Fixed Indexed Annuities (FIA)

What is a fixed indexed annuity

A fixed indexed annuity is a long-term contract between a consumer and a life insurance carrier. The consumer pays a premium, often a lump sum but sometimes a series of payments, and in exchange the carrier promises to credit interest tied to an external market index. The index is used as a measuring stick. The consumer does not own the underlying index or any of its securities.

The defining feature of an FIA is asymmetry. Positive index movement is shared with the contract owner up to a contractual limit. Negative index movement does not reduce the contract's principal value. The contract owner is exposed to the upside, capped or scaled, and protected on the downside.

FIAs are regulated as insurance products at the state level by each state's department of insurance. They are not securities. They do not have prospectuses in the SEC sense, but each carrier publishes a product brochure and a statement of understanding that disclose the contract terms.

How interest is credited

Interest credits happen at the end of each crediting period, often one year, sometimes two, three, five, or six. The carrier measures the change in the chosen index over the period, applies the contract's caps and participation rates, and credits that amount to the contract value. If the index is flat or negative, the contract is credited zero. Principal is not reduced by negative index performance.

The new contract value at the end of the period becomes the floor for the next period. This is sometimes called the annual reset feature. Once interest is credited, that gain is locked in for the rest of the contract.

Cap rate, participation rate, floor, spread

Four contract variables determine how much of the index movement is shared with the owner.

Cap rate

The cap is the maximum interest credited in a given period. If the index gains 15% and the cap is 8%, the contract is credited 8%. Cap rates are set at issue and can change at the start of each crediting period under the terms of the contract. Cap rates are declared annually by the carrier within the renewal range disclosed at issue.

Participation rate

The participation rate is the percentage of the index movement that is shared with the contract. If the index gains 15% and the participation rate is 60%, the contract is credited 9%, which is 15% multiplied by 60%. Some contracts apply only a cap. Some apply only a participation rate. Some apply both: a participation rate followed by a cap.

Floor

The floor is the minimum interest credit in a period. For most FIAs the floor is 0%. The floor is the contractual protection against market loss. A negative index period results in zero credited interest, not a negative credit.

Spread (also called margin or asset fee)

The spread is an annual deduction applied to the credited interest before any cap is reached. If the index gains 15% and the spread is 3% with no cap and 100% participation, the contract is credited 12%, which is 15% minus 3%. Spreads are more common on products that use participation rates without caps. The spread reduces the effective participation in upside.

Crediting methods

The crediting method defines how the index movement is measured over the period. Different methods produce different outcomes from the same index path.

Annual point-to-point

The index value on the first day of the period is compared to the index value on the last day. The difference is the index return. Caps, participation rates, and spreads are applied to that return. This is the most common method.

Monthly point-to-point (monthly sum)

Each monthly change in the index is recorded, with each month subject to a monthly cap, typically 1% to 3%. At the end of the year, the twelve monthly results are summed. Positive months are limited by the cap. Negative months are recorded in full. This method can credit zero or near zero in volatile years, even when the year-end index level is higher than the start.

Monthly average

The carrier records the index value on twelve specified dates throughout the period, calculates the average, and compares the average to the starting value. The result is then subject to participation rate or spread. This method tends to dampen both gains and losses relative to point-to-point.

Performance-triggered (fixed-rate strategy)

Some FIAs include a strategy that credits a fixed declared rate, for example 4%, if the index is flat or positive over the period, and 0% if the index is negative. The contract owner does not benefit from large index gains but is rewarded with a guaranteed rate as long as the index does not decline.

Fees and charges

A base FIA without optional riders typically has no explicit annual fee deducted from the contract value. The carrier compensates itself through the spread between the index option costs and the premium yield on the underlying portfolio. From the consumer's perspective, the cost of the FIA is reflected in the level of caps, participation rates, and spreads, not in a stated fee.

Riders carry explicit annual fees, typically expressed as a percentage of the contract value or the benefit base. Common rider fees range from 0.95% to 1.50% annually. Rider fees are deducted from the contract value every year regardless of index performance.

Surrender charges and market value adjustments are explained in the next section.

Surrender schedule and liquidity

Every FIA has a surrender schedule. A surrender is a withdrawal of contract value beyond the free withdrawal amount during a defined period. The surrender charge declines each year and reaches 0% at the end of the surrender period.

Most FIAs include a free withdrawal provision allowing 10% of the contract value to be withdrawn each year without a surrender charge, beginning in year 2.

A market value adjustment (MVA) may apply on surrenders during the surrender period. The MVA increases or decreases the surrender proceeds based on the change in interest rates since the contract was issued. If interest rates have risen, the MVA reduces the surrender value. If interest rates have fallen, the MVA increases the surrender value.

Optional riders

Guaranteed lifetime withdrawal benefit (GLWB)

A GLWB rider guarantees a stream of income payments for life, even if the contract value reaches zero. The rider tracks a separate "benefit base" that grows by a contractually defined roll-up rate during the deferral period. Once income begins, the carrier pays a percentage of the benefit base each year for life. GLWB rider fees are typically 0.95% to 1.30% of the benefit base annually.

