cap rates – Retirement Income Center

Five weeks ago, ten fixed index annuity (“FIA”) income calculation variables were introduced in the January 23, 2012 post by the same name. The January 30^th post delineated the ten variables between contractual vs. situational variables. The first contractual variable, premium bonus availability, prompted the February 6, 2012 post, 8 Questions to Ask Yourself When Analyzing Premium Bonuses which kicked off a series of posts.

The February 6^th post answered the first three questions. The February 13, 2012 post, What’s a Reasonable Premium Bonus Percentage?, addressed questions #4 and #5. Question #6 was the subject of last week’s post, How Will a Premium Bonus Affect a Fixed Index Annuity’s Value?

This brings us to question #7: How will withdrawals affect my premium bonus? The answer to this question depends on your contract’s withdrawal charge, free withdrawal, and premium bonus recapture provisions, the latter of which is the sixth contractual variable listed in the January 30, 2012 post.

It’s important to keep in mind that while a premium bonus increases the accumulation value and income withdrawals from a FIA when an income rider has been purchased, there are costs associated with this feature. Two of the costs, potential longer terms and potential lower cap rates, were discussed in last week’s post.

Whenever you take a withdrawal from the accumulation value of a FIA that isn’t a required minimum distribution (“RMD”) assuming your FIA is inside an IRA, it’s subject to a withdrawal charge if (a) your withdrawal is taken during the contract’s specified surrender period and (b) the amount of your withdrawal exceeds the allowable free withdrawal amount, which is generally 10% of the accumulation value after the first contract year.

In addition to the withdrawal charge, your withdrawal may also be subject to a premium bonus recapture charge if you were credited with a premium bonus and your FIA has a premium bonus recapture provision. The recapture charge will be a percentage of your premium bonus for any withdrawals during a specified period, generally the first 10 years of your contract. The percentage may decrease the further into the contract you get.

Let’s look at an example to see the affect of a withdrawal charge and premium bonus recapture provision on a withdrawal from a FIA. Suppose you were credited with a premium bonus of 5% of your initial investment of $100,000, or $5,000, your contract has a free withdrawal provision of 10% of the contract value, and you took a withdrawal of $18,000 in the third contract year when your accumulation value was $120,000, the withdrawal charge was 12%, and the premium bonus recapture charge rate was 6%.

In addition to the withdrawal charge of $720 that would be deducted from your withdrawal, (withdrawal of $18,000 less $12,000 (10% of $120,000), or $6,000, multiplied by 12%), you would also be assessed a recapture charge of 6% of your premium bonus of $5,000, or $300. In this example, a total of $1,020 ($720 + $300), or 5.67% of your withdrawal amount of $18,000 would be deducted, leaving you with a net withdrawal of $16,980 before any further potential reduction for income taxes.

As emphasized in the September 12, 2011 post, Introduction to Fixed Index Annuity Indexing Methods, it’s important to keep in mind one of the basic tenets of fixed index annuity interest crediting that applies to all fixed index annuities, i.e., you only participate in gains, not losses. No matter which indexing strategy(ies) you select, if the annual calculation of the gain or loss results in a loss, you won’t realize, or be credited, with any loss.

So how is interest crediting calculated? Fixed index annuity indexing methods have several things in common. With some exceptions, which will be the topic of a future post, most methods share the following three features:

Reliance on a stock market index
Measurement of percentage changes between two points in time
Use of cap rates

Reliance on a Stock Market Index

All indexing methods rely on the use of a stock market index. As discussed in the August 29, 2011 post, Indexing Strategies – The Key to Fixed Index Annuity Growth, a common stock market index that’s typically offered as one of the choices, if not the only choice, is the Standard & Poor’s, or S&P, 500 Index. As mentioned in that post, other stock market index choices that may be offered include the Dow Jones Industrial Average, Nasdaq 100, Euro Stoxx 50, as well as a blended index.

Measurement of Percentage Changes Between Two Points in Time

A second similarity between all fixed index annuity indexing methods is that they measure percentage changes in stock market indexes between two points in time. As discussed 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 date on which the contract is effective. The measurement date for all indexing strategies begins on this date.

As an example, assuming that the contract date for a particular fixed index annuity is September 19, 2011, the measurement period for all indexing methods will always begin and end on the 19^th of a particular month. When the 19^th falls on a weekend or holiday, the most recent stock market index price is assumed to be the price on that day.

Use of Cap Rates

Per the August 1, 2011 post, Do You Want to Limit Your Potential Gains?, with an indexed annuity, there’s a tradeoff for having the ability to limit losses to zero. In addition to losses being controlled, gains are limited. If the return of the index to which the annuity is tied is positive, only a portion of the return, often times subject to a cap, is credited to your account.

Let’s suppose that you chose the S&P 500 annual point-to-point indexing method as the method for determining the amount of your interest crediting and your contract date is September 19, 2011. Let’s further assume that the S&P 500 stock market index increases 12% between September 19, 2011 and September 18, 2012. Unless life insurance companies increase their cap rates over the course of the next year, chances are that your fixed index annuity account probably won’t be credited with 12%. Most likely, your gains will be capped at a much lower rate, possibly 4% or 5%.

Understanding the foregoing three similarities between most fixed index annuity indexing methods is the first step in understanding specific indexing methods. Next week’s post will introduce the simplest and one of the two most common methods – the annual point-to-point cap method.