Tag: Dow Jones Industrial Average

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Roth IRA

Black Friday – Think Roth IRA Conversion

This Friday is Black Friday. It’s the day after Thanksgiving when major retailers open early promoting significant price reductions on lots of items. It has routinely been the busiest shopping day of the year since 2005.

There’s another major sale taking place as I write this post that’s not being publicized. It’s happening in the investment world. It’s one of those perfect storm moments when a confluence of seemingly unrelated factors occurs that results in a short-lived opportunity for those who act on it.

With the recent 1,000 point, or 8%, drop in the Dow Jones Industrial Average (DJIA), closing at 13,593 on September 14th and finishing at 12,588 on Friday, combined with a distinct possibility of higher income tax rates in 2013, with one notable exception, this is one of those moments for individuals considering a Roth IRA conversion.

Let’s start with the exception which is the result of the last major Roth IRA conversion opportunity. In 2010, individuals who did Roth IRA conversions were given the choice of including income from their conversion on their 2010 income tax returns or deferring it. If they chose the latter, they were required to report 50% of the income on their 2011 income tax returns and 50% on their 2012 returns.

Several of my clients did sizeable conversions in 2010, choosing to defer 50% of their Roth IRA conversion income to 2011 and 50% to 2012. While these individuals have enjoyed 30% increases in the equity portion of their Roth IRA accounts since 2010 as a result of the increase in the DJIA from the 10,000 level that will never be taxed, they will also be including large amounts of income from their 2010 conversions on their 2012 income tax returns. Without offsetting losses or deductions, most of these individuals won’t be good candidates for a 2012 Roth IRA conversion.

If your 2012 taxable income is being inflated by a large amount of deferred income from a 2010 Roth IRA conversion without offsetting losses or deductions, you may not be a good candidate for a 2012 Roth IRA conversion. Assuming that you don’t fall under this exception and you haven’t already done a sizeable Roth IRA conversion in 2012, you should be evaluating this strategy as part of your 2012 year-end income tax planning. Once again, there isn’t one, but two, events that make this a potentially timely transaction depending upon your tax situation, either one of which qualifies as a potential trigger.

While it’s possible that the stock market may decline further and income tax rates may not increase in 2013, the recent significant stock market decline in and of itself presents a Roth IRA conversion opportunity. In addition to avoiding taxation on future appreciation of conversion amounts, Roth IRA conversions result in reduction of taxable IRA accounts which in turn offers two other potential benefits.

Smaller taxable IRA accounts translate to smaller required minimum distributions (“RMD’s”) and reduced taxable income beginning at age 70-1/2. In addition, to the extent that you have less taxable income, you may be able to reduce the amount of your taxable Social Security benefits, providing for a second tax reduction opportunity as well as enhanced retirement income longevity.

While you’re setting your alarm clock to take advantage of all of those Black Friday sales, don’t forget about the Roth IRA conversion sale. It may be one of those short-lived investment opportunities that you won’t see for a long time.

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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.

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Annuities Fixed Index Annuities

Fixed Index Annuity Indexing Method Similarities

Retirement Income Center

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:

  1. Reliance on a stock market index
  2. Measurement of percentage changes between two points in time
  3. 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 19th of a particular month. When the 19th 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.

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Annuities Fixed Index Annuities

Indexing Strategies – The Key to Fixed Index Annuity Growth

Retirement Income Center

Last week’s post introduced the two ways that fixed index annuities grow: (1) minimum guarantees and (2) indexing strategies. The minimum guarantee feature, which was discussed last week, is the security blanket that provides the foundation for growth of a fixed index annuity. Per the conclusion of last week’s post, this is the minimum accumulation value that would be paid by the life insurance company to the investor if the investor terminates his/her contract, or to the beneficiary in the event of death.

As discussed in the July 18, 2011 post, Looking for Upside Potential With Downside Protection – Take a Look at Indexed Annuities, indexed annuities are a hybrid product, with returns directly tied to the performance of a stated stock market index. When you complete a fixed index annuity application, you need to choose, and allocate between, one or more indexing strategies.

There are actually two choices that you need to make when selecting a particular indexing strategy: (1) Stock market index and (2) Indexing method. In addition to making these two choices when you invest in a fixed index annuity, you typically have the opportunity to change them on each contract anniversary. Stock market indexes will be discussed in this blog post with a discussion of indexing methods deferred to next week.

