Equity Indexed Annuities

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What Is My Retirement Exit Strategy?

Most workers usually don’t place “Develop An Exit Strategy” high on their priority list. Most people nearing retirement wish they had.

No one wants to lose money in the stock market, but especially not at retirement.  Fixed index annuities are tax-deferred investment vehicles that credit a rate of interest to the investor based on the return of an index; the S&P 500 is a common index that is used in fixed index annuity contracts.

These annuities contain return formulas that must be carefully analyzed to determine what percentage of the index return you are entitled to over various periods of time. They typically provide a percentage of the price return of the index, and are subject to caps and floors — maximum and minimum crediting rates.

The Reasons to Consider a Fixed Indexed Annuity

There are five very good reasons to consider a fixed indexed annuity as a component of your retirement income plan.  An insurance carrier is able to provide each of these five advantages to you as long as you are able to make a time commitment to the carrier.

Possible reasons to consider a fixed indexed annuity

  • Safety from market losses
  • Growth potential
  • Tax advantages
  • Income guarantees
  • Beneficiary planning advantages

The foundation upon which these advantages are provided

  • A time commitment during which you will have limited liquidity

Possible Additional Benefits

  • Up-front premium bonus
  • Return of premium features
  • Bailout features

Safety from Market Losses

If you are like many people, your top priority when you are saving your money is safety.  No one puts their money in a place where they expect to lose it.  We put our money in a place where we expect to get it back one day, hopefully with some nice growth.

The great thing about fixed indexed annuities is that they offer multiple levels of protection, which makes them the gold standard of safety.

  1. First, when you decide to place your money with an insurance company, they must set aside a percentage of that money in “reserves,” that is, in very safe assets.
  2. Second, by contract, a fixed indexed annuity guarantees that your principal is protected and that you can get it back again.  There can be a penalty for early withdrawals above a certain amount, but as the annuity owner, you can control your withdrawals.  So, as long as you are not withdrawing more than the penalty-free withdrawal amounts allowed by the annuity you have chosen, you cannot lose any of your principal.
  3. Third, if you have a problem with the carrier that issued your annuity and you want to get a regulator involved, no matter where that annuity carrier is located, the regulator of that carrier is located in your home state.  Here, annuities even beat money in the bank.  Since most banks are regulated at the federal level, your bank’s regulator may be in Washington, DC.  Your annuity carrier’s regulator is much more local.  You can learn more about the role your state regulator plays in ensuring that your carrier remains able to meet it obligations at the website of your state insurance department.

With these three levels of protection, there is excellent safety in a fixed indexed annuity.

Growth Potential

Once you are satisfied that your money is protected from market drops, your next objective may be to have your money grow.  The annuity industry invented fixed index annuities precisely so that they could offer the potential for better growth potential by having the credited interest rate based on the movement of an outside market index.

Fixed indexed annuities do this:

  • In a year that the index increases in value, they credit an amount of interest that is based on the market index increase.  Features such as caps, participation rates, and spreads dictate what portion of the market index increase will translate into credited interest.  Thus, the interest credit is typically less than the amount of the index increase, but in general, the more the index goes up, the bigger the interest credit.
  • In a year that the index decreases in value, they hold their value.  Neither your principal nor any of the previously credited interest is lost in a year that the index decreases.

This combination of upside potential and downside protection is very powerful.

Tax Advantages  You want your money to grow as fast as possible, and besides having high growth potential, some sort of tax advantage helps to accomplish that goal.  It often makes little financial sense to pay income taxes on money that you are not using for current income.  A tax advantage can be one of the easiest ways to make your money more productive without taking on risk.

Annuities have a tax advantage, and that advantage is tax deferral.  As long as you don’t touch the money in your annuity, you pay no taxes on the interest as it is being credited to your annuity.  The recognition of taxable income is delayed – that is, deferred – until you withdraw money from the annuity.

Also, you can use an annuity as the funding vehicle for IRA or Roth IRA money, although keep in mind that the Internal Revenue Code provides tax deferral to IRA’s, so there is no additional tax benefit gained by funding an IRA with an annuity.  Consider the other benefits provided by an annuity to determine if an annuity is the right choice for your IRA.

Income Guarantees  A key retirement planning advantage with fixed indexed annuities is that the carrier provides a guaranteed minimum level of retirement income.  Over time, as interest is credited to the annuity, and as long as you are not taking withdrawals from the annuity, the amount of that guaranteed income level can only grow, not shrink.

