Banks are marketing a new type product, the indexed certificate of deposit, and this is making insurance professionals wonder how their own indexed product, the fixed indexed annuity, stacks up.
Indexed CDs link their potential credited interest to the performance of an external market index such as the S&P 500. (This distinguishes them from traditional CDs, which provide a guaranteed stated interest rate each year.)
The value proposition is, indexed CDs offer the potential to exceed traditional fixed interest rates without exposing principal to market risk. In addition, if the market index does not create any interest credits, the indexed CD guarantees that depositors will get their money back as long as they hold the CD to the end of the selected term.
But FIAs also derive interest credits from the performance of an external market index. So, how do the two products compare and contrast? Here is an assessment:
What is the same?
Interest crediting method: Both products provide that, if the index rises during the measured period, the owner receives an interest credit. If the index remains level or drops during the measured period, the consumer receives no interest credits. As a result, it is possible to receive a zero earned interest in any given period.
The indexing has market appeal because it offers consumers the potential to earn more than traditional fixed interest rates without the need to take on market risk.
However, banks and insurers take different approaches on this.
Purchasers of indexed CDs agree to keep their money on deposit during the agreed upon term. The bank then lends this money to borrowers and begins earning interest on the loan.
In a traditional CD, the bank keeps a portion of this loan portfolio yield and credits the CD with a lower fixed interest rate. But with the indexed CD, the bank instead uses the interest it would have otherwise credited to the CD to purchase a call option on the chosen market index.
Note: If the market index rises, the call option becomes more valuable, allowing more interest to be credited to the product. Alternatively, if the market index falls, the call option will expire as worthless, so no interest is credited for that period.
With FIAs, however, insurance companies do not manage a commercial loan portfolio. Instead, they aggregate all policyholder premiums in their general account; they guarantee the principal and provide a statutory minimum guarantee. The minimum guarantee assures that the owner will receive more back than the original principal if the owner holds the annuity to the end of the contract. This happens regardless of the performance of the chosen index.
Within the insurance company general account, the insurer manages the assets by investing in a conservative portfolio of highly rated government bonds and investment grade corporate bonds. This generates a yield. The insurance company keeps some of this yield to pay for administrative costs and allow for a profit.
In a traditional fixed annuity, the company pays the consumer the difference expressed as a stated interest rate. In an FIA, however, the insurance company uses the interest it would have otherwise credited to the policyholder to purchase a call option–for the same reason the bank purchases call options, cited above.
If the index rises, the FIA owner receives an interest credit. If the index falls, the FIA owner receives no interest credit for that period but does keep any past interest credits as well as the principal guarantee.
Although FIAs offer many more styles of crediting methods than indexed CDs, consumers will likely view the way interest is earned in both as basically the same.
Stated terms and penalties for early withdrawal: Both products charge consumers for withdrawing money before the end of the term. Generally, indexed CDs come with 5- or 10-year terms, and charges for early withdrawals range from 5% to 10%. FIAs, on the other hand, come with 3- to 15-year terms, and early withdrawal charges can range from 5% to 15% or more–but these products do allow some withdrawals without penalty (the penalty-free withdrawal amount is generally 10% of contract value each year).
What is different between the products?
One could argue that FIA crediting methods are more valuable for consumers than are those in indexed CDs. However, since competing banks could likely match an insurance company’s crediting method, let’s assume that indexed CDs and FIAs would credit roughly the same interest rates over a given period of time.
This is where the insurance producer’s expertise will make the difference. Substantial differences exist between these products that can provide any advisor the necessary edge to fulfill many of the needs of today’s savers. Here are examples:
Liquidity: As indicated above, FIAs offer annual penalty free withdrawals to allow consumers access to a portion of the funds without being exposed to surrender charges. Indexed CDs charge a penalty of up to 10% for any withdrawals.
Minimum guarantee: In FIAs, the insurer minimum guarantee says the owner will get back more than originally deposited, no matter what happens to the index. But in indexed CDs, if the index is flat or falls in value for the product’s term, the minimum guarantee is that the owner will get back the original principal, period.
Annuitization: Generally, FIAs can be converted to a guaranteed lifetime of income through annuitization options. CDs have no such provisions.
Income planning: Many FIAs also offer optional riders that can provide lifetime income while maintaining an available contract value. Certain riders also promise to increase income by 1.5 to 2 times if the consumer becomes confined to a nursing home or suffers certain impairments. Indexed CDs can’t do this.
Nursing home and terminal illness waivers: A large percentage of FIAs also waive 100% of surrender charges for nursing home confinement or terminal illness. Again, the indexed CD comes up short.
Death benefits: Most FIAs waive all surrender charges at death. Indexed CDs will charge beneficiaries if they access the money at the death of the owner before the end of the certificate term.
Tax deferral: FIAs grow on a tax-deferred basis. This is especially important with non-qualified funds. Interest earned in an indexed CD is taxable in the year earned, whether the consumer uses those earnings or not.
Social Security preservation: Interest earned within an indexed CD becomes part of the “threshold income” calculation for Social Security benefits. This could trigger a tax on up to 85% of the Social Security benefits. Tax deferred interest in the FIA is not part of the threshold income calculation, thus potentially preserving more Social Security benefits for the recipient.
Creditor protection: Many states, but not all, have laws protecting annuity owners from creditors; no so for indexed CDs.
In sum, other types of financial institutions may mimic the indexed crediting method of FIAs. But the resulting products cannot stand in competition with the contractual guarantees, liquidity, benefits, waivers and income planning features available through today’s innovative FIA products.
W. Andrew Unkefer is president of Unkefer & Associates, Inc., a national annuity and life insurance marketing organization based in Glendale, Ariz. His e-mail address is email@example.com.