What You Should Know About Choosing The Right Fixed Index Annuity

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With more and more people looking for safe money alternatives, it is no wonder the sales of fixed index annuities (FIAs) have increased from $2.99 billion in 1997 to over $14 billion in 2003.

The upside potential and downside protection of FIAs is particularly appealing to bear-bitten clients who are looking to restore nest eggs but are not willing to risk the entire amount on another bad market.

The question is, with so many complicated FIA product designs on the market, how does an advisor choose the product that is the right fit for the client?

A good place to start the selection process is to understand the 5 parts of the typical FIA product. They include: the index participation rate; the crediting method; the margin or yield spread; the cap; and the annuitization feature. While there are certainly other factors to consider, these 5 can provide the foundation that helps cut through the FIA product clutter.

Here are some highlights on each part:

Index Participation Rate: The index participation rate, or IPR, is the percentage of any index gains that a FIA may receive. For example, if the FIAs index participation rate was 60%, the FIA would benefit from 60% of the indexs increase. Using a 60% IPR, if the index increases by 15%, the FIA hypothetically would benefit from 9% of the gain. Example: index gain x IPR = FIA credited interest; or (15% index gain x 60% IPR = 9%). Many FIA companies guarantee that this rate will never change during the FIAs contract term. If the IPR is not guaranteed through the term, the IPR could be reset at a lower rate.

Crediting Method: The crediting method is how the FIA calculates the interest credited to the policy. Currently, over 40 different crediting methods are being offered by FIA carriers. What follows are descriptions of some of the more popular ones:

Term End Point-to-Point: This compares the change in the index used to credit the interest from a beginning point, such as the beginning of the contract term, to an ending point, such as the end of its term. Point-to-Point may work best when the index to which it links is increasing, since it can benefit from a lower beginning and higher ending point. Also, a company offering a FIA employing this method may offer a higher IPR or higher cap due to more efficient pricing of the financial instruments used which determine IPRs and caps.

Annual Reset: This compares the change in the index from the beginning to the end of each year of the FIA term. Any return is then “locked in” and the beginning index value is reset for the following year. Annual reset products may work best when the linked index experiences volatile “up and down” years during a term, since the FIA can take advantage of starting over each year on its anniversary.

Index Averaging: Often simply called Averaging, this approach averages the indexs value on a daily, weekly or monthly basis, rather than using the actual value of the index on a specified date. Such averaging can help even out volatility and dramatic declines in index-linked interest, or it may reduce the amount of the interest credited to the FIA because it also evens out increases.

Margin and Yield Spread: Some FIAs charge an asset fee, often called a margin or yield spread. If the FIA does include one of these features, it is normally expressed as a percentage, and this percentage is subtracted from any gain in the index linked to the FIA. Hence, if the index gained 15% and the yield spread was 6%, then the interest credited to the FIA would be 9%. Example: index gain yield spread = FIA credited interest; or (15% – 6% = 9%). This can be particularly detrimental to returns if the index gains are low. For example, if the index gained 6% and the yield spread was 6%, then the interest credited to the FIA would be 0%.

Cap: Many FIAs employ what is known as a cap, or a maximum interest rate that can be credited to an FIA in a policy year, or over its entire term. For example, if the index linked to the FIA gained 11% (after any applicable averaging), and the cap rate is 9%, then the gain credited to the FIA would be 9%. Often, an insurance company will offer higher participation, such as 100% IPR, when it includes a cap. Caps were developed because many clients prefer a method employing a 100% IPR and a cap, vs. an IPR of less than 100% without a cap.

Annuitization: As readers of National Underwriter know, annuitization is the process of converting an annuity into a guaranteed income stream for life. This is one way an annuity can be distributed to a fixed index annuity owner when its term ends.

In FIAs as with other annuity types, different annuitization options exist, as well as other distribution choices, including systematic withdrawals and cash lump sums. A few annuity companies offer first-year bonuses and other benefits that are contingent on policyholders having to annuitize the FIA.

On behalf of their clients, producers should take care to understand whether the client must annuitize the FIA, as opposed to being allowed to select one of the other distribution options, in order to receive the benefits promised by the issuing company. Clients will want to know that. Clients also should understand that earnings are taxable as ordinary income when distributed, and if taken before age 59 1/2, may be subject to a 10% federal tax penalty.

Recognizing each part of the fixed index annuity, and asking the right questions about each product offering, can give producers a leg up on differentiating one FIA product from the next. The final part of the equation is making sure the upside potential and downside protection of an FIA is the right fit for the clients portfolio.

is vice president-marketing strategy at Jackson National Life Distributors Inc., Denver, Colo. Her e-mail address is kristen.billows@jnli.com.


Reproduced from National Underwriter Edition, February 25, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.