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Five Things You Should Know About Fixed Index Annuities

Fixed Index Annuities Are Like Quicksand - Easy to Get In, Hard to Get Out

Fixed Index Annuities (FIAs) are financial products that come with their own set of potential pitfalls and complexities. It is important for anyone considering the purchase of a FIA to understand their intricate terms, conditions, and features. Fixed Index Annuities pay some of the highest commissions of any financial product, with some advisors providing buyers only the minimal required disclosures often buried in 175-page contracts

Before you make an expensive mistake, let’s review some of the basics around FIAs.

 1. A Fiduciary Advisor Can’t Sell Fixed Index Annuities

There are a couple of regulatory loopholes consumers should know about fixed index annuities. Regulation Best Interest (Reg BI) was implemented by the SEC to ensure that financial advisors act in the best interests of their clients when recommending securities. However, fixed index annuities (FIAs) are not classified as securities; they are insurance products. Because of this classification, FIAs fall outside the jurisdiction of the SEC and are regulated by state insurance departments. What this means for you:

Different Standards: Financial advisors recommending FIAs are not bound by Reg BI. Instead, they follow state regulations, which have less stringent requirements regarding disclosure and no obligation that the advisor act in the client's best interest. Advisors can recommend FIAs based on incentives like commissions rather than what’s best for you. When an advisor sells a FIA they are NOT a fiduciary!

Additionally, many advisors selling FIAs wear “two hats” – serving clients both as a fiduciary AND as a non-fiduciary insurance salesman. Being dually registered creates confusion for consumers; it can be unclear when the advisor is wearing a fiduciary hat and when they are not. Here’s what you should know:

Your advisor is a fiduciary when providing investment advice or managing investments like mutual funds under a Registered Investment Advisor (RIA) framework. 

Your advisor is NOT a fiduciary when they are selling insurance products like fixed index annuities. The standard for FIAs is that the product must be suitable, there’s no requirement that it be the best option available. This allows the advisor to recommend fixed index annuities, where commissions influence the advisor's recommendations.


2. Fixed Indexed Annuities Are Not Risk-Free

FIAs transfer investment risk to an insurance company, which can sometimes become insolvent. For instance, large insurers like Conseco and Executive Life have gone bankrupt in the past 20 years. The NC Life & Health Insurance Guaranty Association (NCIGA) offers protection up to $300,000, but anything above this amount could be at risk. Therefore, the assertion that fixed index annuities are entirely risk-free is incorrect. For example, if you bought a $1 million FIA and one year later the insurance company went belly up, you would only receive $300,000.

3. You’ll Need a PhD to Understand FIA Crediting Rates & Riders 

Buried inside a 175-page contract are details like caps, participation rates, crediting rates, investment indices and various riders. These contracts are a maze of complexity. Here’s just one example, FIA participation rates and crediting rates are related but not synonymous. Understanding your actual return (time-weighted return) can get complicated. 

Many advisors selling FIAs recommend riders, these are additional policy benefits that come at a cost. Two of the more common type of FIA riders are income riders and death benefit riders. The cost of these riders can range between 1% -1.5% for each rider. These fees lower your overall return, as they reduce the amount credited to your annuity.

We believe the more complicated an investment is, the more likely it benefits the person selling it.  

4. FIAs Aren’t Tax Friendly

Annuities offer tax-deferred growth, but distributions are taxed as ordinary income, which can be as high as 37%. Long-term capital gains from stocks or mutual funds are taxed at much lower rates, between 0% and 20%. Additionally, beneficiaries of annuities pay ordinary income tax on any gains, unlike beneficiaries of taxable brokerage accounts, which receive a step-up in cost basis resulting in your beneficiaries paying no tax!

5. Be Sure to Understand Surrender Fees, Premium Bonuses and Losing Flexibility

Some annuity providers offer premium bonuses to attract buyers, but these often come with expensive surrender penalties of up to 15% which can last 10-15 years. We recently worked with someone who invested $1.5 million in IRA funds in a FIA with another advisor (who claimed he was a fiduciary and didn’t take commissions!). After 2 years, his FIA had grown less than 3% and he decided to surrender the annuities, but he incurred surrender fees of more than $180,000. Don’t make this expensive mistake!

If your advisor touts the “free money” you’ll get from a premium bonus, ask yourself this: Why is an insurance company willing to pay me such a high bonus to invest with them? Could it be because they can likely recoup their cost through fees?

If you put your money in a FIA you lose flexibility with regard to how much and when you take money out. Most people who invest in FIAs don’t realize this until its too late! 

Fixed Index Annuities can be right for certain people in certain situations, but in our experience far too many people buy these products without fully understanding the high fees, unfavorable tax implications, and expensive penalties if they want to get out of the investment.

At Ark Royal Wealth Management we believe in complete fee transparency and will always and only serve you in fee-only fiduciary capacity. No gimmicks, no misdirection – just sound financial advice.

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