Tag: cap rate

Categories
Annuities Fixed Index Annuities

Don’t Underestimate the Power of Zero

Every year since my wife and I began investing in fixed index annuities (FIAs) with income riders several years ago, we’ve received annual statements on the anniversary date of each contract. A reconciliation of the beginning- to the end-of-the-contract-year accumulation value is a key component of each statement. This includes additions, or premiums, premium bonuses, interest credits, withdrawals, surrender charges, and income rider charges.

Distinguishing Feature of Fixed Index Annuities

Interest credits and the methodology used to calculate them is a distinguishing feature of FIAs. The amount of interest credited is primarily dependent upon the performance of a stock market index associated with one or more selected indexing strategies during the previous contract year.

There’s generally a cap rate, or preset maximum amount of interest that will be credited for a particular strategy each year. No interest is credited in years where there is negative performance. The current interest rate of a fixed account also affects total interest credited to the extent that this has been selected as part of one’s overall allocation in a particular year.

The annual interest credits on my wife and my FIA contracts have exceeded our income rider charges as a result of the recent performance of the stock market. This has resulted in an increase in the accumulation value and death benefit of our contracts each year, ignoring additions and premium bonuses.

Protection from Stock Market Downturns

Although we’ve experienced, and are delighted by, the annual net increases in the value of our FIA contracts, my wife and I have yet to realize the unique benefit of owning a FIA compared to other types of investments, i.e., protection from inevitable stock market downturns. Unlike direct investments in mutual funds and exchange traded funds that decrease as well as increase in value, FIAs are insulated from market declines. This is sometimes referred to as the “power of zero.”

How is a FIA owner protected from market downturns? As previously stated, no interest is credited to individual indexing strategies in contract years when performance is negative. In other words, index credits will never be less than zero. This is very comforting when this occurs in a negative year, let alone in a prolonged bear market.

To appreciate this, let’s suppose that you invested in an exchange traded fund tied to the S&P 500 that experienced a decline of 20% in one year. You would need to realize a return of 25% just to break even. This turnaround could potentially take several years. On the other hand, the portion of a FIA tied to the same S&P 500 index would be unaffected by the 20% decline. This would simply be a non-event with no interest credited in the contract year in which this occurred.

In the foregoing example, assuming that 100% of your FIA was tied to the S&P 500 index and there were no additions or withdrawals, your end-of-the-contract-year accumulation value would be identical to what it was at the beginning of the year unless your contract includes an income rider. In this case, your contract’s accumulation value would be reduced by the income rider charge, which generally is 0.5% to 1% of the contract’s income account value. Although an income rider charge reduces a contract’s accumulation value, it has no affect on the amount of income distributions you will ultimately receive.

If you’re approaching, or are in, retirement, or if you’re more sensitive to loss than to gain, FIAs may be an appropriate choice for a portion of your investment portfolio. Don’t underestimate the power of zero.

Categories
Fixed Index Annuities Retirement Income Planning

Cap Rates Are Secondary When Optimizing Retirement Income

process lifecycle

If you’ve been reading Retirement Income Visions™ for any length of time, you know that I’m a fan of fixed index annuities (“FIA’s”) with income riders, or guaranteed minimum withdrawal benefit’s (“GMWB’s”) as part of a retirement income planning solution in the right situation. The ability to create a predictable retirement paycheck with a flexible start date that includes an investment component with upside potential, downside protection, and a potential death benefit is unparalleled in the investment and insurance world.

For you horse race fans, that’s what I call hitting the trifecta! Unlike horse race betting, when you invest in a FIA with an income rider with a highly-rated life insurance company, while the results aren’t guaranteed since they’re subject to the claims paying ability of each individual insurance carrier, your bet is pretty secure given the stellar historical claims paying experience of the life insurance industry.

It’s important to understand that very few FIA’s that are sold today include GMWB’s as part of their base product. If you need sustainable lifetime income beginning at a specific age, you will generally need to purchase an optional income rider when you complete your FIA application. Only about two-thirds of FIA’s on the market today offer an optional income rider. An income rider charge of between 0.75% and 0.95% of your contract’s income account value will generally be deducted from your contract’s accumulation value each year.

