Inflation eats into our purchasing power. It’s the reason why Social Security benefits are eligible for an annual cost-of-living adjustment, and many immediate annuities offer similar provisions. The intent is to help retirees maintain their standard of living despite changing economic conditions.
As individuals plan for retirement, they’re tasked with adopting accumulation and distribution strategies that will provide sustained income for increasingly longer periods of time as health care improves and longevity increases. The likelihood of facing a diminished standard of living often increases as retirement draws nears and risk tolerance goes down. Many retirees favor investment options that offer lower risk profiles, but also lower return potential.
But retirees don’t have as many options to chase yield as they used to. Looking back over the last 50 years, 10-year U.S. Treasury yields averaged roughly 6%, making CDs and other fixed-interest investments viable options to help accumulate retirement assets.
But currently? The yield is just 2.04%. With inflation surging to 7.5% in January, it’s easy to see that the conservative assets retirees turned to for a combination of protection and asset accumulation aren’t currently able to provide the kind of growth needed, particularly for a lengthy retirement.
That’s why fixed indexed annuities (FIAs) have become more popular in recent years. FIAs feature a 0% floor on returns, so retirees typically can only lose assets in these products as a result of fees, not market forces. But with their growth tied to market indices, FIAs have the potential to provide higher returns than traditional low-risk or fixed investments like CDs.
We don’t know what inflation will look like in the future. But with inflation currently at levels we haven’t seen in decades, it’s worth asking whether FIAs are capable of outpacing inflation and offering the growth retirees need. Answering that question requires a basic understanding of how these products credit interest to a retiree’s contract.
The returns
Many FIA contracts have return caps that limit the amount of growth that can be applied to the contract value in a given period. Let’s say an FIA credits interest annually based on the performance of the S&P 500 Index and features a 5% return cap. If the S&P 500 grows by 10% in a given year, the FIA contract value will still only grow by 5%.
Another common limiter is a participation rate, or the percent of index growth that’s applied to the contract in a specific period of time. If an FIA allocation option has an annual participation rate of 50%, then half the index’s growth will be applied to the contract. In this case, if the S&P 500 increases by 12%, the FIA contract will increase by 6%.
Any FIA allocation option could be subject to a return cap, a participation rate or both. When an allocation option uses a return cap, the participation rate is typically 100%. As of January, when inflation was at 7.5%, the average return cap for the 10 best-selling FIA products utilizing the S&P 500 Index was just under 4%. Meanwhile, annual S&P 500 returns for 2021 exceeded 25%. During a period of particularly high inflation, the most popular FIA products on the market weren’t capable of outpacing inflation and captured less than a fifth of the index’s growth.
Many FIA products offer allocation options that have no return cap and a lower participation rate. In other words, a lower participation rate allows for a higher return cap. But what impact does the interaction between the two have on a contract’s growth?
To answer that question, let’s go back in time 30 years and imagine that we’d invested $100,000 in two different FIA investment options that increased based upon the growth of the S&P 500. Our investment options looked like this:
1. A traditional allocation option with a 100% participation rate and a 5% return cap, which is closer to the historical average
2. An allocation option with a 50% participation rate, but a return cap that’s 25% higher, or 6.25%
The results? After 30 years, option two would have grown to $295,634. That’s nearly $30,000 ahead of option one’s current value of $267,713.
What explains the difference? First, remember that we have a 0% floor; if the S&P 500 is flat or down, both investment options just stay flat. That means we only need to pay attention to the years with positive returns.
With a 50% participation rate, when index returns were above 10%, option two’s growth exceeded 5% and outperformed. In this scenario, that happened 70% of the time when returns were positive. And the last 30 years weren’t a fluke. In fact, going back to its inception, when the S&P 500 Index was up, 75% of the time its returns exceeded 10%.
As demonstrated, the combination of a lower participation rate and higher return cap may allow for significantly more growth over time. This effect is particularly pronounced in low interest rate environments like the market we’ve experienced for the last several years, during which insurance companies have less capacity to offer higher return caps. And that might make all the difference when it comes to staying ahead of inflation before and during retirement, helping to ensure your clients can maintain their standard of living and enjoy their golden years.
