Retirement Income Visions

What’s a Reasonable Premium Bonus Percentage?

2012-02-13T01:00:00-08:00

Last week's post, 8 Questions to Ask Yourself When Analyzing Premium Bonuses, introduced a series of questions when considering the purchase of a fixed index annuity ("FIA") with a premium bonus. The first three questions were answered last week.

This week's post addresses questions #4 and #5, dealing with premium bonus percentages as follows:

What percentage should I expect to receive?
Why not purchase the product that offers the highest percentage?

What Percentage Should I Expect to Receive?

Per last week's post, a premium bonus isn't an inherent component of every FIA contract. Of the 267 FIA's on the market today, 138, or approximately 52%, include a premium bonus feature.

Per Exhibit 1, of the 138 FIA's offering premium bonuses, bonus percentages range from 0.5% to 30%. 130 of the 138 products, or approximately 94%, offer bonuses between 0.5% and 10%.

Approximately 26% of all premium bonuses pay 0.5% - 4%, 32% are right at 5%, and 36% are between 6% and 10%. The sweet spot is 5% - 10%, with 68% of all premium bonuses falling into this range.

Why Not Purchase the Product That Offers the Highest Percentage?

What about the eight FIA's that include bonuses greater than 10%? There are four that pay 12% - 17%, one is 20%, two offer 25%, and there's one paying 30%. Why not choose one of these products? As usual, it gets back to the old saying, "There's no free lunch."

In addition to the eight questions you should ask yourself when analyzing premium bonuses, there are two other things to consider any time you're analyzing a FIA with a bonus percentage greater than 10%:

Financial strength of the issuing company
Timing of payment of the bonus

Financial Strength of the Issuing Company

Fixed index annuities by their nature are long-term investments. If you're 50 years old, married, in good health, and you purchase a FIA with an income rider, there's a good chance that either you or your spouse will live well into your eighties, if not nineties.

While life insurance companies as a whole enjoy an excellent historical track record when it comes to fulfilling their contractual commitments, including annuity payouts, you want to choose a company that has the highest ratings from the three major ratings services: Standard & Poor's, A.M. Best, and Moody's. This is especially important when evaluating FIA's with income riders.

Of the eight FIA's that offer premium bonuses greater than 10%, five of the eight products are offered by two life insurance companies with less than excellent ratings. That's an immediate deal killer for me when I'm analyzing FIA's for my clients.

Timing of Payment of the Bonus

Per last week's post, the vast majority of premium bonuses are payable on investments during the first contract year. In addition, several products also pay premium bonuses on subsequent years' investments for a specified number of years.

One of the eight FIA's that pays a premium bonus of 20% is offered by a highly-rated insurance company. Unlike the vast majority of other premium bonuses in the marketplace, this one isn't calculated on the initial investment or subsequent years' investments. It is instead applied to income withdrawals and is only available at the end of ten years.

8 Questions to Ask Yourself When Analyzing Premium Bonuses

2012-02-06T01:00:00-08:00

Last week's post, Contractual vs. Situational Fixed Index Annuity Income Calculation Variables, classified each of the ten fixed index annuity ("FIA") income calculation variables introduced the previous week into two categories -- contractual and situational. The first contractual variable, premium bonus availability, is the subject of this week's post.

There are eight questions that you should ask yourself when considering the purchase of a FIA contract with a premium bonus as follows:

What is a premium bonus?
Why is it offered?
How prevalent is it?
What percentage should I expect to receive?
Why not purchase the product that offers the highest percentage?
How will a premium bonus affect my contract's accumulation value?
How will withdrawals affect my premium bonus?
How will a premium bonus affect the amount of income I will receive from my FIA?

This week's post will answer the first three questions with the answers to the last five questions addressed in subsequent weeks' posts.

What is a Premium Bonus?

A premium bonus is a fixed percentage of the investment in a FIA that's added by some life insurance companies to the FIA's accumulation value of specified products. It's paid on investments, i.e., premiums in insurance lingo, during the first contract year. Several products will also pay premium bonuses on subsequent years' investments for a specified number of years.

As a simple example, assume that you invest $100,000 in a FIA that offers a premium bonus of 5%. The accumulation value of your FIA at the time of investment will be $105,000 ($100,000 + 5% of $100,000).

