By James I. Moore, CFP

“Are you tired of the stock market roller coaster? Protect your money from market decline while participating when the market goes up!”

“With this investment strategy, your gains will be locked in and you will never lose money!”

“How would you like to get stock market growth while keeping your principal completely safe?”

Have you ever come across an advertisement that sounded something like this? The promise does sound appealing. Who wouldn’t want their investments to only go up and never go down? This idea probably seems especially attractive when the market is falling and there is a lot of uncertainty.

So, what is the investment strategy that these advertisements are referring to? When you hear a variation of one of phrases above, there’s a good chance that it’s an ad for some type of fixed index annuity.

What is a fixed index annuity?

 An annuity is a financial product sold by an insurance company. There are different categories of annuities, such as variable annuities or fixed index annuities, but ultimately each individual product is unique because its terms are laid out in its contract.

 A fixed index annuity, sometimes called an equity index annuity, is a tax-deferred vehicle where your investment return is tied to indexes that are designed to replicate market performance. The S&P 500, Russell 2000, and MSCI EAFE are examples of indexes that might be used. These indexes are accompanied by rules specified in the contract that limit the return the annuity holder gets. The rules are typically some combination of cap rates, participation rates, or spread fees (we’ll discuss what those are below). The contract also specifies an interest floor that limits the loss an annuity holder can have over a certain period.

 So, at a high level, a fixed index annuity limits your upside and your downside. The limit to the downside is nice, but to properly evaluate the investment you have to understand and have an accurate view of just how much your upside is limited. Unfortunately, we have encountered annuity holders that had significantly underestimated how much their upside was limited. They were sold a product that sounded like it would provide stock market-like returns, but the reality of how the product was actually performing was not what they were expecting.

 To know if a fixed index annuity is appropriate for you, it is vital to read and understand the details of your contract. Here are a few things to look for:

What are the actual indexes being used?

As mentioned before, the annuity’s return is tied to various market indexes. However, somewhere in the fine print of the contract, you may see that the annuity is using a different index than what you think it is. There are usually two versions of an index, the “Total Return” (TR) index, and the “Price Return” (PR) index.

The TR index includes dividends and interest from the underlying investments. For example, the S&P 500 TR index includes the total return for the S&P 500 along with all the underlying dividends as if they were reinvested. Whenever you hear a reference to the S&P 500, it is usually this TR index that is being referenced. This is the return you would have received if you had actually been invested in the S&P 500.

However, the PR index does not include dividends and interest from the underlying investments. It may not sound like a big deal, but this difference alone could mean giving up 2-4% each year depending on the particular index.

Is there a cap rate?

Another way that the contract can limit the investment return is through a “cap rate”. This is a performance cap number that sets a maximum amount you can earn in a given period, no matter how high the index return. For example, if your cap rate is 6%, the most you can earn in that period is 6%. So, if the index is up 15%, your annuity’s return would only be 6%.

Sometimes the cap rate applies to the total period’s return (typically one year). Other times it applies to each monthly return. For example, if your monthly cap rate is 3%, the most you can earn each month is 3%. If January’s return was 10%, you’d earn 3% for that month. If February’s return was down -5%, you’d usually get the full negative 5% for that month. In this scenario, the negative month completely wipes out the return you got the previous month (3% - 5% = -2%). The guaranteed floor of 0% is usually only applied at the end of the entire period, not each monthly period.

Since upward volatility in markets is normal, these monthly caps can be especially limiting to an annuity’s performance, so make sure you understand how the caps are calculated.

Is there a participation rate?

Another way that an annuity limits the investment return is through a “participation rate”. This is percentage number that specifies how much of an index return you’ll receive. For example, if your participation rate is 50%, your actual return will be 50% of the index’s return (which if it’s a PR index, it is already only a percentage of the TR index to begin with).

For example, assume your contract stipulated that your return was tied to the S&P 500 PR index and you had a 50% participation rate. In 2021, the S&P 500 was up 28.7% (a fantastic year for large-cap stocks). However, the PR index would have only been up 26.9%. Apply the 50% participation rate, and the return you would have received would have been 13.5%.

However, the S&P 500 is not usually up 28% every year. In 2016, the S&P 500 was up 12.0% (still a better-than-average year for large-cap stocks, but much closer to the long-term average historical return). In that year, the PR index was up 9.5%. Apply the 50% participation rate, and the return you would have received would have been 4.8%.

Is there a spread fee?

Another way that an annuity can limit the investment return is through a “spread fee”. This is another percentage number that is subtracted from the index return. For example, if the contract had a 2% spread fee, the index’s return would be reduced by 2%. So, if the index went up by 6% in a given year, the interest credited would only be 4%.

Keep in mind that a contract may have more than one of these limitations (cap rate, participation rate, spread fee) in place and may use different terminology to reference them.

Is there a surrender charge?

Most annuity policies will charge you a surrender fee if you want to withdraw your money before you have owned the annuity for a specific time period. A 7 to 10 year surrender period is typical. The charge may start at 7-10% and go down 1% per year until the annuity has been held for 7 to 10 years. Unfortunately, we have also seen surrender periods even longer than 10 years.

Final thoughts

A fixed index annuity may be an appropriate option for you depending on your situation. If your financial goal is to absolutely never have your investments decline, then the principal protection offered by this product could be one way to accomplish that. However, the long-term inability to keep up with stock market returns could make it a less than ideal investment strategy in order to outpace inflation and meet your long-term financial goals.

If you have questions about an annuity that you are considering, or already own, our Fullerton financial advisory firm is happy to help you evaluate your options. Please feel free visit our website at www.eclecticassociates.com to schedule a complimentary phone call or meeting with one of our fee–only financial advisors.