That guaranteed income can be provided in one of two ways.

  • The first, more traditional way is called “annuitization,” where you essentially trade the cash value of your annuity for a guaranteed stream of payments. Because annuitization is a trade, it provides you with a guaranteed stream of payments, but you lose access to and control over your cash value.
  • The other way, a recent innovation in the annuity industry, is through an optional feature called an income rider.  With such a rider, the carrier provides you with a minimum guaranteed income that you cannot outlive.
  • Every year that you wait to take the first guaranteed income payment, the amount of the guaranteed income grows by a growth percentage that varies by company and is usually in the range of 4% to 8%.  (Keep in mind that this growth percentage only applies to the calculation of guaranteed income, not to the amount available as a lump sum withdrawal.)  These riders sometimes have a cost associated with them, usually no more than 0.75% of your annuity’s value annually depending on the individual carrier and growth percentage selected.  Even after you start taking the guaranteed income payments, you still have the ability to access to your remaining annuity value in the event that you may need it.  But keep in mind that any withdrawal above the guaranteed amount will reduce the future guaranteed level of income that is being generated.  For more details and disclosures, consult the product brochure of the specific income rider you are considering.

With either option, you have the peace of mind that comes from having an assured, guaranteed income for the period you have chosen.  Notice that with an annuity, you can choose to have the carrier guarantee an income that continues for the rest of your life, or for both your and your spouse’s lives, giving you a potentially excellent level of financial security.

Beneficiary Planning Advantages You may be at the point in your life where you are motivated to consider what will happen to your money after your death.  Annuities have some advantages that could be very helpful to some people as they plan for how to pass their money to their beneficiaries at death.

One advantage is speed.  With an annuity, as long as you have a properly designated beneficiary, you can normally avoid the sometimes lengthy and expensive probate process.  So an annuity can be one of the quickest ways to get money to a beneficiary after your death. Another advantage is privacy.  With an annuity, you get to name a beneficiary and avoid passing assets through your will.  This can allow you, for example, to direct money to a particular child who has been very helpful to you as you have aged, while still having your will provide for an equal division of your other assets between all your children.

The Foundation:  A Time Commitment  Most people recognize that liquidity, safety, and growth do not co-exist very well.  For example, with a checking account, you get excellent safety and total liquidity, but most checking accounts pay little or no interest.  With stock market mutual funds, you get good liquidity and hopefully a good rate of growth over time, but you are sacrificing safety because there is no guarantee that you will even be able to get back what you invested when you actually need the money.

So, with financial products, there are trade-offs.  You cannot get all of the most desirable features and benefits in one product.  They all have a purpose and can complement each other in a well-designed and diversified plan.  Since an annuity is going to give you safety of principal and growth potential, it is reasonable to assume that there has to be a trade-off somewhere, and it is with some sacrifice in liquidity.

Fixed indexed annuities require that you make a time commitment, and they enforce that time commitment by a surrender charge.  When you consider buying a fixed indexed annuity, make sure you are comfortable with the length of the surrender charge, because your access to your principal is limited during the surrender charge period.

Your time commitment can typically range from 3 to 16 years, depending upon the features and benefits that appeal to you.  The time commitment does not mean that you do not have any access to your funds.  Many annuity products allow earned interest to be taken after 30 days and others allow up to 10% of your annuity’s value to be taken each year after the first year without penalty.  Of course, if you do not need your funds, leave them in the annuity to accumulate on a tax-deferred basis until you decide to begin taking income payments.

This is contrary to bank certificates of deposit that typically only allow interest to be withdrawn and will impose an early withdrawal penalty for any principal withdrawn.  So to be able to enjoy the unique benefits that annuities provide, you have to allow the insurance company to hold your funds just like you would allow a bank to hold your funds.

With annuities, just as it is with certificates of deposit, there is generally a correlation between the time commitment that we allow the institution to hold our money and the productivity of our funds.  The longer we commit to letting the bank or insurance carrier hold our funds, the higher the rate of interest or upside potential we can enjoy.  A 5-year certificate of deposit will usually pay us a higher rate of interest than a 1-year certificate of deposit.  The same principle holds true with a fixed indexed annuity.  A 10-year product, for example, will typically offer a higher fixed interest rate and higher indexed-based interest crediting than a 5-year product.