Why are Premium Bonuses Offered?

Life insurance companies that choose to include a premium bonus as part of a FIA contract do so for various reasons. The primary reason is in recognition of the fact that fixed index annuities require a long-term commitment in order to reap the potential benefits of this type of investment. This is especially true whenever you purchase an income rider. Life insurance companies will often offer a premium bonus as an incentive to encourage investors to purchase, and retain, their FIA for the long haul.

The availability of a premium bonus is also dictated by the marketplace. Some companies feel that they need to offer a premium bonus in order to be competitive with other products that offer this feature. In addition, investors who either don't work with retirement income planners or who are uneducated about FIA's may place undue emphasis on purchasing a FIA that includes a premium bonus, and, furthermore, one that pays a high percent.

How Prevalent are Premium Bonuses?

A premium bonus isn't an inherent component of every FIA contract. Of the 267 FIA's on the market today, 138, or approximately 52%, include a premium bonus feature.

Contractual vs. Situational Fixed Index Annuity Income Calculation Variables

2012-01-30T01:00:00-08:00

Last week's post, 10 Fixed Index Annuity Income Calculation Variables, introduced ten potential variables that are used to calculate the income, or lifetime retirement paycheck ("LRP"), amount that you will receive when you purchase an income rider with your fixed index annuity ("FIA").

It's important to emphasize that all ten variables won't apply in every situation. Six are contract-dependent and four are situational. Situational variables, by their nature, occur after the fact, and, as such, often cannot be anticipated when deciding which FIA(s) to purchase. Having said this, each variable needs to be taken into consideration by a retirement income planner when analyzing and selecting FIA income riders and products that may be appropriate for a particular situation.

Contractual Variables

Contractual variables are addressed in various sections of a FIA contract. The six contractual variables are as follows:

Premium bonus availability
Income account value interest rate
Number of years income account value interest rate is in effect
Maximum lifetime income withdrawal percentage
Surrender charge schedule
Premium bonus recapture provision

Variables #1 and #6, premium bonus availability and premium bonus recapture provision, are directly related. When offered, premium bonus provisions appear in the base contract since they affect the accumulation value regardless of whether an income rider is also purchased. Variable #5, surrender charge schedule, is also included in the base contract. Variables #2 - #4 are only applicable to income riders, and, as such, will be included in the income rider section of a FIA contract.

Situational Variables

Situational variables, although they will trigger one or more contractual provisions, arise as a result of an action on the part of the contract owner. The four situational variables are as follows:

Initial and subsequent investment amounts
Lifetime payment election date
Accumulation value withdrawal amounts and timing of same
Death of owner prior to commencement of income payments

The first three situational variables are controllable by the contract owner while variable #4, death of the owner prior to commencement of income payments, is unpredictable. Variables #1, #3, and #4 affect both the accumulation value and the income rider payout. Variable #2, lifetime payment election date, is unique to the income rider.

Now that we have made the distinction between contractual vs. situational fixed index annuity income calculation variables, we will continue our exploration of each of these variables in the next several posts, beginning with contractual variables.

10 Fixed Index Annuity Income Calculation Variables

2012-01-23T01:00:00-08:00

The last five weeks' posts have focused on what you don't receive (Your Fixed Index Annuity Income Rider – What You Don't Receive – Parts 1 and 2 and Annuitization Tax Treatment of Nonretirement Distributions) and what you do receive (5 Things You Receive From a Fixed Index Annuity Income Rider – Parts 1 and 2) when you purchase a fixed index annuity income rider.

As stated in Part 1 of 5 Things You Receive From a Fixed Index Annuity Income Rider, there are three types of fixed income annuities that offer lifetime income payments: (a) single-premium immediate annuities, or "SPIA's," (b) deferred income annuities, or "DIA's," and (c) fixed index annuities, or "FIA's."

Per Part 2 of the same post, product-specific illustration software must be used to determine the periodic payment that you will receive from SPIA's and DIA's given certain specified assumptions. The reason for this is that the payment from both of these types of fixed income annuities is an annuity that must be actuarially calculated using a life expectancy factor amongst other variables.

