You’ve probably never heard anyone complain about their pension. That’s because it provides the certainty of knowing how much income they will receive and that it will last as long as they do. That kind of certainty is very difficult to replicate, which is what makes annuities so attractive.
Fixed Indexed Annuities: A Better Way?
Historically, the pension replacement solution was addressed with single premium immediate annuities (SPIAs), which offered the singular promise of providing a guaranteed income for life. However, because interest rates are still hovering near their historic lows, SPIA payouts, which are locked in for the life of the annuitant, are also low. That’s why an increasing number of advisors are turning to fixed indexed annuities (FIA) for generating guaranteed lifetime income. The unique interest crediting and income guarantee features of FIAs not only improve on the rigidity of SPIAs, they can outperform the traditional pension plan while offering more control and flexibility.
In the past, FIAs have been criticized by advisors as being too limiting in terms of their returns. The interest credited on FIAs is based on participation in the growth of a stock market index, but it is capped by the insurer. While the S&P 500 may gain 30% in an annual period, a typical FIA might only credit 3 to 5%. However, should the index decline in value, FIAs will credit a minimum interest of between 0 and 31%. For an increasing number of retirees, that is fine with them. The possibility of earning a return two to three times the rate of a Treasury bond, four to five times the rate of a CD, without any downside risk is more than acceptable to conservative investors who have experienced more than enough volatility in their retirement portfolios.
How an FIA Can Be a Pension Alternative
Less appreciated about FIAs is their unique capacity to generate a guaranteed lifetime income while still providing access to excess values in the contract. Many FIAs are now structured with two account values – Actual Value (also known as the accumulation account) and an Income Benefit Base Value. Understanding the difference between the two is important to understanding the true value of an FIA as an income vehicle.
When investing a lump-sum in an FIA, investors can allocate it between a guaranteed fixed allocation and an index allocation. In most contracts, the allocation percentage can be changed on the contract anniversary. The index allocation generates interest based on participation in an index fund, typically the S&P 500 index. There are different ways the interest amount is calculated, but, whether it is calculated on a monthly basis or an annual point-to-point, once it is credited, the gains are locked in. The actual value of an FIA can only increase, never decrease. As with most annuity contracts, the actual value account is accessible by the investor through withdrawals. Withdrawals of more than 10% of the actual value made prior to the end of the surrender period will be charged a surrender fee.
Income Benefit Base Value
The income benefit base value is often described as an insurance value, which is used to determine the amount of income you can take at a future date. Each year an annual interest rate is credited to the income benefit base (also referred to as a “roll-up”) regardless of the performance of the actual value account. It ensures that, even if the growth of the actual account is lower than the roll-up, the income benefit base continues to grow.
When combined with a lifetime income rider, the guaranteed annual income can be calculated to the penny, based on the age of the annuitant and the time frame between the initial deposit and when the income begins. If, at the time of the income calculation, the actual value is higher than the income benefit base value, the actual value is used; otherwise, the income benefit base value is used.
The big difference between income generation of an FIA and a SPIA is that the income from an FIA is not annuitization. When an SPIA is annuitized, the capital is unavailable to the annuitant. With an FIA, the investor maintains access to his capital. However, any withdrawals from the actual value account may affect the payout of guaranteed income.
While an FIA offers the best of all worlds to retirees looking for certainty along with some upside, it takes a lot of moving parts to accomplish it. FIAs are very difficult to explain, much less understand. However, for financial advisors serving risk-adverse clients who value peace-of-mind over all else, they can be the ultimate pension replacement solution most retirees are looking for.