Anatomy of an FIA: 6 benefits to investors

There are many investment products out there, but none of them combines the features that a fixed indexed annuity does, according to Branislav Nikolić, head of insurance at The Index Standard, during a recent webinar by the National Association for Fixed Annuities.

An FIA provides six benefits to investors, Nikolić said, which are:

1. Principal protection. An FIA gives an investor the opportunity to gain more than what they can with other fixed-rate products, while protecting the investor from losses.

2. Guaranteed income. One popular way of earning income is through optional income benefits that can provide an investor with regular withdrawals either immediately or at a later date.

3. Market participation. An FIA calculates interest based on an accredited method that is linked to an index, not a performance of an index or of the market itself. But an FIA does allow an investor a certain degree of market participation that goes beyond that of other fixed annuity products.

4. Death benefit. 

5. Access to your money.

6. Tax deferral.

With all the different FIAs on the market, how does an advisor choose the best one for a client? Nikolić gave five considerations for making the right choice.

1. Issuing carrier. Consider a carrier’s financial strength, business practices, customer service, transparency, renewal rates and overall in-force experience. 

2. Index lineup. Look for diversity and robustness of index lineup, as well as the variety of trading strategies offered to provide adaptability to changing market conditions and add a layer of resilience to the overall allocation strategy within the annuity.

3. Performance considerations. Understanding the return potential of an indexed annuity is key to the planning process, as is choosing the options inside the annuity that match investors’ risk tolerance and financial goals.

4. Income. Ask what type of income the investor needs. Are they looking for guaranteed income or performance-driven income, level income or increasing income?

5. Other benefits. Look at various riders including long-term care riders.

Advisors must be prepared to answer client questions about annuities. Nikolić listed a few of the questions clients most frequently ask.

What are the different types of fixed annuities? The key difference between fixed and fixed indexed annuities, he said, is the amount of certainty a client wants when receiving interest credits. In a fixed annuity, the insurer tells you the exact interest rate you’ll get ahead of time. This means that no matter how the insurer’s investments perform, the client will be guaranteed the rate and interest credit. On the other hand, with an FIA the issuer offers a credit strategy on a given index and the rates are offered for a given period.

Where does most of the client’s money go? It goes into the insurance company’s general account and is combined with the money from different sources of insurance premium. And with that, insurers are able to pay for the promises they may make to the clients. In fixed annuities, they assure guarantees that they will return your money with some extra gains, which Nikolić described as “scooped out of the pool.”

“But because it’s like a pool of water, the insurer doesn’t necessarily keep track of which dollar was originally yours,” he added. By managing these assets together, the insurance company can make investments that most people don’t have access to. And more importantly, insurers can diversify among many different fixed income investments.

Where do the annuity interest rates come from? Nikolić said he believes there are some factors to consider in determining where annuity interest rates come from. 

“When we think about a product itself, the insurance company must think about the demographics of who is going to be buying the product, how long these people will stay in the contract, other benefits that are attached to the policy — many of the factors play into that,” he said. “When you look at the costs of providing an annuity, you think of operating expenses, computer administration systems, legal fees, distribution and sales costs, and the salaries of all the people who make all this possible. All of that must be considered. 

“The big item on this list is reserves,” he continued. “The reserving requirement is a part of the insurance regulation. It makes sure that a company can make good on its promises. The company also must include compensation for the use of its own money, the capital that’s used to back the guarantees to its clients. Bottom line: It’s not that simple.” 

What are the options and option budgets? The cost of the option contract depends on the nature of an index, which is why participation rates or cap rates can be different depending on an index. The less predictable the returns of an index, the more expensive the option contracts are, Nikolić said.

What are renewal rates? Among the things to understand about renewal rates, Nikolić said, is that these are the rates that the annuity will pay if it’s a fixed rate or will be applicable for the index strategy beyond the first term. Some annuities announce higher rates in the first year of the contract. 

He said two key reasons why these rates change over time are the interest rates that govern the annuity’s option budget and the volatility of underlying indices that govern the option prices. 

How does the insurance company make money? The simple answer, Nikolić said, is that carriers make money by providing insurance. 

“They’re in the business of providing insurance, and they make the money virtually the same way that they do for a fixed annuity and a fixed indexed annuity. In both cases, they calculate how much they need to earn in exchange for using their funds to back the guarantees to their customers,” Nikolic said. “And this is what happens when they figure out the rate for a fixed annuity or index crediting strategies they offer to their customers. They do this through buying the options contracts, they’re there to match the design of your crediting strategies. And it’s important to understand the design and everything that goes into that from index to strategy to the other guarantees involved.”

Susan Rupe is managing editor for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at [email protected].