The lifetime payment that you receive from a FIA, unlike a SPIA or DIA, isn't an annuity that's actuarially determined. In order to receive a FIA lifetime payment, you must purchase an income rider which is a separate component of a FIA contract. While it's possible to annuitize the accumulation value of the base contract, distributions from the income rider are considered to be withdrawals.

So how are FIA income amounts determined? In addition to the accumulation value of a FIA which is the value of your investment before reduction for potential surrender charges, there's generally a separate income account value when you purchase a FIA income rider. Unlike the accumulation value, withdrawals cannot be made from the income account value. The latter is used instead to determine your FIA income, or lifetime retirement paycheck ("LRP") amount.

There are ten potential variables that are used to calculate the FIA income amount as follows:

Initial and subsequent investment amounts
Premium bonus availability
Income account value interest rate
Number of years income account value interest rate is in effect
Lifetime payment election date
Maximum lifetime income withdrawal percentage
Accumulation value withdrawal amounts and timing of same
Surrender charge schedule
Premium bonus recapture provision
Death of owner prior to commencement of income payments

In order to help you understand how a FIA income amount is calculated, FIA income calculation variables will be the topic of Retirement Income Visions™ posts for the next several weeks.

5 Things You Receive From a Fixed Index Annuity Income Rider – Part 2 of 2

2012-01-16T01:00:00-08:00

Part 1 of this post last week made the point that fixed income annuity, or "FIA," riders are a dream-come-true for a retirement income planner like me since it enables me to offer a unique solution for meeting clients' income needs that isn't available elsewhere from other investment products. It emphasized that the five things you receive from a FIA income rider, when taken as a whole, cannot be duplicated by any other investment.

The first two features, guaranteed income and flexible lifetime retirement paycheck, or "LRP," start date were the subject of last week's post. This week we'll take a look at the other three features.

Potential for Increased Lifetime Retirement Paycheck ("LRP") Amount

Tied directly to benefit #2, flexible lifetime retirement paycheck, or "LRP," start date, is a third important perk that's associated with a FIA income rider – potential for increased LRP amount. The longer you wait to begin receiving your LRP, the greater your income will be.

There are several reasons for this which will be the topic of a future blog post. Suffice it to say that the difference in annual income can be significant depending upon the variables of a particular case. In one of my recent proposals for a married couple, the potential annual income ranged between $46,000 and $100,000 depending upon whether they began taking income at the husband's age 65 or 75.

Ability to Calculate an LRP Amount on the Date of Purchase

As a retirement income planner, either my life insurance agency or I can run an illustration using the software for a particular product for the first two types of fixed income annuities discussed in last week's post, i.e., (a) single-premium immediate annuities, or "SPIA's," and (b) deferred income annuities, or "DIA's," to determine the periodic payment that my client will receive given certain specified assumptions. This can only be done using product-specific software.

While there's also product-specific software available for all FIA's that can be used to determine an LRP amount assuming the purchase of an income rider, I'm not dependent on it. Given my client's initial and potential subsequent investment amounts, including frequency of same, I can independently calculate his/her potential LRP amount beginning at various ages for different FIA products to determine which one(s) would be best suited for meeting my client's needs. This capability enables my client to know how much income he/she will receive beginning at various ages before making any investment.

Ability to Adjust Initial and Ongoing Investment Amount to Match One's Income Needs

While it's great to be able to know the annual income amount you will receive beginning in 15 years assuming you invest $200,000 today with annual additions of $20,000 for the next five years and further assuming that you're 52 now, it's preferable from a retirement income planning perspective to be able to do the reverse calculation. That is, assuming that when you retire at 67 with an annual income need of $100,000 and you're projected to receive $25,000 from Social Security and $30,000 from another source, how much do you need to invest today and for the next 15 years in order to close your income need gap of $45,000 ($100,000 - $55,000)?

An FIA with an income rider is a wonderful tool to use in this situation. It can be used to calculate a single lump sum amount that is required to match your income needs as well as a smaller initial investment with subsequent periodic investment amounts.

As stated at the conclusion of Part 1, the foregoing three features, together with guaranteed lifetime income and a flexible LRP start date, distinguishes FIA income riders as a powerful and unique addition to an otherwise conservative investment product with the potential for meeting a retiree's ongoing income needs.

