Under the Hood of Fixed Index Annuities
A fixed index annuity (FIA) is a long-term savings vehicle that offers tax-deferred potential growth that may be linked to a market index (or indices). FIAs are insurance contracts, not registered securities or stock market investments. The contract owner is never invested in the index itself. FIAs typically feature downside market protection which may make them appropriate for people who are unwilling to risk market losses. An FIA may help offset the ups and downs of equities (like mutual funds) in a retirement strategy.
How are FIAs different than fixed annuities? How does the insurance company make an FIA work?
For traditional fixed annuities, 100% of the money the company receives from a contract owner is invested in traditional investments like corporate bonds and similar conservative securities. The largest portion of the investment yield generated is used to credit the contract owner. The remainder covers acquisition and maintenance expenses and provides a profit. In a nutshell, an insurance company makes money on the spread between its investment yield and the interest it credits to contract owners.
Interest is credited on FIAs based in part on growth of an index, however the contract owner’s principal is protected against market declines. To provide for market-linked growth and principal protection, the insurance company might use a small percentage of the contract owner’s premium to purchase a call option or call spread on an index. The call contract would match up to the crediting features on the FIA. The remaining premium is invested by the insurance company in much the same way as a fixed annuity. It is important to note that the interest credit is only linked to the appreciation of the index and does not include dividends of the underlying companies.
The calls are purchased in a highly competitive bidding process among several investment banks. The best call price allows the insurance company to offer the highest crediting provisions. When the market rises, the insurance company uses 100% of the return generated from the expiring call to credit the contract owner.
For example, if the market rises 10% and the cap is 4%, the investment bank would only pay the insurance company a return that coincides with the cap rate (4%). The entire amount is used to credit the contract owner. The insurance company does not deduct any fees for the cost of the call, nor the competitive bidding process. When the corresponding index declines, the calls expire worthless, so there is nothing to pass along to the contract owner. The insurance company still absorbs 100% of the cost of the calls.
What causes FIA cap rates to fluctuate?
The two main factors are interest rates and the call option or call spread costs. Low interest rates result in tighter spreads for the insurance company and more of the premium must be allocated to cover the contractual guarantees. This, along with market volatility that often leads to higher option and spread costs, may result in lower cap rates.
The final word on FIAs
Through periods of uncertainty, many investors worry about their retirement savings being devastated. FIA owners can gain comfort in knowing that their savings are protected from downside market risk. FIAs allow contract owners to transfer all or some risk of equity loss to the insurance company, while receiving competitive pricing and earning potential they may not be able to obtain on their own.1