Assuming that your goal is to maximize sustainable lifetime income, once you, or more likely your retirement income planner, narrows your FIA search to those that include a GMWB or optional income rider, illustrations need to be prepared for multiple products offered by highly-rated life insurance companies that are well-established in the FIA business to determine which ones will provide you with the greatest amount of income for your desired investment amount(s) beginning at various ages.

This is a difficult task due to the fact that there are several variables that are used in the calculation of annual income that will be received from a particular FIA. After analyzing hundreds of FIA illustrations, trust me, it requires a lot of skill, hands-on experience, and access to dozens of options, including appointment as a licensed life insurance agent with multiple life insurance carriers, in order to offer an independent optimal recommendation for a particular situation. One product may provide greater income beginning at age 62, however, another one may be more suitable if you don’t plan on taking withdrawals until age 70.

What about cap rates? Assuming your goal isn’t to create a predictable retirement paycheck, there’s no need to purchase a FIA with a GMWB or income rider. If this is your situation, you should be paying close attention to the caps, or limits, on interest that will be credited to your account each year that are associated with various indexing methods offered by a particular FIA depending upon its performance during the previous contract year.

If, on the other hand, your primary goal is to optimize lifetime income beginning at a particular age, cap rates, while important, should be a secondary consideration when choosing a FIA. While higher cap rates may result in a greater accumulation value that may more seamlessly absorb income rider charges associated with good market performance and may potentially result in a greater death benefit, they generally won’t affect the amount of lifetime income that you will ultimately receive from a particular FIA. This is due to the fact that the lifetime income calculation of most FIA’s is generally independent of indexing method performance. Furthermore, even if there’s no remaining accumulation value in your contract as a result of income withdrawals over many years, you will continue to receive your income so long as you’re alive.

While cap rates are often hyped by life insurance companies when promoting FIA’s, they should be a secondary consideration when your primary goal is to create and optimize a predictable retirement paycheck beginning at a specific age. If this is your situation, you or your retirement income planner should be devoting the majority of your research to locating those FIA’s offered by highly-rated life insurance companies that are well-established in the FIA business that include a GMWB or income rider that will enable you to achieve your goal.

Categories
Annuities Fixed Index Annuities

How Will a Premium Bonus Affect a Fixed Index Annuity’s Value?

Retirement Income Center

Two weeks ago, we began a series, 8 Questions to Ask Yourself When Analyzing Premium Bonuses, when considering the purchase of a fixed index annuity (“FIA”). The first five questions were answered in the last two weeks’ posts. This week, we answer question #6: How will a premium bonus affect my contract’s accumulation value?

As we learned in 8 Questions to Ask Yourself…, a premium bonus increases the value of a FIA by a fixed percentage of your initial year, and potentially subsequent years’ investment amounts at no cost to you. As such, it gives your FIA a “kick start” that it wouldn’t otherwise have without a premium bonus.

So why wouldn’t you purchase a FIA with a premium bonus? There are basically two reasons: (1) Potential longer terms, and (2) Potential lower cap rates

Potential Longer Terms

For one thing, FIA’s that offer premium bonuses generally have a longer term than those that don’t. Longer terms result in exposure to surrender charges for more years than FIA’s with shorter terms. This isn’t typically a consideration if you purchase a FIA with an income rider and aren’t planning on withdrawing income for a number of years. On the other hand, if you don’t purchase an income rider and want to take partial or total withdrawals, surrender charges are an important consideration.

Let’s take a look at the offerings of my life insurance agency to show you the affect of the presence or absence of a premium bonus on the term of a FIA. My agency currently offers a total of 47 FIA’s from 13 of the highest-rated life insurance companies. Some of the FIA’s have multiple configurations, resulting in a total of 62 offerings. The term of each FIA ranges from five to fifteen years.

