Uncapped Fixed-Indexed Annuities
June 1, 2018 by Ben Mattlin
In recent years, the fastest-growing area of the annuity market has been the fixed-indexed annuity (FIA). Some say the primary reason is its irresistible sales pitch.
A number of major insurers have either entered or expanded their presence in the space in recent years. Long known for its position in the variable annuity business, Prudential entered the fixed-indexed annuity market earlier this year.
FIAs allow their holders to benefit from increases in a designated index, such as the S&P 500, without the risk they’d have by investing directly in that index through a mutual fund or ETF. All annuities, of course, are insurance contracts designed for retirement; they are not securities.
But FIAs credit annuitants when an index goes up and simultaneously offer downside protection via a floor, or bottom, when the index goes down. That is, clients are guaranteed a minimum interest rate, which could be as low as 0%, that protects both the principal and any credits accrued.
This protection comes at a cost. Most FIAs have a cap, so accounts don’t get the full benefit of index increases, only a percentage.
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Lately, however, certain advisors have been recommending uncapped FIAs that remove the upper limit. But exactly when, why, how and for whom these contracts make sense gets a little more complicated.
For Those Nearing Retirement
Clients who are “approaching retirement have traditionally allocated more heavily to fixed-income products in an effort to de-risk their portfolios,” observes Roger Ibbotson, chairman and chief investment officer at Zebra Capital Management in Milford, Conn., and professor emeritus of finance at the Yale School of Management. “This approach is sound, but I am concerned that fixed-income returns will disappoint in the coming years because rates will rise, leaving retirees stressed for income.”
So Ibbotson recommends uncapped FIAs. He and his team recently completed a study that found, in part, that uncapped FIAs would have outperformed equivalent bonds on an annualized basis for the past 90 years. “In simulation, we wanted to see as fairly as possible how would today’s contracts have performed over time,” he explains. “How would they stack up against stocks and bonds? We modeled what we believed to be a generic structure—an FIA based upon the S&P 500 price index. In simulation, the FIA outperformed government bonds with comparable if not better risk characteristics.”
That’s the good news. But then things get thorny. “FIAs are longer-term investments—i.e., nine to 12 years in the accumulation phase. Although insurance companies offer liquidity during this phase, it comes at a cost,” he says. “FIAs are also more complicated than stocks, bonds and mutual funds. As a result, it is very important for investors to work with a trusted advisor and a reputable insurance provider.”
Complex Insurance Products?
To be clear, FIAs are not registered with the SEC or backed by the FDIC. They are insurance products backed only by the issuing insurance companies. They do not invest in equities or indexes. The performance of whatever index they are tied to is merely one factor in determining how much interest, if any, is credited to each account.
Furthermore, uncapped does not mean unlimited. The insurance companies have formulas that limit interest credits even in up markets. These formulas may factor in participation rates, spreads, margins or other measures to effectively collect from stakeholders. If a traditional FIA cap is a “hard” limit, the multifaceted, varying considerations levied on uncapped FIAs are considered “soft” limits.
“During each term, the insurer sets what’s called a participation rate,” says Ibbotson. “For example, during a three-year term, the insurer might offer a 60% uncapped participation rate on the S&P 500 index price. In a capped structure, the insurer might offer a higher participation rate but with a cap.” Perhaps a 65% participation rate with an 8% cap, he says. So if the index is up 20% on an annualized basis over that three-year period, “in an uncapped structure you would receive 12%—60% times 20%—[but] in a capped structure you would receive 8%.”
Make sure your clients understand in advance exactly what’s to be taken off the top when interest is credited. Whatever the formula, no deduction will be taken from the principal when the index is down.
Annual Variations
Whether uncapped FIAs are appropriate for a client may depend partly on one’s view of the applicable index. “They will normally outperform FIAs with caps when the equity markets are generating a very high return, and underperform in other years,” cautions Joe Heider, president of Cirrus Wealth Management in Cleveland.
