Fixed annuities have taken the market by storm this year, as carriers have responded to growing client demand for financial products that provide a guaranteed level of income. Much of this growth, however, has been driven by a new crop of fixed indexed annuity products that have been designed to allow clients to participate in gains generated within the wider investment markets. While market conditions today are perceived to be relatively stable in comparison to those seen in recent years, many clients are still wary of the potential for severe losses, which has motivated carriers to develop a type of hybrid fixed indexed annuity product that allows clients greater potential for participation in market gains, while still minimizing the risk of loss.
Hybrid indexed annuities: how they work
A hybrid fixed indexed annuity — while known by a variety of names throughout the market — is essentially a type of fixed indexed annuity that ties the potential for participation in market gains to more than one index. While the traditional fixed indexed annuity bases the performance of the annuity upon one major index (usually a stock index, such as the S&P 500), the hybrid fixed indexed annuity is able to allocate the risk of loss — and maximize the potential for gain — by combining multiple indices.
Unlike directly investing in an index (or indices), the fixed indexed annuity product itself offers a cushion against investment losses in exchange for a cap on the potential for investment gains. In many cases, the hybrid products are considered to be more favorable investment products because of the fact that they allocate risk between a variety of indices, including nontraditional indices that might not otherwise be available in a standard fixed indexed annuity.
For example, in some cases the hybrid index (which is typically specific to the carrier itself) will consist of both a major stock index and a bond index. In this case, the carrier is able to maximize growth potential while hedging against the risk of loss because weight is shifted (often on a daily basis) between the stock and bond indices based on market volatility.
What to Watch For
While some hybrid fixed indexed annuity products are marketed as employing an “uncapped” indexing strategy, it is important that clients understand that this does not mean that the products allow for 100 percent participation in any market gains. In order to offer protection against downside risk, the carrier imposes a cap on the level of the client’s participation.
Often, gains are credited to the client’s contract annually — a crediting method often referred to as “annual point-to-point” — or even monthly in some cases. However, these gains may be subject to a rate cap that limits the participation to a certain percentage of market gains. In other cases, a “spread” may be used to minimize the risk to the carrier. A spread is essentially a fixed percentage that is subtracted from any gain that the indices generate within a set period. For example, a 4 percent spread would simply reduce a 10 percent gain for the year, so that the client’s account is actually credited with a 6 percent gain.
Essentially, it is important for clients to realize that the potential for growth in these relatively new indexed annuities is not unlimited and that it is important to read the fine print in order to determine the particular limitations that do apply.
Fixed annuity products are trending generally because of the guarantees they offer, but for the client who is interested in participating in market gains with the potential for allocating risk between a variety of traditional and non-traditional indices, the new crop of hybrid fixed indexed products might provide the right fit.
For previous coverage of developments surrounding indexed annuities in Advisor’s Journal, see Indexed Annuities: A Swiftly Tilting Product Class.