Tag: indexing method

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Annuities Fixed Index Annuities

12 Questions When Considering Fixed Index Annuities

It’s hard to believe, however, it’s been over a year since I began writing about fixed index annuities, or “FIA’s”, as a retirement income planning strategy. Beginning with the July 11, 2011 post, Shelter a Portion of Your Portfolio From the Next Stock Market Freefall, this has been the subject matter of virtually every Retirement Income Visions™ weekly post. Several of the posts, including the last nine, have been organized into multi-part series.

As evidenced by the titles of many of the posts as well as the number of parts in the various series, this is a highly technical area. Not to mention that there are currently 251 products offered by 40 life insurance companies to choose from.

The following is a list of 12 questions you should ask yourself when considering the purchase of fixed index annuities:

  • Are fixed index annuities suitable for me?
  • How will they fit into my retirement income plan?
  • Should they be part of my nonretirement or retirement investments?
  • What are the current and future income tax consequences?
  • Should I purchase an income rider?
  • When should I begin to purchase fixed index annuities?
  • How much should I invest in fixed index annuities?
  • Should I make ongoing investments in addition to my initial investment?
  • When should I begin to take income withdrawals?
  • Which indexing methods should I choose?
  • Should I consider products that offer a premium bonus?
  • Which product(s) is (are) best for me?

As you can appreciate, these aren’t easy questions to answer individually, let alone collectively. Next week’s post will provide you with guidance regarding how to go about finding answers to each of these questions.

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Annuities Celebration Fixed Index Annuities Retirement Income Planning

Retirement Income Visions Celebrates 3-Year Anniversary!

Thanks to my clients, subscribers, and other readers, Retirement Income Visions™ is celebrating its three-year anniversary. Retirement Income Visions™ has published a weekly post each Monday morning, the theme of which is Innovative Strategies for Creating and Optimizing Retirement Income™.

As stated in the initial post on August 16, 2009, Retirement Income Visions™ Makes Its Debut, the importance of retirement income planning as a separate and distinct discipline from traditional retirement planning was magnified during the October, 2007 – March, 2009 stock market decline. Just ask anyone who retired just prior to, or during, this period that didn’t have a retirement income plan in place when he/she retired.

With increasing life expectancies, record-low interest rates, traditional pension plans going by the wayside, soaring health and long-term care costs, and the potential for inflation, retirement income planning is no longer an option. It has become a necessity for anyone who wants to ensure that he/she will have sufficient income to meet his/her expenses for the duration of retirement. Recognizing this fact, The American College launched its Retirement Income Certified Professional™ (RICP™) program earlier this year in which I was one of the first enrollees.

Since its inception, Retirement Income Visions™ has used a themed approach, with several weeks of posts focusing on a relevant retirement income planning strategy. This year was no exception. The weekly posts, together with the customized Glossary of Terms, which currently includes definitions of 137 terms to assist in the understanding of technical subject matter, has contributed to a growing body of knowledge in the relatively new retirement income planning profession.

While the first two years of Retirement Income Visions™ presented a variety of retirement income planning strategies, fixed index annuities, or “FIA’s,” have been the sole focus of virtually every weekly post for the past 13 months. Continuing a theme that began on July 11, 2011 during the second year of publication with Shelter a Portion of Your Portfolio From the Next Stock Market Freefall, the inner workings of FIA’s, including their unique benefits as a retirement income planning solution, has been discussed in detail. As a result, Retirement Income Visions™ has become an authoritative source of information on this important and timely topic.

Although FIA’s has been the theme of almost every post for over a year, the posts have been organized by a number of sub-themes. Following the July 11, 2011 post, the introduction to the FIA strategy continued with the next five posts, Looking for Upside Potential With Downside Protection – Take a Look at Indexed Annuities (July 18, 2011), Limit Your Losses to Zero (July 25, 2011), Do You Want to Limit Your Potential Gains? (August 1, 2011), When is the Best Time to Invest in Indexed Annuities? (August 8, 2011), and How Does Your Fixed Index Annuity Grow? (August 22, 2011).