5 Things You Receive From a Fixed Index Annuity Income Rider – Part 1 of 2

2012-01-09T01:00:00-08:00

As the saying goes, it's better to give than to receive. With this in mind, the last three week's posts focused on what you don't receive when you purchase an income rider with a fixed index annuity, or "FIA." With Christmas and Hanukkah just behind us as I write this week's post, it's time to take a look at what you receive from this optional addition to your FIA.

Let's start with some basic terminology. Although many life insurance companies refer to it as an income rider, you will also see the phrase, guaranteed minimum withdrawal benefit rider, or "GMWB" rider, for short. The latter terminology is simply another name for an income rider.

FIA income riders are a dream-come-true for a retirement income planner like me since it enables me to offer a unique solution for meeting clients' income needs that isn't available elsewhere from other investment products. Specifically, a FIA income rider has the following five features that, when taken as a whole, cannot be duplicated by any other investment:

Guaranteed, subject to individual life insurance company claims-paying abilities, lifetime income or lifetime retirement paycheck ("LRP")
Flexible LRP start date
Potential for increased LRP amount
Ability to calculate an LRP amount on the date of purchase
Ability to adjust initial and ongoing investment amount to match one's income needs.

While all features except for #2 are available with other types of fixed income annuities, there are no other investment products that offer all five in one package. The first two features are the subject of this week's post, with features #3 - #5 discussed in Part 2 next week.

Guaranteed Lifetime Income

A FIA income rider is designed to create lifetime income, or a lifetime retirement paycheck, or "LRP." Moreover, since it's being paid by a life insurance company, it's intended to be a guaranteed payment, subject to each individual company's claims-paying ability. While this is a wonderful feature from a retirement income planning perspective, it's one that's common to all fixed income annuities. As such, in and of itself, it isn't a unique feature of FIA income riders.

Flexible LRP Start Date

When it comes to lifetime income payments, there are three types of fixed income annuities that offer this: (a) single-premium immediate annuities, or "SPIA's," (b) deferred income annuities, or "DIA's," and (c) fixed index annuities, or "FIA's." The LRP start date for SPIA's is one month after purchase. LRP's from DIA's are deferred to a contractually specified date that can be any time beginning at least one year after date of purchase. Whether you purchase a SPIA or a DIA, your start date is locked in when you make your investment.

When you purchase an income rider with a FIA, on the other hand, your LRP start date is flexible. Furthermore, unlike SPIA's and DIA's, you aren't required to lock in your start date when you purchase your FIA. With all FIA's, there's a one-year waiting period between the effective date of the income rider and the date when you may begin to receive your LRP. The effective date of the rider is always the same as the effective date of your FIA contract since an income rider must be added to your contract when your purchase a FIA. In addition to waiting a year to begin your LRP, with most FIA's, you must also be at least 50 years old.

The foregoing two features, in and of themselves, would make for a very nice retirement income planning solution. As you will learn next week, this is just the tip of the iceberg that distinguishes FIA income riders as a powerful and unique addition to an otherwise conservative investment product with the potential for meeting a retiree's ongoing income needs.

Annuitization Tax Treatment of Nonretirement Distributions

2012-01-02T01:00:00-08:00

Per last week's post, there are four things that you don't receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities. The first three, i.e., annuitization, immediate payments, and ability to receive payments over a fixed period, were discussed in last week's post. The fourth thing – annuitization tax treatment of nonretirement distributions – is the subject of this week's post.

Before we discuss tax treatment of distributions, I want to talk briefly about taxation of annuities during the accumulation stage before any distributions are made. Similar to IRA's and other qualified retirement plans, unless they're immediately annuitized, all annuities, including fixed income annuities, enjoy tax-deferred growth. That is, until distributions are taken, there's no taxation. This is true whether the annuity is held within a nonretirement account, a traditional IRA or other qualified plan, or a Roth IRA.

Once payments begin, they're subject to taxation. Income tax treatment is dependent upon the type of account or plan in which the annuity is held. The remainder of this post will discuss income tax treatment of payments as it pertains specifically to fixed index annuity income riders.

