This time the unnamed beneficiary gets zero.
Jim Lorenzen, CFP®, AIF®
The most common risk associated with all fixed-rate investments is interest rate risk. If interest rates rise—and the fed has already sent some pretty strong signals higher rates are on the way—investors could be stuck with the old lower rates, especially if the rate hikes occur during the penalty period.
This may not be a huge issue with CDs most people tend to “ladder” shorter-term CDs . Missing out on a half-point increase for six months is really an opportunity cost of 0.25%. The bigger problem, of course, is the loss of purchasing power on an after-tax basis.
Fixed annuities tend to have surrender charges with longer time spans—and therefore have a larger interest rate risk exposure. Penalty periods of five to ten years aren’t uncommon. Waiting several years through several potential rate increases can have a larger impact. The longer surrender period usually does come with higher interest crediting rates, to be sure; but, it’s worth doing the math—it’s hard to get ‘sold’ on longer terms and accompanying surrender charges when the outlook for increases is unknown. Given how long rates have been so low, a pendulum swing isn’t hard to believe. Remember, the insurance company’s annuity products purchased today will be backed by low-yielding bonds held today for most of the penalty period.
Fixed Indexed Annuities offer an opportunity for higher interest based on the performance of some outside index. Despite the fact many people choose the S&P500 index as the calculation benchmark, these products are not investments in the stock market. They are still insurance company IOUs paying a fixed rate—it’s just that the fixed rate paid each year is determined by the performance of the outside index; however, they always come with some limiting factor—usually a ‘cap’ on the amount they’ll credit or crediting based on some sort of ‘spread’ factor. Many professionals figure a fixed indexed annuity might actually return 1-2% more than it’s fixed-rate guarantee. So, one that offers a fixed rate of 4% might be expected to provide a long-term return of 5-6%; however, the return could be less. It all depends on the performance of the external index chosen, so short-terms carry more risk than long term, if history is any indication.
Remember, too, that insurance companies can change their crediting rates. Nevertheless, when you compare the expected return of an FIA to a 5-year CD, it’s still a popular alternative, providing other factors meet with your needs. Remember, however, longer-term products also mean longer-term interest rate exposure, as noted above.
Premium Bonuses, too, may not be as good as they sound. While they provide purchasing incentives, they virtually always result in lower crediting rates, further increasing interest rate risk. It may be better to seek a shorter-term product without a bonus that allows you to move to a higher rate product sooner. Why get stuck in a long-term contract?
Personal Take: Generally, whatever you want to accomplish with an annuity might be better accomplished in another way, often with greater liquidity and sometimes even better benefits. In any case, it pays to do your homework. Just as all investments can’t be good, all annuities aren’t necessarily bad. For many, the peace of mind knowing income is protected is worth the trade-off. Just remember, tax-deferred means tax postponed. Do YOU know what tax rates will be when you plan to begin taxable withdrawals? Neither do I.
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and an ACCREDITED INVESTMENT FIDUCIARY® serving private clients since 1991. Jim is Founding Principal of The Independent Financial Group, a registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.