If you take out more than the penalty-free amount (which varies by carrier and product), there can be substantial surrender penalties imposed (perhaps as high as 20% of the annuity’s value for a premature withdrawal), so you want to use an annuity as a part of an overall plan where you also own other accounts that have no surrender penalties for your short-term liquidity needs.  Use these other accounts for emergency funds and to pursue financial opportunities that arise.  Remember, annuities are designed to provide safe growth prior to retirement and guaranteed income streams during retirement.  They are not designed for short-term liquidity.  You will want to have sufficient funds for that purpose in other accounts, such as checking, savings, and money market accounts.

Choose fixed indexed annuity products for a specific purpose, such as principal-protected growth and income generation, where 100% liquidity is not needed during the surrender charge period.  Once the surrender charge period is over, you can withdraw any and all of your money from the annuity at any time without a surrender penalty.  Keep in mind that withdrawing money from an annuity will usually result in reporting of taxable income and, if taken prior to age 59½, may result in a 10% penalty tax on earnings.

Possible Additional Benefits The annuity marketplace is very competitive, and thus carriers often have attractive additional features designed to differentiate their products from the competition.  Some fixed indexed annuities have features such as these noted below:

  • Up-front premium bonus:  Some annuity products have a premium bonus that immediately bumps up your contract value.  The percentages will vary by carrier.  But for example, if you put $100,000 into an annuity that offers a 5% premium bonus, your contract value on day 1 will be $105,000.  This premium bonus is available to earn interest right from the inception of the contract.  You are not, however, allowed to withdraw the premium bonus right away.  The premium bonus is often subject to recapture charges if you take withdrawals above the penalty-free withdrawal amount in the early years of the contract.  (In other words, what we said earlier about the time commitment applies to the premium bonus, too.)  Keep in mind that premium bonus annuities may include lower cap rates, higher spreads, or other limitations that are not found in annuities that don’t have a premium bonus feature.
  • Return of premium features:  All fixed indexed annuity products have surrender charges, and so with most of them, you actually can lose money if you cancel the contract during the period where the surrender charge applies.  (Again, if you abide by the time commitment, the surrender charge reduces over time and ultimately disappears, so you receive your principal plus all credited interest with no risk of loss.)  But some carriers differentiate their products by providing that even if you choose to terminate your annuity contract early, you are guaranteed to receive back at least what you paid in.
  • Bailout features:  Some carriers provide for the surrender charges to be waived in case of certain hardships, such as if you are diagnosed with a terminal illness, or become confined to a nursing home, or even if a renewal rate or “cap” rate falls below a certain level on your annuity.

In summary, you can see that annuities offer a lot of positive features – safety from market losses, growth potential, tax advantages, income guarantees, and beneficiary planning advantages – all built on the foundation of the time commitment that you make to the carrier.


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Wednesday, August 21st, 2013 Wealth Management, Wealth Preservation Comments Off on What Is My Retirement Exit Strategy?

Transferring Retirement Risks

We purchase insurance for two reasons: risk and loss.  Creating a retirement strategy includes where you are going to place your investments and for what period of time.  If you know anything at all about investing, you’re most likely familiar with investment diversification — the “don’t put all your eggs in one basket” theory of investing. An important refinement of this theory is retirement income diversification. Transferring retirement risks to another party makes sense.

There are several forces converging on those who are retired or who are near retirement.  Those forces are decreased levels of Social Security, an increased lifespan, and the decreased availability of pensions with definite benefits.  No one can stop any of these changes whether demographic or economic from occurring.

All retirees can do, then is work as hard as they can to plan well for retirement so their money lasts in spite of these factors.  It is critical that you ensure you’re making an investment that’s relatively safe and trustworthy. That’s harder to do these days, as trying to outguess the economic cycle is a fools game. Even people whose primary job is forecasting macroeconomic trends have trouble getting it right.

Forecasts of future economic conditions are notoriously inaccurate.  If anyone tells you that they definitely know what is going to happen, it is a huge signal that they cannot be trusted. No one definitely knows, unless they are privy to related inside information. You cannot predict what will definitely happen.

There are various economic climates: normal times, recession/deflation or high inflation.  And given the likely length of your retirement, there’s a good chance you’ll experience all three economic environments. Which is why it pays to diversify your sources of retirement income.

Interest rates are being manipulated, temporarily, by the Fed, to be lower than they normally would be.  The only thing saving Washington from even worse numbers is the long period of artificially low interest rates that have allowed our government to accumulate massive amounts of debt without “Paying the Piper.”