At the two extremes when it comes to taxation are traditional IRA's and Roth IRA's. If held within a traditional IRA or other qualified plan, all distributions, other than those deemed to come from nondeductible contributions, are taxable as ordinary income. For fixed index annuities held within a Roth IRA, and assuming that the investment has been held for at least until the greater of five years or age 59-1/2, none of the distributions are taxable.

Taxation of distributions from annuities held within nonretirement accounts, on the other hand, uses a hybrid approach. Furthermore, the tax treatment is different depending upon whether you're annuitizing an annuity vs. receiving payments from a fixed index annuity income rider.

When you annuitize a nonretirement fixed income annuity, part of each payment is considered to be a return of principal and part is deemed to be earnings. The principal portion is nontaxable and the earnings are taxable as ordinary income. Once the total amount of the investment in the contract is recovered, all future payments are fully taxable.

Per the "Annuitization" section of last week's post, income rider payments are deemed to be withdrawals vs. annuitization of a fixed index annuity contract. This is an important distinction when it comes to income tax treatment of nonretirement distributions. As withdrawals, last-in first-out, or "LIFO," tax treatment applies for investments made after August 13, 1982. This means that the first money that comes out is taxable as ordinary income similar to distributions from contributory IRA's. Once all of the earnings have been received, all future payments are considered to be a return of investment, and, as such, are nontaxable.

In summary, the fourth and final thing that you don't receive when you purchase an income rider with a fixed index annuity is annuitization tax treatment of nonretirement distributions. This is initially less favorable compared to annuitization since distributions are fully taxable until all earnings have been received. After this occurs, future distributions are nontaxable vs. taxable as ordinary income once the investment in the contract has been recovered when you annuitize an annuity.

Your Fixed Index Annuity Income Rider – What You Don’t Receive – Part 2 of 2

2011-12-26T01:00:00-08:00

Per Part 1 of this two-part series, before we talk about what you receive when you purchase an income rider with a fixed index annuity, it's important to understand what you don't receive. As stated last week, this needs to be placed in the context of fixed income annuities. If you haven't done so already, I recommend that you read last week's post before continuing with this one.

There are four things that you don't receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities:

Annuitization
Immediate payments
Ability to receive payments over a fixed period
Annuitization tax treatment of nonretirement distributions

The first three things will be addressed in the remainder of this post, with a discussion of annuitization tax treatment of nonretirement distributions deferred to next week.

Annuitization

As explained last week, one of the unique features that's associated with a fixed income annuity is the right to annuitize, or receive an income stream for a specified length of time from your investment. While you retain the right to annuitize the accumulation value of a fixed index annuity, the determination of income rider payment amounts is a separate calculation, independent of the accumulation value. Although they reduce the accumulation value of the contract, income rider payments are deemed to be withdrawals vs. annuitization of the contract. This is an important distinction when it comes to income tax treatment as you will learn about next week.

Immediate Payments

With a fixed index annuity income rider, you have flexibility as to when you begin receiving your income so long as you don't need the income right away. Unlike fixed income annuities, however, where the payments that you receive can be either immediate or deferred, with fixed index annuities, the earliest income starting date generally doesn't begin until twelve months after the contract's issue date.

Ability to Receive Payments Over a Fixed Period

Another important difference between a fixed income annuity and the receipt of income payments using an income rider that's attached to a fixed index annuity is the payment duration. Per Part 1, when you annuitize a fixed income annuity, the payments are made (a) over a stated period of months or years, or (b) for the duration of the insured's and potentially his/her spouse's and/or other individuals' lifetime(s) depending upon the payout option selected. With a fixed index annuity, payments are for life. This is the case even if there's no accumulation value remaining in the fixed index annuity.

Your Fixed Index Annuity Income Rider – What You Don’t Receive – Part 1 of 2

2011-12-19T01:00:00-08:00

As stated in last week's post, while a fixed index annuity has several unique conservative and desirable investment features, assuming your goal is to create a lifetime retirement paycheck, you need to apply for an optional income rider when your retirement income planner submits your application. As pointed out last week, income riders are currently available with less than 40% of all fixed index annuities.

What exactly do you receive when you purchase an income rider with your fixed index annuity? How does it work? How can it be used as part of a retirement income planning strategy to create a lifetime retirement paycheck?

