returns (similar to market-like returns) or, in some cases, even better. You should always keep in mind that the index you select should be a popular index like the S&P 500, Russell Small-cap, Dow Jones, etc. You should almost never select an index that has a volatility control mechanism in place. They say that the volatility control mechanism reduces volatility, and hence both downside and upside get limited, but, as a Fixed Indexed Annuity investor, you already have your downside covered. So for you, it only limits the upside.
Coming to liquidity, this is something that you definitely cannot match with stocks, but you can still optimize your annuity in such a way that you have access to funds most of the time you require it. Most of the annuities are RMD friendly, offer 10% free withdrawals each year, and offer 100% free withdrawals in cases like terminal illness, nursing home, etc. It is not as liquid as stocks, but this is somewhere you need to settle for less. Although low liquidity allows you to keep a check on your spending; for emergency cases, there are certain provisions that will anyway help you to access your money.
You can research popular annuities on the web. We also regularly keep doing annuity product reviews on our website. If you want to have a particular annuity review, please let us know in the comments.
Conclusion
In conclusion, fixed indexed annuities offers a unique combination of potential growth and protection from market downturns, making them an attractive option for those saving for retirement. While they are not without their drawbacks, they offer the potential for higher returns compared to traditional fixed annuities, a measure of stability and predictability in retirement planning, and tax-deferred growth. As with any investment, it’s important to carefully consider your individual financial situation and to consult with a financial advisor before making a decision.