Enhanced death benefit rider

The base FIA pays the contract value (or a return of premium if larger) to beneficiaries at death. An enhanced death benefit rider increases the death benefit, typically by applying a roll-up rate or stepped-up benefit base. Fees range from 0.50% to 1.00% annually.

Long-term care rider

Some FIAs include a rider that doubles or triples the income or withdrawal allowance if the contract owner is confined to a nursing facility or unable to perform two activities of daily living. These riders typically require a waiting period and medical underwriting at claim.

Bonus features

Some FIAs offer a premium bonus, a credit added to the contract value at issue, commonly 4% to 10%. Bonus features generally come with longer surrender periods and lower caps or participation rates. The bonus is also typically subject to a vesting schedule.

Tax treatment

FIAs are tax-deferred. Interest credited to a non-qualified FIA is not taxable until withdrawn. When withdrawn, the gain is taxed as ordinary income, not as long-term capital gains. Withdrawals before age 59½ may be subject to a 10% federal tax penalty in addition to ordinary income tax.

FIAs can be funded with qualified money such as IRA, 401(k), or 403(b) rollovers, or with non-qualified after-tax money. Qualified FIAs are subject to required minimum distribution (RMD) rules starting at the age set by current IRS regulations.

The tax treatment of withdrawals differs between qualified and non-qualified contracts:

• Non-qualified contracts: LIFO ordering. Earnings come out first and are fully taxable. The basis (original after-tax premium) comes out after all earnings have been withdrawn.
• Qualified contracts: Standard IRA rules. All withdrawals are taxable as ordinary income.

When a fixed indexed annuity fits

An FIA may be appropriate when several of the following conditions apply:

• The contract owner has retirement assets that should not be exposed to market losses during the next 5 to 15 years.
• The contract owner wants higher potential growth than a fixed-rate vehicle (MYGA, CD, Treasury) while keeping principal protection.
• The contract owner is willing to accept liquidity constraints during the surrender period in exchange for the protection feature.
• The contract owner is funding a retirement income strategy and wants the option to add a lifetime income rider.
• The contract owner does not need access to more than the free withdrawal allowance, typically 10% per year.

When a fixed indexed annuity does not fit

An FIA is rarely a good match when any of the following are true:

• The contract owner may need full access to the principal during the surrender period.
• The contract owner expects to outperform the FIA by accepting full market exposure and is comfortable with downside risk.
• The contract owner's time horizon is shorter than the surrender period.
• The contract owner does not understand the crediting method, caps, participation rates, and surrender mechanics.
• The contract owner is being sold an FIA as a primary growth vehicle for assets that should remain liquid.

Compared to MYGA, SPIA, variable annuities

Cross-reference: MYGA, SPIA, Variable annuities.

Frequently asked questions

Can a fixed indexed annuity lose money?

The contract value cannot decline due to negative index performance because the floor is 0%. However, the contract value can decline due to rider fees deducted annually, withdrawals beyond the free withdrawal allowance during the surrender period (which trigger surrender charges), or a market value adjustment on surrender if interest rates have risen since issue. The principal protection feature applies specifically to market loss, not to all forms of withdrawal cost.

What index do most FIAs track?

The S&P 500 (price return, excluding dividends) is the most common reference index. Many FIAs also offer proprietary or volatility-controlled indexes designed and licensed by index providers such as S&P, Bloomberg, or Nasdaq. Volatility-controlled indexes typically come with uncapped participation rates and longer participation periods.

How is the cap rate set?

The carrier purchases options on the chosen index to finance the upside. The cost of those options is funded by the carrier's portfolio yield. When interest rates rise, the carrier's portfolio yield increases, allowing higher caps. When rates fall, caps decrease. Caps are declared at the start of each crediting period and disclosed in the renewal range at issue.

Is an FIA the same as an equity-indexed annuity?

Yes. The product was originally called an equity-indexed annuity and was renamed to fixed indexed annuity to clarify that the contract is regulated as a fixed insurance product, not as a security.

Can the carrier change the cap rate after issue?

Yes, within the limits stated in the contract. Every FIA discloses a renewal range, the maximum and minimum cap rate the carrier can set in future periods. The carrier may declare a new cap each crediting period but cannot exceed the contractual range.

Sources

• National Association of Insurance Commissioners
• NAIC Annuity Consumer Information
• Federal Reserve Economic Data (FRED)
• S&P Dow Jones Indices, S&P 500 historical performance data
• Individual carrier product brochures, statements of understanding, and rate cards (cited on each carrier and product page)
• A.M. Best Financial Strength Ratings

Related

• FIA Cap Rate Simulator, model 10-year outcomes using historical S&P data
• Glossary: Cap Rate
• Glossary: Participation Rate
• Glossary: Surrender Charge
• Glossary: GLWB rider
• Independent product reviews, factual breakdowns of named FIA products