The next twelve posts, beginning with the August 29, 2011 post, Indexing Strategies – The Key to Fixed Index Annuity Growth, through the November 14, 2011 post, How to Get Interest Credited to Your Fixed Index Annuity When the Market Declines, presented a thorough discussion of the various traditional fixed index annuity indexing strategies. This included an introduction to, and comparison of, the following indexing methods: annual point-to-point, monthly point-to-point, monthly average, trigger indexing, inverse performance trigger indexing, as well as the fixed account that’s included as one of the strategy choices by virtually every FIA.

Moving beyond the base product, the subject of the next nine posts was an introduction to the income rider that’s offered by many FIA’s. The income, or guaranteed minimum withdrawal benefit (“GMWB”), rider is the mechanism for providing guaranteed (subject to the claims-paying ability of individual life insurance companies) lifetime income with a flexible start date that is essential to so many retirement income plans. This kicked off with the enlightening December 5, 2011 and December 12, 2011 posts, No Pension? Create Your Own and Add an Income Rider to Your Fixed Index Annuity to Create a Retirement Paycheck. The introduction to income rider series also included two two-part series, Your Fixed Index Annuity Income Rider – What You Don’t Receive (December 19, 2011 and December 26, 2011) and 5 Things You Receive From a Fixed Index Annuity Income Rider (January 9, 2012 and January 16, 2012).

Following two posts introducing fixed index annuity income calculation variables on January 23, 2012 and January 30, 2012 (10 Fixed Index Annuity Income Calculation Variables and Contractual vs. Situation Fixed Index Annuity Income Calculation Variables), a five-part series ensued revolving around a topic often misunderstood by the general public — premium bonuses. The posts in this series included 8 Questions to Ask Yourself When Analyzing Premium Bonuses (February 6, 2012), What’s a Reasonable Premium Bonus Percentage? (February 13, 2012), How Will a Premium Bonus Affect a Fixed Index Annuity’s Value? (February 20, 2012), How Will Withdrawals Affect Your Premium Bonus? (February 27, 2012), and How Will a Premium Bonus Affect Your Fixed Index Annuity Income Distribution? (March 5, 2012).

The next five posts delved into the inner workings behind the variables and interaction of variables behind the calculation of income withdrawal amounts from FIA income riders. This included the following posts: Income Account Value vs. Accumulation Value – What’s the Difference? (March 19, 2012), How is Your Fixed Index Annuity’s Income Account Value Calculated? (April 2, 2012), How Much Income Will You Receive From Your Fixed Index Annuity? (April 9, 2012), and a two-part series, Don’t Be Fooled by Interest Rates – It’s a Package Deal (April 16, 2012 and April 23, 2012).

When Should You Begin Your Lifetime Retirement Payout? was the subject of a two-part series (May 7, 2012 and May 14, 2012) followed by another timing question, When Should You Begin Investing in Income Rider Fixed Index Annuities? (May 21, 2012).

The May 28, 2012 through June 18, 2012 four-part series, Fixed Index Annuity Income Rider Similarities to Social Security, was a well-received and timely topic. This was followed by a second five-part comparison series beginning on June 25, 2012 and continuing through July 23, 2012, FIA’s With Income Riders vs. DIA’s: Which is Right for You?

The last two weeks’ posts have addressed the topic of valuation of a FIA’s income rider stream. This included the July 30, 2012 post, What is the Real Value of Your Fixed Index Annuity, and the August 6, 2012 post, Why Isn’t the Value of Your Income Stream Shown on Your Fixed Index Annuity Statement?.

As I did in my August 9, 2010 and August 15, 2011 “anniversary” posts, I would like to conclude this post by thanking all of my readers for taking the time to read Retirement Income Visions™. Once again, a special thanks to my clients and non-clients, alike, who continue to give me tremendous and much-appreciated feedback and inspiration. Last, but not least, thank you to Nira, my incredible wife, for her enduring support of my blog writing and other professional activities.