26 out of the 62 offerings, or approximately 42%, have a premium bonus ranging from 3% – 10% with one at 20%. The shortest term is five years for one FIA paying a premium bonus of 5%. There are four FIA’s with a term of eight or nine years paying premium bonuses of 3% – 5%. The vast majority of FIA’s paying premium bonuses have a 10-year term, with 17 of 26 premium bonus FIA’s, or 65%, falling into this category. The bonuses of these 17 FIA’s range from 3% – 7%, with one offering 20%.

Potential Lower Cap Rates

In addition to a longer term for the majority of FIA’s offering premium bonuses, it’s also common to find lower cap rates on FIA’s offering premium bonuses vs. similar products not offering them, all else being equal.

While, as previously stated, a FIA with a premium bonus enjoys the advantage of an accumulation value “kick start” vs. a FIA with no bonus, this advantage can potentially be offset in the long run by lower cap rates.

As a result, the accumulation value of a FIA without a premium bonus, all else being equal, may exceed the value of a FIA with one over many years. Every situation is different, with the actual experience dependent upon the amount of the premium bonus vs the cumulative amount of actual interest credited.

In summary, FIA’s with premium bonuses generally have longer terms and lower cap rates than similar products that don’t include a bonus feature. As an example, one of the more competitive, well-known FIA’s offered by my life insurance agency offers the following two versions of an otherwise identical product:

  1. 7-year term, no bonus, and annual point-to-point caps of 3.25% or 3.5% depending upon the index selected
  2. 10-year term, 5% bonus, and annual point-to-point caps of 3% on all indices.

As you can see, the tradeoff for the 5% premium bonus is a three-year longer term (10 years vs. 7 years) and 0.25% – 0.50% lower annual point-to-point cap rates.

Categories
Annuities Fixed Index Annuities

Diversify Your Fixed Index Annuity Indexing Methods

Retirement Income Center

Per the conclusion of last week’s post, Which is the Best Fixed Index Annuity Indexing Method?, no one can predict how a particular fixed index annuity indexing method will perform during any contract year. Differences in contract dates, stock market indexes, and cap rates, combined with the unpredictability of the stock market itself, makes it extremely difficult, if not impossible, to forecast the best performing method for any contract year.

Given this reality, there are four basic strategies that you can use to diversify your fixed index annuity indexing methods to reduce the pressure of picking the “winning horse” and improve your chances for obtaining interest crediting in a particular contract year:

  1. Select multiple methods
  2. Choose a blended index if available
  3. Purchase multiple fixed index annuity contracts
  4. Use the fixed account

Select Multiple Methods

Most fixed index annuities offer multiple indexing methods and, furthermore, give you the ability to allocate your initial investment as well as any available premium bonus to more than one method. As an example, you could allocate 40% to the annual point-to-point cap method, 30% to the monthly point-to-point cap method, and 30% to the monthly average method.

Choose a Blended Index If Available

Many fixed index annuities offer a blended index. The blend generally consists of a weighting of three different indexing methods. The blend is typically pre-assigned or are sometimes weighted based on performance. An example of the latter would be best-performing – 50%, second-best performing – 30%, and third-best performing – 20%.

Purchase Multiple Fixed Index Annuity Contracts

It’s quite common for life insurance companies to offer multiple fixed index annuity products. As a general rule, the more a particular company specializes in fixed index annuities, the more products they will offer. The insurance agency with which I’m associated works with 12 highly-rated life insurance companies that offer a total of 44 fixed index annuity products. Each product has different stock market indexes, indexing methods, and cap rates, with the latter being dependent upon other features available in a particular product in addition to current market interest rates. Investing in multiple fixed index annuity contracts allows you to take advantage of different, and sometimes unique, crediting methods available through different products.

Use the Fixed Account

When in doubt, use the fixed account. Every fixed index annuity generally offers a fixed account as one of the choices for allocating premium dollars. Unlike indexing methods that are generally tied to the performance of a stock market index, the fixed account credits a predetermined fixed interest rate. It’s usually a modest rate, typically in the neighborhood of 1% – 2% these days. There is also a minimum guaranteed fixed interest rate for the fixed account that’s generally 1%. It’s common for fixed index annuities to credit the fixed account for subsequent premiums received during a contract year.

