Sales trends in annuities may be markedly different at the start of 2018 — less than 1.5 years away — when new Department of Labor regulations kick in regarding the way retirement investments are sold. Judging from unusually brisk sales of one particular kind of annuity — fixed indexed annuities (FIAs) — that is likely to be a good thing.
Under the new regulations, brokers will follow new fiduciary guidelines in selling select annuities and other retirement products. In the case of annuities — specifically FIAs and variable annuities — that means they will sell them only if they are truly best for particular clients, putting client needs ahead of the size of broker commissions. Too often, this isn’t the case today, and soaring sales of FIAs bang that point home.
Annuities are primarily sold, not bought. This has served the wealth management industry well enough so far, but times are changing. The new rules will increasingly force annuity brokers to act like product-agnostic fee-only financial planners — a fundamentally new approach. They will have to take buyer education more seriously, making sure clients understand why they are buying one particular annuity instead of another.
This brings us to FIAs, which have been selling like hot cakes in recent quarters during a time when overall annuity sales have been flat and variable annuity sales have been spiraling downward. In Q1 2016, FIA sales reached $15.6 billion, a 35 percent increase over Q1 2015 and the second-highest quarterly sales mark ever, according to the Insured Retirement Institute. Total Q1 2016 annuity sales, meanwhile, totaled $56.7 billion, a 7.6 percent decrease from Q1 2015.
An FIA is a fixed annuity with a variable rate of return pegged to an investment index. It can do better than a fixed annuity if the index rises appreciably, and FIAs lose no money in a year in which the market is down. In addition, FIA buyers often purchase a lifetime income rider, which means they get a respectable annual income stream regardless of how the market performs.
Some buyers know exactly what they are getting with an FIA and have decided it is best for their siutation. Many, however, don’t understand key product basics. In particular, many people falsely believe they are getting market-like returns with no risk. It’s true that they don’t have risk, but they don’t receive market-like returns either. They get only a portion of the increase in an index, which today typically as little as 25 percent.
FIA buyers should always know this, but often they don’t because brokers often don’t tell them. That’s because too many are more concerned with the high upfront FIA commission — typically 5 to 7 percent — and less concerned with serving their clients’ best interests.
Nothing is worse than not telling a client that he or she often receives only a modest portion of the increase in the index. But there are also other drawbacks to FIAs. One often overlooked point is that indices exclude dividends and so the return from an FIA will also exclude dividend income. That’s no small omission given that dividends have been a strong component of equity returns over time. In addition, most FIAs have unusually long surrender fee periods.
One telling statistic courtesy of Fidelity Investments is that over the 10-year period ended in 2015, the S&P 500 average annual return was 7.3 percent (5 percent without dividends), compared to 3.14 percent annually for a representative FIA that Fidelity chose to use for comparison purposes.
Again, some people fully understand FIA basics and embrace them. And not all FIAs are equal — a few have begun linking FIAs to 100 percent of a diversified low-volatility index, which doesn’t rise as much over time as the S&P 500 but does much better than most alternatives. What is important is that prospective FIA buyers truly go to the trouble to understand what they are actually getting from the product they’re looking at. At least until 2018.
Now that you understand the basics of FIAs, here is a brief update on the four other major types of annuities:
Variable annuities (VAs)
VA sales have been declining because a volatile stock market has scared prospective investors. But VAs are still the top sellers. They make sense for pre-retirees and retirees who want 100 percent long-term exposure to the stock market. They offer investors a relatively rich mix of subaccounts (funds) in which to invest and the option of a lifetime income rider.
If you want an annuity that is straightforward and simple (i.e., unencumbered by the likes of fees or riders), take a look at a fixed annuity. It pays more than a bank CD, offers a guaranteed interest rate and unequivocally states exactly what you will receive. The most popular type of fixed annuity is a Multi-Year Guaranteed Annuity (MYGA). MYGAs pay a guaranteed rate of interest, generally 2 percent to roughly 3 percent for three to 10 years.
Immediate annuities make the most sense for those who want to get the highest interest rates possible amid today’s record-low interest rates. Annual withdrawal rates in a typical non-immediate annuity average 4 to roughly 5 percent. By comparison, the annual payout of an immediate annuity can be as high as 10 percent, depending on the buyer’s age (the older the buyer, the higher the payout rate). And because the payout rate is derived from the tax-free principal invested in an immediate annuity as well as interest, taxes on payments are lower. The drawback of immediate annuities is that buyers sacrifice principal in exchange for higher payouts.
Deferred income annuities (DIAs)
DIAs are for people who want an annuity that offers the most for their money at some point in the future, but not today. A DIA is a high-paying immediate annuity that delays payments until the client elects to receive them years down the road. DIA withdrawals are also taxed at a lower rate. This type of annuity makes the most sense for 50 to 65 years old who are still working and don’t plan to retire for years. More so than other annuities, DIAs protect people from outliving their savings — and for less money. The drawback is uncertainty about how long you will live. You need longevity on your side to come out ahead.
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