Categories
Annuities Fixed Index Annuities

How to Get Interest Credited to Your Fixed Index Annuity When the Market Declines

Retirement Income Center

Last week’s post, Don’t Neglect Your Fixed Index Annuity Fixed Account, made the point that you’re not guaranteed to receive interest crediting with the majority of fixed index annuity indexing methods due to the fact that interest is only credited when the result of the calculation is positive. Per the post, one way to obtain interest crediting in the event of negative performance of your chosen index or indeces, is to allocate a portion, or perhaps all, of your fixed index annuity to the fixed account.

Per last week’s post, to the extent that you choose the fixed account, you will receive three benefits unavailable from traditional indexing methods: (1) guaranteed return, (2) pre-determined return, and (3) opportunity to offset a portion or all of an income rider charge in the event of a negative indexing method return. While the predetermined annual return is generally very favorable to that of a one-year CD, it is nonetheless modest, typically in the range of 1% to 2% these days.

Recognizing the fact that (a) the performance of traditional indexing methods, e.g., annual point-to-point cap, monthly point-to-point cap, and monthly average cap, can be negative and result in no interest crediting and (b) fixed account returns, while positive, are currently low, two life insurance companies have introduced an indexing method that favors negative stock market index performance. The method is called the inverse performance trigger.

Currently available through the Midland National Life MNL Endeavor and North American Performance Choice fixed index annuity series, with six and four different products, respectively, interest crediting of pre-determined specified percentages will occur when the performance of the stock market index associated with the inverse performance trigger indexing method is zero or negative. North American’s Performance Choice series inverse performance trigger uses the S&P 500 annual point-to-point cap method to measure performance. Current annual interest crediting for its four products, which ranges between 2.5% and 4.6%, is almost identical to its traditional annual point-to-point interest crediting amounts.

To demonstrate the inverse performance trigger indexing method, let’s suppose that you purchased a fixed index annuity on October 1, 2010 that offers the inverse performance trigger tied to the S&P 500 annual point-to-point cap method as one of its indexing method choices. Let’s further assume that you allocated 100% of your contract to this selection. In order to determine whether you would receive the predetermined interest crediting on your contract anniversary on September 30, 2011, you need to compare the S&P 500 price on September 30, 2011 to October 1, 2010. If the price on September 30, 2011 is less than or equal to the price on October 1, 2010, you will receive the specified interest crediting.

In our example, the price of the S&P 500 on September 30, 2011 was 1,131.42 and on October 1, 2010 it was 1,146.24. Since the September 30, 2011 price was less than the October 1, 2010 price, interest would be credited. It makes no difference that the price on September 30, 2011 was only 14.82 points, or 1.3%, less than the price on October 1, 2010. The full amount of interest would be credited to your fixed index annuity contract.

Given the fact that (a) traditional indexing methods can result in no interest crediting in a particular year and (b) fixed account returns are currently low, I would expect to see more fixed index annuity products offer the inverse performance trigger as one of their indexing method choices.

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Annuities Fixed Index Annuities

Don’t Neglect Your Fixed Index Annuity Fixed Account

Retirement Income Center

Last week’s post, Diversify Your Fixed Index Annuity Indexing Methods discussed 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 year. One of the strategies, allocation of accumulation value to the fixed account, is the topic of this week’s post.

Per last week’s post, unlike indexing methods that are generally tied to the performance of a stock market index, the fixed account credits a predetermined fixed interest rate for the percentage of your fixed index annuity that is allocated to this investment choice. The fixed account offers three advantages over traditional index crediting methods

  1. Guaranteed return
  2. Pre-determined return
  3. Opportunity to offset a portion or all of an income rider charge in the event of a negative indexing method return

Guaranteed Return

Even though you will improve your chances for obtaining interest crediting by implementing one of the first three fixed index annuity indexing method diversification strategies per last week’s post, i.e., select multiple methods, choose a blended index if available, or purchase multiple fixed index annuity contracts, you won’t be guaranteed to receive interest crediting in a particular contract year. This is due to the fact that interest is only credited with the vast majority of indexing methods when the result of the calculation is positive. When you choose the fixed account, you will receive a guaranteed return no matter how any of the available indexing methods perform.