What will happen with interest rates in the next trading day or week is almost entirely a roll of the dice. Forecasting longer-term rates is no easy task. Economists are correct on long-term interest rates only 35 percent of the time – far less than a coin flip.  I do think that interest rates are very likely to continue to rise. This is a relatively easy prediction to make. Rates can’t go a whole lot lower and they will go higher at some point, I just know I don’t know when.

Because it’s next to impossible for most of us to accurately predict when high inflation or a recession will occur, when interest rates will rise or fall and how the stock market will perform, a risk transfer strategy can help you protect your retirement paycheck whatever direction the economy takes.

For the vast majority of the last few years, it was relatively simple to predict the likely direction of the stock markets. This direction was up. Now it is not so simple.   The stock market’s fair value is vastly more related to normalized interest rates―versus the current (and temporary) unusual interest rates created by quantitative easing and other factors.

With the Federal Reserve’s intention to taper its easing, yields have risen quickly, causing municipal bonds to experience their worst decline since September 2008.  As people see the value of their bond holdings fall, there may be an overreaction in favor of stocks―just as there was an overreaction in favor of bonds that is now waning.

Your annuities are your portfolio’s shock absorber. We believe annuities will continue to be an attractive investment for those looking for regular income. Annuities tend to be looked at as a premium to stocks because annuity returns are, generally, more certain. Retirees will continue to want annuity exposure with demand “driven by an aging population looking for diversification out of stocks and by investment vehicles such as fixed indexed annuities.

With inflation-adjusted annuities, you’re guaranteed that your income lasts for the rest of your life and is adjusted for inflation, no matter how long you live and no matter what happens in the stock and bond markets.

Single-premium immediate annuities are best for retirees who are looking to bridge their Social Security benefits with their monthly expenses. If the need is for an income for life, an immediate life annuity makes good sense. It is the only financial instrument that can guarantee a specific amount of income for as long as the recipient lives.

We recommend deferred income annuities for consumers around a decade before retirement age.  You can buy this longevity insurance at age 55 and start receiving income payments at 65.  Many people like the security offered by this type of investment, because it’s impossible to outlive your money when you buy a pension.

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Saturday, July 13th, 2013 Wealth Distribution, Wealth Management Comments Off on Transferring Retirement Risks

Financial Tornado Protection

Today’s times brings with it a pressure to increase income in order to maintain your lifestyle.  It is an era of enthusiasm, confidence, and optimism. It is in such times of optimism that people take their savings out from under their mattresses and out of banks and invest it.  They feel that there is simply nowhere else to put their money to work, which is why the stock market continues to edge upward to new record highs.

The booming stock market may look good on the surface, but it is most likely a mirage. Those of us in the financial planning trenches know that by historical measures, the market is extremely overvalued. Of course, you could also make a lot of money, especially with how well things are going in the current bullish stock market that continues to somewhat defy gravity.

Although the stock market has the reputation of being a risky investment, it does not appear that way in today’s environment. The reality is that investors are rushing into the stock market and not wanting to miss out on the Wall Street party, which appears to be attracting many party goers. As more people invest in the stock market, stock prices tend to rise.

The strong bull market (when prices are rising in the stock market) entice even more people to invest.  The market gains experienced recently, with the Dow first topping 15,000 on its way to setting record highs, are giving investors a false sense of security. The stock market has once again become a place where everyday people truly believed that they can become rich.  Confident in what seems a never-ending rise in prices, many speculators neglect to seriously consider the risk they were taking.

To many, the continual increase of stocks seems inevitable.  The stock market goes up like an escalator, but goes down like an elevator.  Devastation to you retirement by a financial tornado is imminently brewing. The financial crisis is an ugly situation that no sane person would want to experience because it comes with very drastic results that can reduce wealth and standard of living.

Chasing dreams is one thing, but being prudent is another. You don’t want to risk your entire investing capital on the stock market, in spite of any temptation to do so. This is when you have to fight against the greed that might be in you—the greed that’s in most of us—and it won’t be easy.  You just need to be on top of things, and don’t let greed ravage your sensibility toward the stock market.

It’s not that the stock market is gaining value… it’s that our money is losing value. And so if you have a debased currency… a devalued currency, the price of everything goes up. Stocks are no exception.

The overall market (let’s say, the S&P 500) price is a function of supply and demand. Companies have enormous profit margins and are using their excess cash to buy back shares. This, of course, reduces shares outstanding. When supply goes down, price goes up. This is why the stock market right now is at all time highs.