Yet supporters insist that you can’t argue with success. “The use of a spread or fee, as opposed to a cap, allows well-designed FIAs to offer much greater upside potential to the client,” says Don Dady, co-founder of Annexus, a Scottsdale, Ariz.-based retirement-products developer and one of the forces behind the creation of uncapped FIAs, “and the real-world performance of our products for more than a decade has shown this to be true.”
Uncapped FIAs seem particularly pertinent these days with interest rates on the rise. “The recent low-rate environment has motivated more advisors to look for alternatives to bonds for a portion of clients’ retirement portfolios, and more and more advisors have been identifying uncapped FIAs as the right alternative,” says Dady. “A rising interest-rate environment reinforces the need to consider bond alternatives.”
Trade-offs
While some form of annuity may have a place in most retirement portfolios, if for no other reason than they mitigate longevity risk—i.e., the chance that clients outlive their savings—uncapped FIAs aren’t necessarily right for everyone. “There are trade-offs that clients need to understand and be comfortable with,” says Dady.
So it’s understandable that some advisors are more cautious. “Policyholders with an uncapped strategy will benefit more than policyholders with capped strategies in the years where the market goes up by 10 plus percent,” acknowledges Scott Stolz, senior vice president of the Private Client Group Investment and Wealth Solutions at Raymond James in St. Petersburg, Fla. “On the other hand, because of the spread that is deducted from the returns, policyholders with uncapped strategies will also experience more years of a 0% return than policyholders with capped strategies.”
Uncapped FIAs may be best, he says, for clients who are tempted by the stock market but wary of equity volatility. “While we never believe in positioning FIAs as an equity alternative,” Stolz says, “uncapped strategies can be a good alternative for clients that want to reduce their exposure to equities but still benefit from years where the market outperforms long-term averages.”
Maturity Counts
They are also a better fit for more mature clients. “Uncapped FIAs would be most appropriate for conservative to moderate investors that would like to have principal protection features. These clients may be approaching retirement,” says Jessica Rorar, a senior planner at ValMark Financial Group in Akron, Ohio. “These types of products would be inappropriate for younger investors who are aggressive investors. Usually, principal protection isn’t a concern for these types of investors. Also, indexed annuities don’t credit dividends. These younger, aggressive, risk-tolerant investors want to fully participate in the upside opportunity of the market, and FIAs don’t allow them to do this due to participation rates and/or spreads/caps.”
She adds that timing may be key. “Rising interest rates usually push up participation rates and/or caps of FIA products. The client may want to hold off locking into a [fixed-index annuity] until rates stabilize,” says Rorar.
Proprietary or Custom Indexes
Another important consideration is the particular index that the uncapped FIA follows. “I am a fan of uncapped FIAs that use non-proprietary indices,” says Rorar. “Some carriers market uncapped FIAs [with] proprietary indices upon which the client doesn’t know the underlying holdings.”
A similar note of caution comes from Frank O’Connor, vice president for research and outreach at the Insured Retirement Institute in Washington, D.C. “The custom indexes used in the products can be complex,” he says, “so I think it’s important that advisors are clear in explaining to clients how a custom index works and how the return would differ from the market index, or indexes, on which it is based.”
A Good Alternative for Some
For the time being, though, the consensus seems pretty positive about uncapped FIAs. “They make sense for people that are looking for fixed investments and are willing to take on the risk of underperforming other fixed investments,” says Andrew Murdoch, president of Somerset Wealth Strategies in Portland, Ore. “We feel the underperformance risk is very low in this environment. [In a] higher rate environment, we recommend the bird in hand of higher rates. But right now we like the FIA.”
And within the FIA world, Murdoch tends to favor the uncapped option. “When the market moves, it can really move,” he says. And that, he adds, is “why I personally prefer uncapped indexes.” Drilling down deeper within uncapped FIAs, he likes those with “high participation rates on low volatility indexes, or roughly 50% participation rates on the S&P 500,” he says. “They give a decent chance of beating bond funds without [the] interest rate risk.”