Pre-Determined Return

In addition to being guaranteed, your return will be a pre-determined percentage of accumulation value allocated to the fixed account. Although the return is usually modest, typically in the neighborhood of 1% – 2% these days, it generally exceeds 1-year CD rates. Furthermore, there is also a minimum guaranteed fixed interest rate for the fixed account that’s generally 1%.

Opportunity to Offset a Portion or All of an Income Rider Charge in the Event of a Negative Indexing Method Return

While it’s true that you will never receive less than 0% interest crediting when the performance of your chosen indexing method is negative in a particular year, it’s possible that the accumulation value of your fixed index annuity will decrease as a result of an income rider charge. Although it’s optional, it’s common to add an income rider to a fixed index annuity. The purpose of this rider is to provide you and a joint annuitant, if applicable, with a pre-determined guaranteed income stream that you can turn on generally beginning one year from your contract date, with the amount of income increasing the longer you defer your income start date.

In order to offer this feature, life insurance companies assess a charge. It’s calculated as a percentage of either the accumulation value or the income account and is generally in the range of 0.6% to 0.95%. The income rider charge is deducted from the accumulation value. When the performance of one or more indexing method(s) is (are) negative, the income rider charge will result in a decline in the accumulation value. This can also occur when the performance during a particular contract year is modest.

By allocating funds to the fixed account, you have the ability to offset a portion, or potentially all, of the income rider charge in a given year in the event that the performance of the portion of your accumulation value that is allocated to one or more chosen indexing methods is negative or modest. The amount of the offset will depend upon the amount of the charge and the percentage allocated to the fixed account. The tradeoff is that your interest rate crediting may be less than the returns from one or more indexing methods when the latter’s performance is superior to that of the fixed account.

Don’t neglect the fixed account when choosing or changing your fixed index annuity allocation methods. When selected, you will receive a guaranteed, pre-determined rate of return. Furthermore, to the extent that you include an income rider with your contract, it will offset a portion, or potentially all, of your income rider charge in the event of a negative indexing method return.

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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.

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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

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

Retirement Income Center

Last week’s post, What’s the Point-to-Point?, introduced the annual point-to-point cap method, which is the simplest fixed index annuity indexing method. This post will discuss the monthly point-to-point cap method and  will compare it to the annual point-to-point cap method.

The monthly point-to-point cap method, or monthly sum crediting method as it’s otherwise known, is similar to the annual point-to-point cap method, with the following three differences:

1. The calculation involves the determination of twelve monthly percentage changes vs. one annual percentage change.
2. The limit, or cap rate, is applied to each monthly percentage change, or 12 times, vs. one time with the annual point-to-point cap method.
3. The monthly capped changes are added together to determine the annual interest amount to be credited.

To illustrate how the monthly point-to-point cap method works and how it differs from the annual point-to-point cap method, let’s assume, similar to last week’s post, that you purchased a fixed index annuity on September 16, 2010 and you selected the S&P 500 stock index as the market index, only this time you chose the monthly, instead of the annual, point-to-point cap method for determination of the annual interest crediting to your contract. Let’s further assume that the monthly cap rate is 1.8%.

Exhibit 1 shows the monthly prices for the 16th of each month beginning September 16, 2010 through and including September 16, 2011. Using the monthly prices, the dollar and percentage changes are calculated and shown in the next two columns, respectively. Once the monthly percentage changes are determined, the assumed cap rate of 1.8% is applied to each month’s percentage change to determine the monthly capped percentage change which is displayed in the final column. The 12 monthly capped percentage changes are then added together. If the result is positive, then this is the annual interest amount that is credited to the contract. If, on the other hand, the result is negative, no interest is 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 combination of the monthly cap of 1.8% plus the sizeable negative changes (5.9%, 4.7%, and 9.4%) for the three negative months resulted in total monthly capped changes of -6.4%. Since there was a loss, 0% interest was credited.

In the illustrated contract year, the annual point-to-point cap method, with its interest crediting of 4% proved to be the better solution. This occurred because there was a positive price change between the S&P 500 stock index between the beginning and end of the contract year vs. the negative total of the monthly capped changes.

