Q: What Is A Fixed Index Annuity?

A: Fixed Index Annuities are fixed annuities. They differ from traditional annuities in that the crediting of excess interest is based on the movements of an external Fixed index. Index annuities protect the principal from market risk while providing the potential for a higher return than one might get from traditional long term savings vehicles.

Fixed index annuities share the same basic features as other fixed annuities. Interest compounding within the annuity grows tax-deferred; interest is not taxed until it is withdrawn. The owner may elect to annuitize the annuity and has several lifetime income options. Index annuities provide minimum interest guarantees and the death benefit may avoid probate.

Many index annuities offer access to interest through surrender penalty free withdrawals, although index annuities are subject to the same “under age 59 1/2” IRS penalties as traditional fixed annuities. Index annuities have surrender penalties that, depending on the product, last from one to fifteen years. Fixed index annuities are regulated as insurance products and not as securities. The same licensing required for the agent to sell traditional fixed annuities is used with Fixed indexed annuities.

Q: Does The Index Return Include Reinvested Dividends?

A: No.

Q: Where’s The Risk?

A: Both stocks and mutual funds offer the potential for gains, and long term investors in these vehicles have realized average returns that are higher than safer alternatives, but these vehicles still have market risk. The stock market goes up and down and on any given day these investments may be worth more or less than originally paid.

Index annuities eliminate this market risk on the principal investment. When a customer buys an index annuity their principal is backed by, and is as safe as, the insurance company that issued the annuity. As with all fixed rate insurance products index annuities provide a minimum guaranteed return. Excess interest beyond this minimum guarantee is calculated based on movements on an external index, but the customer is not directly involved in buying the investments.

Q: What Is The Difference Between A Traditional Annuity And An Index Annuity?

A: The difference between index and most traditional fixed annuities is the crediting of excess interest beyond the minimum guaranteed rate. In a traditional fixed annuity the initial and renewal interest rate is generally decided by the insurance companies’ net investment income from their portfolio and other market and internal factors. With an index annuity the rate is based on the performance on an independent index. The degree to which the customer participates in this performance, their participation rate, is determined by the carrier at the time of the initial premium. This rate is either guaranteed for the surrender period or may be declared more often.

The participation rate may either be expressed as a percentage of calculated index movement, which is calculated by deducting an asset fee or a yield spread or a combination of both. For example, if the calculated index gain was 10% for the year and the participation rate was 70%, the annuity contract would be credited with 7% interest. Or, if the calculated index gain was 10% and the annuity deducted a 3% asset fee or yield spread from the gain, the annuity contract would be credited with 7% interest.

The minimum interest guarantee usually only applies if the total return for the entire surrender period is less than the guaranteed return. As an example, say that the annuity guaranteed 3% a year based on 100% of the premium. This means that at the end of a seven year term that annuity would return a minimum of $1.23 for each $1 of premium. If, using our previous example, the applied participation rate resulted in a 7% interest credit the annuity contract would earn 7% interest – not 7% + 3%. If the calculated index gain was zero for a year, the annuity would not credit the minimum guarantee of 3% for the year, the contract would record 0% interest. The minimum guarantee would only apply if the total interest for the period averaged less than 3% a year.

Fixed index annuities are treated as insurance products, and not securities, because the market risk is assumed by the carrier, not the customer. And, all index annuities guarantee a minimum return even if the index declines.

Q: How Do The Different Crediting Methods Work?

A: The high point (high water mark) term annuity locks in the highest level of the index during the term and credits any gain for the period based on the participation rate in effect at the time of purchase; the point-to-point annuity uses the ending value of the index. Example: If the high point or point-to-point annuity had a participation rate of 75% and the index moved from 100 to 150 by the end of the term, a 50% increase, the annuity would credit a gain of 37.5% (50% x 75%) for the term. However, if the value of 150 was the highest anniversary value and the index value at the end of the term was 140, the high point term would use the 150 value as the end point. The point-to-point annuity does not lock in gains until the end of the term and its calculation would reflect the 140 ending index value.

The term yield spread annuity usually computes the annual effective yield based on the highest anniversary level of the index during the term and then deducts a guaranteed yield spread to determine the annual return credited to the policy.

Example: If the guaranteed yield spread was 2% and the index moved from a value of 100 to a highest value of 177 during a seven year term the annuity would compute the annual effective yield for the index (8.5%), deduct the guaranteed yield spread (8.5% – 2%) and credit the annuity with an annual return of 6.5%.

The annual reset annuity structures recognize annual positive changes in the index and credits the gain to the annuity’s accumulation value based on the participation rate in effect. Positive gains are locked in each year, negative movements are treated as zero gains.