In recent months, there have been four factors that have created a sweet spot for stocks. Indeed, stocks have rallied, and both the Dow and the S&P 500® Index have reached new all-time highs. But evidence has been mounting that three of these factors may be souring, and that instead of staging a long lasting break-out, the market may in fact be at a peak.

Taking the economy first, there is now clear evidence that the global economy is slowing down. Whether it is just a soft patch—like we’ve experienced in recent years—or something more serious remains to be seen, but the loss of momentum is unmistakable.

In terms of consumer sentiment, we continue to see the kind of optimism that one tends to see in a significant market advance. But when sentiment is one sided, it tells us that the risk is high, and that, if the fundamental story changes, there may be too many investors on the wrong side of the market.  The caveat is that sentiment is merely an attribute of price, so one-sided sentiment on its own is not enough to turn the market.

Why are the S&P and Dow near their highs despite clear evidence that, both technically and fundamentally, things are not as good as they were a month ago? Short sighted investing isn’t wise for most people. They look at a 50% gain as fantastic. Then if they experience a 33.3% loss it doesn’t seem so bad compared to the 50% gain. But do they do the math? One hundred dollars which gains 50% becomes one hundred and fifty. One hundred and fifty dollars that looses 33.3% becomes one hundred dollars. That takes two years to get a zero return. Your sock will do that good.

A long time ago, before there was such things as financial companies; people had to look after their own assets. Typically, the most valuable things in the home, like jewelry, bonds, gold, silver, and cash, was kept in safes that were hidden in the house. However, there are a lot of ways now to protect your assets other than investing in a giant safe that weighs hundreds of pounds. Instead, a better strategy would be to reduce the money in people’s hands by implementing reasonable programs.

There are several ways to go about managing wealth. Like annuity policies that allow you to plan for a disaster, save on tax and increase the monetary value on the principle amount. They work as both protection and investment.

In the past many people had a choice of getting a safe way of making money, but not the chance of higher returns. Or they could try for those higher returns, but would also run a risk of losing a lot of their principal investment. However, with fixed indexed annuities you have a shot at both without putting your principal at any risk! Offering you a guarantee for the principal, but also a link to the market, however, even with those downturns in the market, you wouldn’t lose principal.

What if you took your earnings and invested them into a fixed indexed annuity? Just take the money you have made and move it into an investment that never goes down and will get market like returns. Why not invest your principal in an indexed annuity that never goes down and has no risk to your principal and then invest all of the earnings in the market? That way you keep your principal safe and still have market returns from your interest being reinvested into the market. This idea takes the risk of investing your nest egg in volatile investments out of the picture.

The indexed annuity is a great way to lock in your earnings and put the money you earn to work for you. It can work as a market growth overflow account. When the market goes down again at least your earnings will be protected and your principal is protected. Your income generating or growth generating asset is safe and secure. And when the market goes down the only money that will be affected is your earnings that you invested in the market. Always protect your income generating investments when possible.

These ideas use indexed annuities to make your retirement money safe and secure. Your investments will be protected from market downturns. When the market is up it is very easy to forget the down years but if you prepare now for the market going down again, it won’t be so bad next time. After the market goes down again is too late. Now is the time to make a few changes.

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Wednesday, May 22nd, 2013 Wealth Management Comments Off on Financial Tornado Protection

A Floor Under Your Retirement

As more baby boomers and seniors begin retirement, many of them will simultaneously begin a search for alternative financing option.  In a constantly changing economic and investment environment, many Americans are concerned about the security of their retirement portfolios. Continued volatility and dramatic swings in the market have made retirement planning a challenging endeavor.

Choosing the right accumulation vehicle for retirement can be difficult. With so many choices, which product will be right for you?  On one hand, you want the safety and guarantee of principal and credited interest. On the other hand, most people prefer the potential of higher interest by being linked to the market—the return potential that a fixed-rate product cannot offer.

In the past, the choices were either (1) receive the guarantee of principle and a minimum amount of interest, or (2) link to the market with the potential of higher returns, but also accept the downside risk to your principal. But investing a lump sum in hopes of generating more income than the annuity comes with significant stock-market risk. A Fixed Indexed Annuity is a great blanket investment to cover you when you’re about to retire, or retired.  Indexed annuities are a conservative safe money place for retirement dollars.