As defined in Retirement Income Visions™ Glossary, a stock market index measures the performance of a specific group of stocks. 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. The S&P 500 is an index of 500 large cap stocks weighted by market value that’s designed to be a leading indicator of the overall U.S. stock market performance.

Other stock market index choices that may be available for fixed index annuities offering multiple choices include the Dow Jones Industrial Average, Nasdaq 100, Euro Stoxx 50, as well as a blended index. The Dow Jones Industrial Average, or DJIA, is the oldest and most popular stock market index in the United States. It’s a price weighted index that includes just 30 companies, and, as such, isn’t considered to be as good a measure of the overall stock market as the S&P 500.

The Nasdaq, or National Association of Securities Dealers Automated Quotation system, is a computerized trading system that doesn’t have a physical trading floor. The Nasdaq 100 is an index composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange.

The Euro Stoxx 50 is a market capitalization weighted stock index of 50 of the largest European companies that have fully transitioned to the euro currency. Weightings are adjusted each quarter and the index is reconstituted on an annual basis in September.

In addition to the foregoing stock market indexes, fixed index annuities may also offer a blended index as one of the available choices. A blended index consists of a specified weighting of three or more of the most popular indexes offered. When available, it provides an opportunity to participate in multiple indexes by choosing a single index vs. making specified percentage allocations amongst multiple indexes.

Finally, while not a stock market index per se, most fixed index annuities also offer a fixed account. This option pays a specified low interest rate that isn’t tied to the performance of a stock market index.

Choosing one or more stock market indexes is the first step when selecting an indexing strategy. The second step, choosing an indexing method, which is the topic of next week’s post, is more complicated.

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Annuities Fixed Index Annuities

Do You Want to Limit Your Potential Gains?

Retirement Income Center

With Tuesday’s debt-limit deadline just three days away as I write this post following six straight sessions of declines in the Dow Jones Industrial Average, with a total loss of 581.17 points, or 4.6%, from its close of 12,724.41 on July 21st to 12,143.24 on Friday, the American public is understandably on edge. An investment in U.S. government bonds, a traditional safe haven, is no longer the gold standard in the face of a potential unprecedented imminent rating downgrade.

So the proverbial question, “Where do I invest my money?,” is often heard during these uncertain times. Last week’s post, Limit Your Losses to Zero, continued the discussion of indexed annuities, a defensive investment strategy that protects against, and eliminates, market losses. Unlike the value of a direct investment in a market index which fluctuates up and down in response to the performance of the particular index, an investor’s return in an indexed annuity is controlled. Losses are never realized, with minimum rates of return credited during market declines. Per the example in last week’s post, whereas an investment of $100,000 in the Dow Jones Industrial Average on October 9, 2007 declined in value to approximately $78,000 three years later, the same investment in an indexed annuity grew to approximately $113,000, or $35,000, or 45% more.

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 for purposes of this week’s illustration that our investors, Dow Jones and Ann Uity invested the same $100,000 on December 31, 1996 instead of on October 9, 2007. Once again, Dow invests his $100,000 in a Dow Jones Industrial Average index fund and Ann invests her $100,000 in an indexed annuity tied to the S&P 500 stock market index. Ann’s indexed annuity has a minimum rate of return of 2% that she will realize when the index’s return is negative. Ann’s investment also has a cap of 5%. Gains are credited to Ann’s account, however, any increases in the S&P 500 stock market index in excess of 5% are forfeited.

How would Dow and Ann have done during the first three years since they each invested $100,000 on December 31, 1996? Per Exhibit 1, Dow’s initial investment of $100,000 would have increased to $122,641 on December 31, 1997, increased to $142,386 on December 31, 1998, and increased to $178,298 on December 31, 1999. Ann’s initial investment of $100,000 would have increased to $105,000 ($100,000 x 1.05%) on December 31, 1997, increased to $110,250 ($105,000 x 1.05%) on December 31, 1998, and increased to $115,763 ($110,250 x 1.05%) on December 31, 1999.