Diversification is an important concept when it comes to risk-reduction investment strategies. The four strategies discussed in this post will help you diversify your fixed index annuity methods and will improve your chances for obtaining interest crediting in a particular contract year.

Categories
Annuities Fixed Index Annuities

Which is the Best Fixed Index Annuity Indexing Method?

Retirement Income Center

Beginning with the August 22, 2011 post, How Does Your Fixed Index Annuity Grow?, fixed index annuity strategies, and, in particular, indexing methods, have been the focus of the last nine posts. The last four posts explained four methods, with the first three being the most widely used:

  1. 1. Annual point-to-point cap method
  2. 2. Monthly point-to-point cap method, or monthly sum crediting method
  3. 3. Monthly average method
  4. 4. Trigger Indexing method

Each of these methods is used to determine the amount of interest that’s credited to a fixed index annuity each year. So which of these four methods is the best one? Is there one method that consistently produces superior results and should be favored over the others?

Let’s take a look at the variables associated with all four methods in order to answer this question. There are three key variables as follows:

  1. Contract date
  2. Stock market index
  3. Cap rate

Contract Date

As emphasized in the September 6, 2011 post, Contract Date – The Driver of Fixed Index Annuity Performance, no matter which stock market index(es) and indexing method(s) is (are) chosen, interest crediting is first, and foremost, driven by the contract date, or the date on which the contract is effective. Since interest is credited to a fixed index annuity based on the performance during a particular contract year, and not a calendar year, there are generally 365 potential measuring periods. Given this fact, even if the same stock market index and indexing method is chosen for the same product, the amount of interest that is credited during a particular year to each contract could be different depending upon the contract date.

Stock Market Index

As discussed in the August 29, 2011 post, Indexing Strategies – The Key to Fixed Index Annuity Growth, in addition to choosing an indexing method, you need to choose a stock market index as part of selecting an indexing strategy. There are typically several choices offered, with the most common one being the Standard & Poor’s, or S&P, 500 Index. While the performance of some indexes may be similar, e.g., the S&P 500 and the Dow Jones Industrial Average, there are often differences from index to index. Furthermore, the differences will be dependent upon the individual contract date.

Cap Rate

As explained in the Glossary of Terms, a cap rate is a preset limit on the percentage of indexed growth that is used to calculate interest credited to a fixed index annuity under the annual point-to-point, monthly point-to-point or monthly sum, and monthly average crediting methods. Each product has different cap rates depending upon the features associated with the product. As a general rule, the longer the term of the particular fixed index annuity, the higher the cap rates, all else being equal. In addition, life insurance companies have the right to change cap rates and periodically do so in response to changes in the interest rate environment.

Conclusion

As you can see, there are many moving parts that come into play when calculating the amount of interest that will be credited to any fixed index annuity during a particular contract year. Even when identical indexing methods and cap rates are used, small differences in contract dates can result in different interest crediting amounts. Although generalizations can be, and are often, made about the performance of different indexing methods during different market conditions, no one can predict how a particular method will perform during any contract year.

A great example of this was demonstrated in Exhibit 1 of the October 3, 2011 post, Monthly vs. Annual Point-to-Point Fixed Index Annuity Indexing Method. Using the monthly point-to-point method, even though nine out of twelve months experienced positive changes, with 3% or greater changes for six of the nine months, the combination of the monthly cap of 1.8% plus sizeable negative changes for the three negative months resulted in total monthly capped changes of -6.4%, with 0% interest being credited. The annual point-to-point cap method, with its interest crediting of 4%, proved to be the better solution in this particular situation.

Categories
Annuities Fixed Index Annuities

Fixed Index Annuity Indexing Method with a Trigger

Retirement Income Center

The last three posts introduced three fixed index annuity indexing methods that are used to determine the annual amount of interest that is credited to a fixed index annuity:

  1. Annual point-to-point cap method
  2. Monthly point-to-point cap method, or monthly sum crediting method
  3. Monthly average method

With each of these three methods, the amount of interest that’s credited during a particular contract year is unknown ahead of time, must be calculated, and generally changes year to year. Like all indexing methods, if the result of the calculation is negative, no interest is credited.

