Some nerves were recently rattled when the Dow Jones Industrial Average (DJIA) declined 2,052 points, or 7.6%, in six trading sessions, going from a high of 26,952 on October 3rd to a low of 24,900 on October 11th. The loss increased to 2,830 points, or 10.5%, when the DJIA hit a low of 24,122 yesterday before it closed at 24,443.
Given its 9.5-year ascent of 317%, or 33% per year, from its low of 6,470 on March 6, 2009 to its recent high, many people are wondering more and more if this is the beginning of a long-overdue major correction.
What most people don’t realize is that when the stock market experiences a sizable decline, their investments need to work a lot harder just to get back to where they were before the downturn. As an example, suppose you invested $500,000 in a DJIA portfolio on December 31, 2007. The DJIA finished down 34% in 2008, resulting in your portfolio being worth $330,000 on December 31, 2008. In order to recover its loss of $170,000, your portfolio would need to increase 52%.
Fixed index annuities, or FIAs, are insulated from stock market declines. Unlike investments in stocks, bonds, mutual funds, index funds, and exchange traded funds that fluctuate in value, the value of FIAs either increase or remain unchanged.
Value Increases When Stock Market Increases
The performance of a FIA is tied to the performance of stock market indices associated with one or more indexing strategies chosen by you. Interest is credited annually to your contract value based on performance of each selected indexing strategy during the previous contract year.
Interest will be credited to your FIA account, or accumulation value, whenever the performance of a chosen indexing strategy has been positive during the previous contract year. The amount of interest that’s credited is generally subject to a cap rate, or preset maximum amount.
Value is Unchanged When Stock Market Declines
Whenever the value of an indexing strategy is either unchanged or has declined from the previous contract year, your FIA will be credited with no interest at the end of the contract year. The value is simply unchanged from what it was a year ago.
To illustrate, suppose that instead of investing $500,000 in a DJIA portfolio on December 31, 2007, you invested $500,000 in XYZ fixed index annuity. Let’s assume that you allocated 100% of your investment to the DJIA indexing strategy which declined 34% in 2008.
No interest would be credited to your FIA contract value in 2008. Furthermore, you wouldn’t be penalized by the negative performance of your strategy. Unlike a direct investment in a DJIA portfolio which would have been worth $330,000 on December 31, 2008, the value of your FIA would have been $500,000.
Gains are Retained
Unlike other types of investments, FIAs are unaffected by stock market declines. While annual gains from increases in indexing strategies are limited by cap rates, they’re locked in.
The ability to shelter gains from subsequent losses isn’t available with most other types of investments. This benefit can be especially important for older retired individuals who don’t have a long time horizon to recover from sizable stock market losses. Never underestimate peace of mind.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.