Financial Planning for April 2008

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Is An Equity Index Annuity for You?
The current volatility of the stock market has many clients seeking safety for their retirement nest egg. At the same time, they are not content with the low yields typically offered by more stable investments like fixed annuities. Using equity index annuities (EIA) is one way to increase investment return, but are they a miracle cure? This article is intended to help you answer that question for yourself.

We can better understand the concept behind EIAs by knowing a little about annuities in general. An annuity is an insurance product. When talking about investment return, there are two main types of annuities – fixed and variable.

Fixed annuities offer a customer a fixed rate of return. When you enter into a fixed annuity, you pay your premium to the insurance company and it, in return, guarantees you will receive a stream of periodic payments based on your initial investment plus a set interest rate. While this type annuity protects against loss of principal, it severely limits your return in a rising market.

Variable annuities, on the other hand, do not limit your investment return. Insurers do not guarantee the value of variable annuities. Instead, they invest your premium in mutual funds based on your instructions. Thereafter, the value of your annuity rests on the value of the underlying funds. While this allows you to participate in rising markets, it also subjects your money to the same risks as if you invested directly in the stock market.

Equity index annuities are a hybrid of the fixed and variable annuity. The EIA contract allows a customer to participate to some degree in the gains of the stock market while minimizing the possible loss of principal. It does this by establishing a minimum return (typically zero percent) while allowing for an increase in value based on some portion of the change in a specified stock index.

For example, assume you invested $100,000 in an EIA. The contract calls for a floor, or minimum interest rate, of zero percent, but allows for a return based on 70% of the change in the S&P 500 Index. Let’s say the change in the S&P from the time you invest to the time interest is credited to your contract is 15%. At the time interest is credited, your contract will be credited with $10,500 (70% of $15,000). On the other hand, if the index goes down 10%, your contract will still be worth $100,000, assuming no withdrawals.

Often, an EIA will include a cap interest rate. The cap limits your upside investment gain. Let’s say the annuity in the previous example has a rate cap of 8%. The amount credited to your annuity will be $8,000 instead of $10,500

There are three main ways an insurer credits income to your EIA:
  • Under the annual reset method, the interest rate is determined from year to year based on the difference in the underlying index at the beginning and ending of the year. For example, let’s assume the index is 1,000 at the beginning of the year and 1,050 at the end of the year. If your participation rate is 80%, the value of a $100,000 contract at the end of the year will be $104,000. Under the annual reset method, your annuity will never go below $104,000. The drawback to the annual reset is that the participation rate may change from year to year and interest rate caps may be used.

  • If your contract credits the income based on a point-to-point method, annual changes in the index do not come into play. Instead, the value of your annuity is based on the change in the index through the ending date of the annuity’s income accumulation period. Let’s say the term used to credit income to your annuity is the typical seven years. If the index change is 15% during that period and your participation rate is 80% with no cap, the value of your annuity will be $112,000. It won’t matter that the index was up 40% at one point. While this method may allow for higher participation rates, since interest is not credited until the end of the annuity term, you may receive no interest if you must cash out early.

  • Using the high-water mark method, interest will be credited based on the highest change in the index during the period. Let’s say you purchase your annuity and at the end of year one, the index has doubled. After that, the index declines to the point where the change is nil by the end of the annuity term. Your annuity will increase based on the highest change (100%) during the period. These type annuities typically have lower participation rates and often use caps to limit the exposure to the insurance company.
Does all of this sound good so far? As good as the EIA sounds, there are some major drawbacks you should be aware of. Annuities are, in the end, insurance products and not pure investments. As such, your return will be limited because the insurance company will keep a portion of earnings for administrative and mortality costs.

Another drawback to the EIA, as with most annuities, is that there is typically a surrender charge. This means you will pay an early withdrawal penalty if you pull your money out prior to a specified period (typically seven to 10 years). Because of this charge, it is possible to lose money using an EIA.

If you are under 59 ½ years old, withdrawal of funds from a tax deferred annuity can trigger a 10% federal tax penalty in addition to income taxes on the increase in the value of the annuity.

One mistake many taxpayers make is selling other investments to purchase an annuity. This works well when there is no gain in the other investments. However, when there is a gain in those investments, they create an unnecessary tax liability. Make sure you don’t fall into this trap.

At the end of the day, EIAs do provide some protection for your retirement dollars - but not without a cost. Because they are long-term investments, with significant penalties on early withdrawal, you should not use any funds that may be needed in the near future to purchase annuities. Additionally, EIAs may not be suitable for older individuals due to penalties associated with early withdrawal of funds. If you are looking at such a contract, it pays to get a second opinion. Give us a call if you need help in deciphering the real effect an EIA will have on your financial picture.

Have a terrific April.


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