Who should look at an Fixed Indexed Annuity? Anyone who wants to invest in the market but is afraid of losing any money.  If your goal is to have income during retirement years, you do not want to take any risk with this money, most retirees switching to a lump sum will need a bulletproof drawdown strategy that lets them tap enough cash to cover expenses. And lastly feel that you will be in an even lower tax bracket when you retire, then an annuity is great.

Economists have realized that retirees should annuitize much more of their income than they do and the fact that they do not has become known as the “annuity puzzle.”  Annuities products are perfectly suited to protect against longevity risk.  Fixed annuities are one of the oldest and most well-known products that can be used as a hedge against longevity risk for a retiree.

Guaranteed Lifetime Income – Fixed index annuities can provide you with a guaranteed income stream with the purchase of a fixed index annuity. You have the ability to choose from several different annuity payment options. With nonqualified plans, a portion of each annuity payment represents a return of premium that is not taxed, which reduces the income tax on your annuity payments.

With an Immediate Annuity, you will receive one check per month for the rest of your life, no matter how long you live. The amount of this monthly check is determined by the size of your account, the interest rates at that time, and your life expectancy.

The longer the annuitant receives annuity payments, the higher the return on investment the annuitant is going to realize. This is common sense to a certain extent, as the total number of annuity payments received by the annuitant is the effective “gamble” the annuitant is taking when buying the annuity.

With a joint-and-survivor annuity, the amount of each check will be 10% to 15% smaller because they will be sent every month for as long as you or your spouse is alive. You can also opt for a life with 5, 10, or 20-year certain contract, which will guarantee that monthly checks are sent to your heirs after you and your spouse are deceased.

The Power of Tax Deferral – All annuity values accumulate on a tax deferred basis until withdrawn. Therefore, your money can grow faster because you earn interest on dollars that would otherwise be paid as taxes. Your principal earns interest and the interest compounds allowing you to accumulate more money over a shorter period of time, thereby earning a greater return on your money.

Annuities can be funded with pre-tax or post-tax dollars. So let’s say that you have some money sitting in your money market account which you have already paid taxes on and you want to shelter it from current taxes. One way to do it would be to deposit your money into an annuity. Until you withdraw it, all your growth and interest is sheltered from taxes. In other words, an annuity offers you the same tax-deferring benefits as a retirement account does.

Annuities have some liquidity.  Fixed index annuity contracts generally allow for some form of penalty-free withdrawals, up to 10% of the full accumulation value, once each contract year after the first contract anniversary.

Let’s look under the Hood!  While the index annuity concept offers many features of a traditional fixed annuity, it has a rather unique feature that allows a potential of stock market-linked interest credits without the potential of any market-type loss. In contrast to a securities-type product or mutual fund where the investor bears the market risk, the fixed index annuity concept insulates the contract owner from any risk of loss of principal due to market downturns.

Safety and Guarantee of Principal – A fixed index annuity (also referred to as an equity indexed annuity) provides you with the best features of a traditional fixed annuity – a guarantee of principal. Unlike most securities or mutual funds where your account balance can fluctuate due to market performance, premium deposited into a fixed index annuity is guaranteed to never go down due to market downturns. A contract owner of a fixed index annuity participates in market-indexed interest without market-type loss.

All indexed annuities have a floor of zero, meaning the absolute worst case scenario due to a downturn in the market index is a consumer might receive no interest in a particular year, however, he or she cannot lose any previously credited interest or premiums.

What is Indexing? – Earnings on a fixed index annuity are based on stock market-like performance from certain indices. But what is indexing? Indexing is simply an investment strategy that follows the performance of select securities, such as the Standard & Poor’s 500® Index.

The S&P 500® is a collection of 500 select industry leaders and thus a benchmark for U.S. Stock Market performance. A fixed index annuity is linked to the performance of this type of market index, without the risk of directly participating in stock or equity investments. With indexing, you can participate in a diversified passive investment strategy: a link to the market and its potential gains without subjecting yourself to the potential downfalls of the market.

The Standard and Poor’s 500 index is made up of 500 stocks that are actually more a gauge of what the entire stock market is doing than the traditional Dow Jones Industrial Average that we hear about every day. The reason this is true is that the Dow Jones Average is calculated from only 30 stocks, realistically not an overview. To participate in this index trend, the insurance companies created an index annuity.