While Dow participated in 100% of the annual gains of the S&P 500 stock market index that ranged from a low of 16.1% to a high of 25.2% during each of the three years of the bull market, Ann’s gains were limited to 5% per year. Whereas Dow’s investment of $100,000 increased by approximately 78%, or an average of 26% per year, to $178,000, Ann’s investment increased by only 16%, or an average of 5.25% per year, to $116,000. Dow’s investment value of approximately $178,000 on December 31, 1999 was $62,000, or 54%, greater than Ann’s investment value of approximately $116,000 on the same date.

As we have seen, although the use of an indexed annuity limits your losses to zero, it also limits your participation in gains. Given this reality, should you invest in indexed annuities? As stated at the conclusion of last week’s post, if the pain of losing is greater than the pleasure of winning, it’s probably worthwhile to analyze how indexed annuities may work for you. As always, investment diversification should be the overriding consideration when designing any investment plan, especially a retirement income plan.

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Annuities Fixed Index Annuities

Limit Your Losses to Zero

Retirement Income Center

When the Dow Jones Industrial Average declined by 7,617.48 points, or 53.8%, going from an all-time high of 14,164.53 on October 9, 2007 to a low of 6,547.05 on March 9, 2009 in just seventeen months, what did you do and how did you feel? Assuming you were in the stock market, did you remain fully invested or did you liquidate a portion, or maybe even all, of your holdings?

If you chose the latter approach, perhaps the pain of losing was simply greater than the pleasure of winning for you. If this was the case, indexed annuities may be a good solution for you. With an indexed annuity, your return can vary due to the fact that it is tied to a stock market index, however, it will always be positive. As stated in last week’s post, Looking for Upside Potential With Downside Protection – Take a Look at Indexed Annuities, there are two possibilities with indexed annuities:

  1. If the index’s return is negative, no loss is posted to your account. You will receive the minimum rate of return stated in your contract.
  2. If the index’s return is positive, only a portion of the return, often times subject to a cap, is credited to your account.

To illustrate the benefit of investing in an indexed annuity at the beginning of a sizeable market downturn, let’s take two investors, Dow Jones and Ann Uity, both of whom have $100,000 to invest on October 9, 2007. Dow invests his $100,000 in a Dow Jones Industrial Average index fund. Ann invests her $100,000 in an indexed annuity tied to the S&P 500 stock market index with a minimum rate of return of 2%. Although, as stated in last week’s post, the minimum rate of return may not be on the full premium paid into the policy, let’s assume that Ann’s minimum rate of return is credited on her full premium of $100,000.

Without getting into all of the various indexing methods available when investing in indexed annuities, let’s assume that Ann’s return is measured once a year on the anniversary date of her investment. Let’s further assume that Ann’s contract states that she will be credited with 100% of the percentage gains in the S&P 500 stock market index with a cap of 5%, i.e., her maximum percentage gain in any year is limited to 5%.

How would Dow and Ann have fared during the first three years since they each invested $100,000 on October 9, 2007? Per Exhibit 1, Dow’s initial investment of $100,000 would have decreased to $61,839 on October 9, 2008, increased to $69,645 on October 9, 2010, and increased to $77,705 on October 9, 2010. Ann’s initial investment of $100,000 would have increased to $102,000 on October 9, 2008 ($100,000 x 1.02%), increased to $107,100 on October 9, 2009 ($102,000 x 1.05%), and increased to $112,455 on October 9, 2010 ($107,100 x 1.05%).

Whereas Dow experienced a 38.2% loss in the value of his portfolio in year 1, Ann’s portfolio increased by 2% – her minimum rate of return. As a result, Ann’s investment was significantly greater than Dow Jones on each of the three anniversary dates, with a difference of approximately $40,000 on October 9, 2008, $37,000 on October 9, 2009, and $35,000 on October 9, 2010. Although Dow was credited with gains of 12.6% and 11.6% in years 2 and 3, respectively, vs. Ann’s gains which were limited to 5% in the same two years, Ann’s investment value of $112,455 was approximately $35,000, or 44.7%, greater than Dow’s value of $77,705 at the end of year 3. Given this differential, unless Dow experiences several more years of double digit returns without any losses, it will be very difficult for him to catch up with Ann.

Although an extreme example was used, with an investment at the peak of the market preceding a tumultuous slide over a relatively short period of time, it nonetheless illustrates the loss protection offered by indexed annuities during a market freefall. If the pain of losing is greater than the pleasure of winning, it’s probably worthwhile to analyze how indexed annuities may work for you.