There’s a fourth indexing method that’s not as widely used as the other three methods known as trigger indexing. The basic difference between trigger indexing and the other three indexing methods is that the interest rate isn’t calculated using trigger indexing. It’s instead a predefined percentage that’s triggered by a specified event. The predefined percentage is credited in each contract year during which the value of the specified stock market index at the end of the year is greater than or equal to its value at the beginning of the year. The amount of the change in the index during the year is irrelevant.

As an example, let’s assume that our fixed index annuity contract has a value of $300,000 at the beginning of the current contract year, trigger indexing has been chosen as the indexing method, and the trigger index interest rate is 4%. Let’s further assume that the value of the index used to determine interest crediting was 1,100 at the beginning of the current contract year. So long as the value of the index is at least 1,100 on the last day of the contract year, $12,000 (4% x $300,000) will be credited, resulting in a value of $312,000 at the end of the current contract year. If the value of the index is less than 1,100 at the end of the contract year, no interest will be credited.

Let’s contrast trigger indexing with its closest cousin, the annual point-to-point cap method. Both methods compare the change in the value of a specified stock market index at the end of a contract year to the value of the index at the beginning of the year. As we just learned, whenever the change isn’t negative, a specified interest rate will be credited using the trigger indexing method. In our example, even if there’s no change, 4%, or $12,000, was credited.

With the annual point-to-point cap method, the amount of interest that’s credited is dependent on the amount of the percentage change during the year and furthermore, is subject to a cap rate, or preset limit, on the percentage. Assuming a cap rate of 4%, so long as there’s an increase in the index value during the year, interest will be credited, however, it will be limited to 4% in the event that the amount of the change is 4% or greater.

So which indexing method should you choose? Ah, the topic for next week’s post.

Categories
Annuities Fixed Index Annuities

Monthly Average vs. Monthly Point-to-Point Fixed Index Annuity Indexing Method

Retirement Income Center

We continue our miniseries about fixed index annuity indexing methods that began on September 12th with a discussion of the monthly average indexing method. The previous two posts, What’s the Point-to-Point? and Monthly vs. Annual Point-to-point Fixed Index Annuity Indexing Method introduced the annual and monthly point-to-point methods, respectively.

In order to help you understand the monthly average indexing method, we will compare it to the monthly point-to-point, or monthly sum crediting method as it is otherwise known. Per last week’s post, there are three steps associated with the latter method that are performed each contract year:

  1. Calculate twelve monthly percentage changes in selected stock market index.
  2. Apply the product’s cap rate to each of the twelve monthly percentage changes.
  3. Add the twelve monthly capped percentage changes together to determine the annual interest amount to be credited.

As with all indexing methods, if the result of step #3 is 0 or negative, no interest is credited during that contract year.

There are four steps used with the monthly average indexing method as follows, with the first step identical to the monthly point-to-point method:

  1. Calculate twelve monthly percentage changes in selected stock market index.
  2. Add the twelve monthly percentage changes together.
  3. Divide the total of step #2 by twelve.
  4. Apply the product’s cap rate to the result obtained in step #3.

The best way to illustrate the monthly average indexing method is with an example. Exhibit 1 shows the monthly prices for the 16th of each month beginning September 16, 2010 through and including September 16, 2011. This is the exact time period that was used to produce Exhibit 1 in last week’s post. Using the monthly prices, the dollar and percentage changes are calculated and shown in the next two columns, respectively.

Unlike the monthly point-to-point cap method that applies a cap rate to each of the twelve monthly percentage changes, the changes are simply added together to arrive at total monthly percentage changes. The total is then divided by twelve to arrive at an average percentage change. In this example, total monthly percentage changes of 9.2% is divided by twelve to arrive at an average percentage change of 0.8%. Since 0.8% is less than the assumed cap rate of 4%, the amount of interest credited for the contract year is 0.8%. Once again, if the result was 0 or negative, no interest would be credited.