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

Introduction to Fixed Index Annuity Indexing Methods

Retirement Income Center

As stated at the conclusion of last week’s post, fixed index annuity interest crediting is determined on an annual basis by the performance of one or more chosen stock market indexes and indexing methods based on the original contract date. As a result, there are generally 365 possible measuring periods.

Since stock prices often change daily, there is a high likelihood that the price of a particular stock index, which can be based on stock prices of dozens, hundreds, or even thousands, of individual companies, will fluctuate on a daily basis. Consequently, individual fixed index annuity interest crediting can vary widely from contract to contract even if identical stock market indexes and indexing methods are chosen. Since performance is date sensitive, different indexing strategies may be superior to others within the same year, let alone from year to year.

Having said this, 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 the loss. You will instead be credited with 0% interest for that year. This is an attractive feature of fixed index annuities for investors concerned with preservation of principal.

The August 29, 2011 post, Indexing Strategies – The Key to Fixed Index Annuity Growth, discussed the first choice that needs to be made when selecting a particular indexing strategy – stock market index. Once you make this choice, you need to also select one or more indexing methods.

The two most common indexing methods are the annual and monthly point-to-point cap methods, with the latter also known as the monthly sum crediting method. Both of these methods have a predefined limit, or cap, on the maximum periodic, i.e., annual or monthly, rate of interest that will be used in the interest crediting calculation. The cap varies by life insurance company and product. It isn’t uncommon for life insurance companies to offer several fixed index annuity products with different features, including different cap rates.

Every fixed index annuity has a specified term, or surrender period, that generally ranges between five and fifteen years. There’s a declining surrender charge that will be assessed by the life insurance company on annual withdrawals in excess of a penalty-free withdrawal amount that’s typically 10% of the total premiums paid. The charge is deducted from the accumulation value during the assigned term that’s used for calculating the surrender value of the contract in the event that an investor chooses to terminate his/her participation in the contract.

Generally speaking, higher cap rates are associated with longer fixed index annuity terms. The longer your commitment, the greater is generally your opportunity for earning a higher potential return, all else being equal. Life insurance companies set cap rates for each fixed index annuity product based on marketplace conditions. Furthermore, each company generally reserves the right to change cap rates for each of its products on each contract anniversary in response to changes in marketplace conditions. Each product generally has a predefined floor below which the cap rate will never drop. For instance, a fixed index annuity contract may state that its annual caps will never be less than 1%.

Next week’s post will discuss three important similarities between all fixed index annuity indexing methods.

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Annuities Fixed Index Annuities

Contract Date – The Driver of Fixed Index Annuity Performance

Retirement Income Center

Last week’s post began a discussion about the second way that fixed index annuities grow in addition to a contract’s defined minimum guarantees – indexing strategies. It pointed out that there are actually two choices that you need to make when selecting a particular indexing strategy: (1) Stock market index and (2) Indexing method. Stock market indexes, including how they work and the different types that are typically available when working with fixed indexed annuities, was the subject of last week’s post.

What is the purpose of an indexing method? An indexing method, together with a particular stock market index, determines the amount of interest that is credited to the value of a fixed index annuity on the contract anniversary date each year. Interest crediting is flexible and will vary for each fixed index annuity contract based on several factors.

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. This is the date on which the contract is effective. The measurement date for all indexing strategies begins on this date.

Every indexing strategy uses a contract year. In the first year, this period begins on the contract date and ends on the day before the contract anniversary date. In subsequent years, the ending date is the same, however, the contract year begins on the contract anniversary date.

Suppose that you applied for a fixed index annuity for your IRA last month using funds that were rolled over from your dormant 401(k) plan and your fixed index annuity is issued with a September 6, 2011 contract date. The measurement period for calculation of interest crediting during your first contract year will begin on September 6, 2011 and will end on September 5, 2012. Your second contract year, or measurement period, will begin on September 6, 2012 and will end on September 5, 2013, and so forth.