Before we talk about what you receive when you purchase an income rider with a fixed index annuity, it's important to understand what you don't receive. The remainder of this post will begin a two-part discussion devoted to this topic.

In order to understand what you don't receive when you purchase an income rider with your fixed index annuity, we need to place it in the context of fixed income annuities. A fixed income annuity is the broad class of annuities under which fixed index annuities fall.

One of the unique features that's associated with a fixed income annuity is the right to annuitize your investment. Per the Glossary, annuitization is defined as the irrevocable structured payout of an annuity with a specified payment beginning at a specified date, paid at specified intervals over a stated period of months or years or for the duration of the annuitant's and potentially his/her spouse's and/or other individuals' lifetime(s) depending upon the payout option selected. That's a roundabout way of saying that you're entitled to receive an income stream for a specified length of time.

In addition, when you purchase a fixed income annuity, the timing of commencement of payments can be different, depending upon whether you purchase an immediate or deferred fixed income annuity. With an immediate annuity, payments begin one month after date of purchase. Deferred annuities generally won't begin making payments for at least 12 months from date of purchase.

Finally, with fixed income annuities, when the income stream as defined by the terms of the annuity contract ends, so does the annuity contract. Unless there's a refund feature, there's no accumulation value that's payable to the annuitant(s) or to his/her beneficiaries.

Now that you have a basic understanding of fixed income annuities, I will continue the discussion regarding what you don't receive when you purchase an income rider with a fixed index annuity next week when I share with you the unique characteristics of fixed index annuity income riders compared to fixed income annuities in Part 2.

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

2011-12-12T01:00:00-08:00

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.

No Pension? Create Your Own

2011-12-05T01:00:00-08:00

Last week's post, A Retirement Paycheck is Essential, emphasized that it's imperative for each and every one of us to have a retirement income plan. The cornerstone of a retirement income plan is a retirement paycheck. Specifically, we need to know that when we stop working, we will receive a predetermined monthly payment for the rest of our life, and, if married, our spouse's life. Furthermore, this monthly payment needs to be in addition to whatever Social Security benefits we may receive.

Given the fact that the majority of us won't receive a pension from an employer's defined benefit plan that our parents' generation took for granted (see the November 21, 2011 post, Where Have All the Pensions Gone?), it's incumbent upon us to create our own retirement paycheck. This isn't an task and generally requires the assistance of an experienced retirement income planner.

As pointed out in the Where Have All the Pensions Gone? Post, the nature of many investment vehicles don't lend themselves to plan for a predictable known future lifetime or joint lifetime stream of income. This is true, for example, whether you're talking about a savings account, CD, bond, stock, mutual fund, or exchange traded fund.

Fortunately, there exists a long-standing, reliable, conservative investment solution that's specifically designed to provide us with a predetermined monthly payment for the rest of our life. The payment will be made without interruption, no matter how the stock market is performing. This investment solution is commonly known as a fixed income annuity and is offered exclusively by life insurance companies.

Unlike a traditional defined benefit pension plan that pays a defined stream of income that generally doesn't change beginning at retirement age and ending at death, a fixed income annuity strategy can be quite flexible. There are several types of fixed income annuities that can be used to customize a retirement income plan that dovetails with one's retirement income needs. This entails both timing and amount of payment, including adjustment for inflation.

There are two broad classes of fixed income annuities that are distinguished by the timing of the commencement of the initial income payment: (a) single premium immediate and (b) deferred. A feature shared by both types of annuities is "annuitization," or the conversion of an annuity to an irrevocable structured payment plan with a specified payout by a life insurance company to an individual(s) or "annuitant(s)" over a specified period of time through different lifetime and term certain options offered by the insurance company.

Single premium immediate annuities, or "SPIAs," make periodic payments, typically monthly, for a specified number of months or for an individual's lifetime or joint lifetimes as applicable. The payments generally begin one month after purchase of a SPIA, hence the name "immediate."

The second broad class of fixed income annuities, deferred income annuities, or "DIAs," although they play an important role in a retirement income plan, aren't as prevalent in the marketplace as SPIAs. Like SPIAs, DIAs pay periodic income for a specified period of time or over one's lifetime or joint lifetimes as applicable. Unlike SPIAs, the start date of the payments for DIAs is deferred for at least 13 months from the date of investment.