Example: If an annual reset annuity had a participation rate of 75% and the index increased 10%, the annuity would credit 7.5% for the year. If the index decreased the following year the annual reset structure would record a 0% return, but the 7.5% return from the previous year would be unaffected. The annual yield spread structures recognize annual positive changes in the index and credit the gain to the annuity’s accumulation value after deducting a yield spread or asset fee. Positive gains are locked in each year, negative movements are treated as zero gains.

Example: If an annual reset annuity had a yield spread of 2.5% and the index increased 10%, the annuity would credit 7.5% for the year. If the index decreased the following year the structure would record a 0% return, but the 7.5% return from the previous year would be unaffected. Any of these structures could impose a cap of the earnings credited, average the daily, weekly, monthly or quarterly values of the index to determine index movement, or use a combination of variations to determine excess interest credited. The participation rate for almost every point-to point, high point term and term yield spread is guaranteed for the length of the surrender charges.

The participation rate for most annual rest structures is declared each year and could change annually thereafter. Many annual reset structures that declare rates yearly have a minimum participation rate or maximum yield spread according to their contract.

Because of the many variations used in calculating index movement using only the participation rate to select an index annuity is misleading at best, unless you are comparing identical crediting structures. If annuity “A” has a participation rate of 90% and annuity “B” has a participation rate of 50%, annuity “B” may well produce the highest return if the two products have different crediting structures.

What Is The Profile Of An Index Annuity Buyer?

Index annuities are designed for people that are averse to risk. The type of person whom, if given a choice between an investment that has an equal chance of doubling in a year or losing 20% of its value versus an investment that will make 6%, will always choose the low risk/low return alternative. Certificate of deposit and traditional fixed annuity buyers fit this profile. Fixed index annuities can be used to overcome this aversion to risk by providing the potential for higher returns than traditional savings vehicles without market risk to principal.

Q: Where Are Index Annuities Used?

A: They’re an ideal bridge for a customer that has never invested in the stock market because of the fear of loss, but wants the potential for a higher return than they’re earning on other saving instruments.

Index annuities are also attractive for stock market investors that want to take their profits, don’t want to lose principal, but want the potential for a higher return than they might get from a money market account.

Q: Are Index Annuities Mutual Funds?

A: No. Although the excess interest in an index annuity is linked to the performance of an index, index annuities are not Fixed investments or mutual funds. Mutual fund returns include reinvested dividends and subject the principal to market risk. Index annuities do not include reinvested dividends, but the principal is protected from market risk.

At current participation rates, no index annuity will provide the same returns as fixed mutual funds in a rising stock market. However, many index annuities could provide a substantially higher return than bank instruments or traditional fixed annuities. And, if the market falls index annuities provide the protection of a minimum guaranteed return.

Q: What Solutions Can An Index Annuity Provide?

A: Say that an individual has taken early retirement and has a lump sum pension plan distribution. The person will start drawing on these funds to provide income in a few years. The money could be invested in mutual funds. Over time, Fixed investments have produced high returns, but the stock market is fickle in the short term and could go down. An index annuity guards against risk to principal if the market goes down while providing higher upside potential than certificates of deposit.

Or, a retired couple already owns traditional fixed annuities and are planning to leave the money in the annuities to their children. An index annuity assures them of earning at least a minimum return while giving them the possibility of bequeathing an even greater legacy.

Or, many people invest their retirement funds in fixed rate instruments. This may be prudent for a worker in their fifties, but it’s a costly strategy for a thirty year old. An index annuity gives these workers guarantees and higher potential growth. Index annuities are an attractive tool for SEP, SIMPLE and 403(b) retirement plans. They are attractive to the no-load investor. And, they may be an alternative in asset allocation models to bonds.

Q: What Are Annual Index Annuity Sales?

A: Index annuities were introduced in 1995. Since that time sales have grown to over $5 billion a year. By spring 2009, index annuities represented $15 billion of in force annuity contracts. This represents the fastest growth of any insurance product heretofore introduced.

Q: Why Stonewood Financial?

A: Based in Louisville, Kentucky, Stonewood Financial is dedicated to helping its clients make the most of their retirement years. We can help you with the difficult questions including where you should safely put your retirement income and how much you can safely allocate to each area.

CEO Marty Ruby is an actuary and MBA with years of experience in the insurance industry. He is fully qualified to guide you through the development of a solid retirement income strategy.

Have other questions or need more information? Call Stonewood Financial now and you could earn an immediate Upfront Bonus on your investment! To arrange a confidential meeting, please give us a call at 502-588-7155, ext 178 or email us.