Tag: stock market index

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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.

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Annuities Fixed Index Annuities Retirement Income Planning

Add an Income Rider to Your Fixed Index Annuity to Create a Retirement Paycheck

Retirement Income Center

As stressed in the last three week’s posts, Where Have All the Pensions Gone?, A Retirement Paycheck is Essential, and No Pension? Create Your Own, we need to know that when we stop working, we will receive a predetermined monthly payment, i.e., a retirement paycheck, for the rest of our life, and, if married, our spouse’s life. Furthermore, due to its inadequacy and uncertainty, this monthly payment needs to be in addition to whatever Social Security benefits we may receive.

Per last week’s post, No Pension? Create Your Own, a retirement income planning strategy that’s becoming more widely used the last few years is the addition of a rider, or endorsement, to a fixed index annuity to generate a retirement paycheck. The concept of fixed index annuities isn’t new to readers of Retirement Income Visions™. This topic has been featured for the last five months, beginning with the July 11, 2011 post, Shelter a Portion of Your Portfolio From the Next Stock Market Freefall.

Up until now, the fixed index annuity strategy has been presented as a conservative, tax-deferred investment approach to obtain (a) higher interest rates compared to similar-duration CD’s, (b) a higher potential rate of return than traditional fixed annuities, and (c) downside protection. As discussed in several posts, greater potential return is available as a result of interest crediting being tied to the performance of one or more stock market indices. Fixed index annuities also offer downside protection since interest crediting is never less than zero, even when the return of selected stock market indices is negative.

When you purchase a fixed index annuity, although you will realize all of the benefits mentioned in the previous paragraph, you won’t create a lifetime retirement paycheck unless you also apply for an optional income rider when your retirement income planner submits your application. An income rider, like all insurance contract riders, provides coverage that’s in addition to, and isn’t included as part of, the base contract. Since the features of the income rider aren’t included in the base contract, an additional charge must be paid to the life insurance company in order to obtain the benefits associated with the rider.

Income riders aren’t available with most fixed index annuities. In a search of 484 products, only 182, or 37.6%, offer an income rider. It’s important to keep in mind that all fixed index annuity income riders aren’t created equally. When available, each fixed index annuity income rider has its own specifications for determining the amount of income that the annuitant(s) will receive when the rider is activated. In addition, every life insurance company that offers an income rider reserves the right to change the specifications for products offered to new applicants.

How does a fixed index annuity income rider work? Specifically, how can it be used as part of a retirement income planning strategy to create a retirement paycheck? Next week’s post will be the first in a series of posts about this topic.

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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.

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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

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.

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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

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.

Categories
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.

Categories
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.