Per Exhibit 1, even though nine out of twelve months experienced positive changes, with 3% or greater changes for six of the nine months, the sizeable negative changes (5.9%, 4.7%, and 9.4%) for the three negative months offset a large amount of the positive changes to result in a relatively small average monthly change of 0.8%. Although not a significant amount, it’s nonetheless greater than the interest of 0% that would have been credited using the monthly point-to-point cap method for the identical time period per Exhibit 1 of last week’s post. Assuming an accumulation value of $150,000, the amount of interest that would be credited using the monthly average indexing method would be $1,200 ($150,000 x 0.8%).

Of the three methods presented in this post and the previous two posts, the annual point-to-point method would have resulted in the highest interest crediting for the contract year beginning September 16, 2010 through and including September 16, 2011. Per the example in the September 26, 2011 post, What’s the Point-to-Point?, the assumed cap rate of 4% would have been the amount of interest credited using the annual point-to-point method. Assuming an accumulation value of $150,000 the amount of interest that would be credited using this method would be $6,000 ($150,000 x 4%).

As stated at the conclusion of last week’s post, it’s important to keep in mind that no indexing method is always going to be superior to another. Each method will result in different interest crediting depending upon market performance during a particular contract year as well as the cap rates associated with each product.

Categories
Annuities Fixed Index Annuities

What’s the Point-to-Point?

Retirement Income Center

Per last week’s post, Fixed Index Annuity Indexing Method Similarities, most indexing methods share three features: (1) Reliance on a stock market index, (2) Measurement of percentage changes between two points in time, and (3) Use of cap rates.

All three of these features are common to the annual and monthly point-to-point cap methods. The latter method is also often referred to as the monthly sum crediting method. These two methods are the most common indexing methods that are used to calculate annual interest crediting on fixed index annuities.

When analyzing any fixed index annuity indexing method, it’s important to keep in mind that there are two steps associated with all methods: (1) Calculation and (2) Limit. In the case of both the annual and monthly point-to-point cap methods, the calculation involves the determination of the percentage change, or changes, between two points in time. The limit applies cap rates, or maximum percentages, to the result of the calculation(s) to determine the amount of interest that is credited during a particular contract year.

With both methods, if the annual result is negative, no interest is credited during that particular contract year. In addition, if the date on which the change is being measured falls on a weekend or holiday, the price for the most recent date on which the stock market was open is used to measure the change.

The remainder of this post will discuss the annual point-to-point cap method, including an illustration of how this method works, with a discussion of the monthly point-to-point cap method, or monthly sum crediting method, deferred to next week.

The annual point-to-point cap method is the simplest fixed index annuity indexing method. The two steps that are used to arrive at the annual interest amount that is credited are as follows:

1. Calculation: Determination of annual percentage change of selected stock index.
2. Limit: Application of a cap rate.

To illustrate the annual point-to-point cap method, let’s assume that you purchased a fixed index annuity on September 16, 2010 and you selected the S&P 500 stock index as the market index and the annual point-to-point cap method for determination of the annual interest to be credited to your contract. Let’s assume that the contract’s cap rate is 4% which is in the range of many annual point-to-point cap method cap rates today.

With the annual point-to-point cap method, the calculation measures the difference between an index price on the contract date in the first year or contract anniversary date in subsequent years and the day before the contract anniversary date. On September 16, 2010, the contract date, the S&P 500 closed at 1,124.66. On September 15, 2011, the day before the contract anniversary date, the S&P 500 closed at 1,209.11. The difference in prices on these two dates is 84.45 points, or 7.5%. Since the assumed limit, or cap rate, is 4%, you would be credited with interest of 4% during your first contract year.

The annual point-to-point cap method is easy to understand and apply, however, it’s only one of several fixed index annuity indexing methods available for use in determining annual interest crediting amounts. Next week’s post features the monthly point-to-point cap method, otherwise known as the monthly sum crediting method.