Planning for retirement is no longer as simple as depending on Social Security or a pension. As a result, many are turning to other financial instruments, such as a fixed index annuity (FIA), to meet their retirement needs. In this episode of Money Script Monday, Sean answers the three most frequently asked questions consumers bring up when they are considering a fixed index annuity.

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Video transcription

Hello and welcome, my name is Sean Brady and welcome to another edition of Money Script Monday. Today I'm going to be answering the three most frequently asked questions about FIAs (fixed index annuities).

Retirement used to be simple, all we had to do was hold down a job and then you could retire comfortably. But those were things of the past. We used to be able to just rely on Social Security, maybe a pension and maybe some personal savings set aside. But it's just not the case anymore.

The future of Social Security is uncertain, pensions are all but gone and the responsibility of our retirement relies primarily on us as individuals and our personal accounts. And that's why we invest in things like 401Ks, IRAs, investments like stocks and we're doing this primarily in the accumulation phase of our life. And that means majority of our working years.

Once we near retirement, we're starting to look for other financial instruments that are better suited for the distribution phase of our life. And that's why you've taken some real interest in FIAs. But you also might have some other questions like, "How's the insurance company able to deliver on these promises?" And that's why today I'm going to answer these three questions.

1. How is my premium invested?
2. How do they (insurance company) earn a profit?
3. How can they afford a contract's index interest credits?

Question #1: How is my premium invested?

Generally speaking, insurance companies are going to invest 95% to 99% of your premium into a highly rated fixed income portfolio and then they're going to take that other remaining 1% to 5% to purchase hedging instruments which allows them to offer those various index crediting methods that you see on FIAs.

Majority of this portfolio's going to be in things like corporate bonds but they also invest in a wide variety of fixed income investments such as mortgage loans, mortgage back securities and government bonds among a number of other things. These fixed income investments are going to range from quality and overall, it's going to be considered a highly-rated investment grade portfolio. Other companies out there may invest in lower rated fixed investments which may yield them a higher return but it's going to add more risk to the portfolio. It's up to you to have your financial professional find you a company that is strong and stable and in the FIA space for the long haul.

Question #2: How does an insurance company earn a profit?

Revenue - Expenses = Profit

Every year that portfolio's going to earn them a yield and the portfolio I'm discussing is the one I had mentioned in the first question. Part of the yield is going to be used in a number of different ways...

• The commission to pay the financial professional.
• The acquisition and maintenance expenses.
• The basic product benefits, things like death benefits or premium bonus.
• The hedging budget which is what they are able to do and offer that fixed index interest credits to the policy holders.

And then the remainder is profit for the insurance company.

Question #3: How can an insurance company afford a contract's indexed interest credits?

As I mentioned before, the insurance company reserves 1% to 5% for the hedging budget. The goal of the hedging budget is to ensure that index performance, no matter what happens, they're able to deliver on their promises.

The beginning of the year hedging budget is represented on the left. Throughout the course of the year, that hedging budget or the assets within the hedging budget is either going to grow or it'll shrink. If there's a favorable result at the end of the year, then the client's going to get a credit to their policy. If the result is unfavorable, then that 1% to 5% will expire and be worthless and they'll get a 0% credit for the year. But it's important to know that 95% to 99% of the client's assets are in fixed income. So the insurance company can keep their promises to their client meaning the principal has been protected.

Just a quick recap here. How's my premium invested? Majority of the assets or premium is going to highly rated fixed income portfolio and then they reserve a small percentage for hedging instruments. That's how they offer those various crediting methods.

How do they earn a profit? It's simple, "revenue - expenses = profit".

And then finally, how can they afford a contract's index interest credits? You start off with a small percentage going to the hedging budget. It'll either grow or it'll shrink. And your principal is protected.

This concludes today's presentation. Thank you for watching and we'll see you next time on Money Script Monday. Take care.