Like all annuities, an index annuity is a contract with an insurance company for a specific period of time. The surrender period on an index annuity is usually about 7 to 10 years. The index annuity tracks an index such as the Standard and Poor’s 500 index, and your return on your money will usually be a percentage of what that particular index did for your corresponding investment year. For instance, let’s say your index annuity happens to track the S&P 500 index.

If the S&P 500 index goes up, you would get a set percentage of what the yearly return of the index was from the time you deposited the money in this annuity until one year from that date, up to a pre-set maximum. In this case, let’s say that your index annuity will give you 50% of what the S& P index returned, up to a maximum of 10%.

You invest $20,000 on March 15th. March 15th one year later the S&P index has increased 30% since you opened the account. According to the terms of your annuity, they have to give you 50% of that increase up to a maximum of 10%.

Since 50% of 30% is 15% which is 5% higher than the pre-set yearly maximum of 10% you will get credited with 10% of your original deposit or in this case $2,000. If the S&P index had only gone up 15% for the year, you would be entitled to 7.5% on your investment- (50% of 15%=7.5%).

Why, you might be asking, do you only get a percentage of what the index does up to a maximum? Why wouldn’t it be better simply to invest in a mutual fund that buys the entire index and get 100% of the return? For some people, it would be better, but for others who do not want to take any risk at all this index annuity might be better.

Here’s why. When you invest in a regular index mutual fund, you get to participate 100% in all the upside–and any downward swerves as well. For instance, if the market went up 10% one year and the next year it went down 20%, you would participate in that downward movement as well.

So lets say that you invested $20,000 in a good no load S&P index fund. The first year it went up 10%, now you would have $22,000. The next year it went down 20% now you would have only $17,600 or $2,400 under what you started with. That may make you too nervous. In index annuities, you do not participate in any downside risk.

To follow the same example, in a particular index annuity if you invested $20,000 and the market went up 10% you would end up with $21,000 for that year.(50% of 10% is 5% or $1,000) But the next year when the market went down 20%, you would not participate in that downside activity and you would still have $21,000 in your account.

Within this particular index annuity, for example, your money can only go up; it cannot go down. In the long run I would rather have $21,000 after two years in my index annuity than just $17,600 in my S&P index fund. That is why the index annuity does not credit you with 100% of the return. It is set in reserve to protect you from the downside.

Consider, too, one last safety feature. If you invest in an index annuity and the market goes down every single year, it still won’t matter to you. Because it is an index annuity, the insurance company usually guarantees you that, after your surrender period is over, you will get at least 110% of what you originally put in. If you put in $20,000, the worst-cast scenario would leave you, after seven years, with $22,000, or about a 1.5% minimum guaranteed yearly return on your investment no matter what happens in the market.

Bottom line: if you are willing to give up some upside potential, you can also protect yourself totally against downside risk with an index annuity

In recent years, many indexed annuities can be issued with a rider designed to supply a lifetime income payment to the policyholder that does not require annuitization, thus leaving the policyholder in control of the balance of the account. These “income riders” are calculated separately than the indexed annuity itself, however, they use the same initial premium figures for each calculation.

An “income rider” generally will provide a specified accumulation rate which is guaranteed for a certain period of years. The “income rider” calculations create an “income pool” which is strictly an accounting figure that cannot be accessed as a single lump sum by the policyholder or beneficiary.

The “income pool” continues to grow annually at the specified accumulation rate until such time the guarantee period expires or the policyholder opts to begin taking “lifetime income payments” from the account.

Once “lifetime income payments” begin, the “income pool” stops accumulating, and the value of the income pool is used to determine the amount of income that will be paid out annually (it can usually be paid monthly, quarterly or semi-annually as well).

The amount of income produced by the “income rider” will depend on several factors, primarily the age of the policyholder at the time they opt for income, the specified accumulation rate and the length of time the “income pool” has been given to accumulate.

Each time an income payment is paid to the policyholder, the indexed annuity account value is decreased by that same amount. “Income riders” that provide lifetime income are generally used as a means of allowing a policyholder to supplement their income, especially in retirement, without the possibility of outliving their money because even if the indexed annuity’s account value falls to zero, the income payment from the “income rider” will continue until the death of the policyholder.

If the policyholder dies and funds remain in the indexed annuity account value, those funds would be paid to the beneficiary(-ies). Some of these income riders are offered with no fees, while others carry an annual fee (generally 1% or less) which is deducted directly from the indexed annuity account value.

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Tuesday, March 26th, 2013 Wealth Management Comments Off on A Floor Under Your Retirement

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