Since each contract year for each fixed index annuity contract is determined by the contract date, there are 365 (366 for fixed index annuity contracts issued in leap years once every four years) possible measuring periods. Forgetting about choices of stock market indexes and indexing methods, given the sheer number of measuring periods, no single indexing method will result in the highest interest crediting in every situation. The performance of a particular indexing method will be different if the contract year begins on September 6th vs. if it begins on February 23rd, and, furthermore, will vary from year to year.

While generalizations can, and are often made, about the performance of various types of indexing methods during different types of markets, e.g., bull vs. bear, it’s important to keep in mind that no one can predict the change in a particular stock market index from one date to the same date a year later, let alone predict the individual monthly changes during a particular year that is required for working with certain indexing methods.

In summary, fixed index annuity interest crediting is determined on an annual basis by the performance of one or more chosen stock market indexes and indexing methods based on the original contract date. Given the fact that there are 365 or 366 possible measuring periods and typically several choices of indexing strategies, interest crediting amounts will generally be different for each contract issued for each fixed index annuity product.

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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

How Does Your Fixed Index Annuity Grow?

Retirement Income Center

“Mary, Mary, quite contrary, how does your garden grow? With silver bells, and cockle shells, and pretty maids all in a row.” Applied to fixed index annuities, this popular English nursery rhyme might read as follows: “FIA, FIA, quite contrary, how does your accumulation value grow? With minimum guarantees, and indexing strategies, and not too many down years in a row.” Please note that all references to “guarantees” are subject to the claims-paying ability of individual life insurance companies issuing fixed index annuity contracts.

With each passing week, Retirement Income Visions™ ongoing fixed index annuities series that began on July 11th with Shelter a Portion of Your Portfolio From the Next Stock Market Freefall is proving to be very timely. Volatility has been the name of the game since the Dow Jones Industrial Average closed at its recent high of 12,724.41 on July 21st. With its close of 10,817.65 on Friday, the Dow is down 1,906.76, or 15%, in 21 trading sessions since July 21st. This has included six trading sessions with changes of 420 – 635 points from the previous session close, with four of those being declines.

So how do fixed index annuities have the potential to grow each year and overcome the volatility associated with the stock market? As alluded to in the modern version of the traditional English nursery rhyme at the beginning of this post, there are two ways: (1) minimum guarantees, and (2) indexing strategies. The remainder of this post will discuss minimum guarantees with a presentation of indexing strategies beginning next week.

Every fixed index annuity contract includes a minimum guarantee section. This is one of the first things that I discuss with my clients when reviewing a fixed index annuity. I explain to them that, while the objective of investing in a fixed index annuity isn’t to plan for the guaranteed minimum value, it’s comforting to know that this is the minimum amount that will be received if they terminate their contract or if they die. An investor in a fixed index annuity would receive the contract’s guaranteed minimum value only if it’s greater than the contract’s cash surrender value.

How is the guaranteed minimum value calculated? While this varies by life insurance company and product, in addition to potential withdrawals which reduce the minimum value, there are generally two components used in the calculation: (1) percentage of premium, and (2) interest rate. The percentage of premium that’s used will generally be 87.5% to 100% and the interest rate will range between 1% – 3%. As a rule of thumb, 1% is typically credited on 100% of premiums while interest rates of 2% – 3% are generally credited on 87.5% – 90% of premiums.

I have prepared Exhibit 1 to illustrate two examples of the calculation of the guaranteed minimum value of a fixed index annuity. Contract A calculates its minimum guarantee using 87.5% of the premium and an interest rate of 2% while contract B applies an interest rate of 1% to 100% of the premium. While contract B immediately grows by $1,000 and its minimum value is $101,000 at the end of year 1, the minimum value of contract A of $89,250 is $11,750 less than contract B. Per Exhibit 1, although contract A gets off to a slow start, contract A’s minimum value catches up with, and overtakes, contract’s B’s minimum value beginning in year 14.

In summary, the minimum guarantee feature is the security blanket for a fixed index annuity. 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. Next week’s post begins a discussion of indexing strategies, the key for potential investment growth.