SPIAs and DIAs can be used alone or in combination to create a retirement paycheck. In addition, a rider, or endorsement, can be added to a fixed index annuity to generate a retirement paycheck. This retirement income planning strategy, which is striking a chord with more and more people the last few years, will be introduced in next week's post.

A Retirement Paycheck is Essential

2011-11-28T01:00:00-08:00

Last week's post, Where Have All the Pensions Gone? made the point that given (a) the scarcity of traditional defined benefit pension plans, (b) the inability of 401(k) plans, employee and self-employed retirement plans, and many nonretirement investment vehicles to provide for a predetermined monthly lifetime income beginning at a specified age, and (c) the inadequacy and uncertainty of the Social Security system, it behooves each and every one of us to create our own pension plan.

With this week's post, I want to expand upon and clarify the conclusion in last week's post. I understated the point when I said that it behooves each and every one of us to create our own pension plan. It isn't simply beneficial or worthwhile to create our own pension plan – it's imperative that we do so. To do otherwise is to leave our retirement exposed to too many variables beyond our control and, in turn, risk that we will outlive our retirement assets.

Retirement Roadblocks

Outliving one's retirement assets can happen in any number of ways, including, but not limited to, experiencing one or more of the following eight retirement roadblocks:

Insufficient investment assets to sustain a longer- than-average life expectancy
Prolonged higher-than-average inflation
Sequence of returns with bad early years. See the October 5, 2009 post, The Sequences of Returns – The Roulette Wheel of Retirement.
Withdrawal drag. See the September 28, 2009 post, Withdrawal Drag – The Silent Killer.
Excessive investment withdrawals relative to available retirement assets
Uninsured events, e.g., long-term care
Unfavorable income tax law changes
Poor investment management

As you can see, too many things can happen, many of which are beyond our control, that can prematurely deplete one's investment assets. Although unplanned, the occurrence of one or more of these events could easily derail what's suppose to be our golden years.

Something we have the ability to control, and, furthermore, as previously stated, is imperative for us to do, is creation of our own pension plan. Specifically, we need to replace employment income with a retirement paycheck.

The risk that we will outlive our retirement assets is shared by individuals of all means. A sizeable nest egg, while it can sustain one through many years of retirement, can also be depleted before the end of one's and one's spouses, if married, lifetime(s) in the absence of a sound retirement income plan.

Although a retirement paycheck doesn't guarantee that we won't outlive our retirement assets, it will eliminate our exposure to several of the eight retirement roadblocks, and, in turn, improve our odds for success.

Where Have All the Pensions Gone?

2011-11-21T01:00:00-08:00

If you aren't receiving a pension from a former private sector employer, there's a pretty good chance that your employee benefit package doesn't include this once-cherished perk. According to a study by Towers Watson & Co., as of May 31, 2011, only 30% of Fortune 100 companies offered a defined benefit plan to new salaried employees. That's down from 37% at the end of 2010, 43% in 2009, 47% in 2008, and 83% as recently as 2002. This is a far cry from 1985 when 90% of Fortune 100 companies offered a traditional pension plan to new employees.

While defined contribution plans, predominantly 401(k) plans, have replaced defined benefit plans in the private sector, the pension aspect is lacking in the majority of such plans today. Specifically, with limited exceptions, these plans generally don't provide for a predetermined monthly payment that an employee can expect to receive beginning at a specified age for the rest of his/her life and his/her spouse's life if married.

Furthermore, to the extent that a 401(k) plan is available, the future accumulation value of a participant's account is unknown. It's dependent upon several variables, including number of years of participation, IRS-imposed employee and employer contribution limits, employee contribution amounts, potential employer matching contributions, investment offerings, performance of chosen investments, participant loans, and potential plan distributions.

The inability to provide for a known monthly lifetime income upon retirement is not unique to employer-sponsored plans. It's also common to employee and self-employed retirement plans, including, but not limited to, traditional IRA's, Roth IRA's, and SEP-IRA's.

In addition, the nature of many investment vehicles, whether held inside or outside a retirement plan, don't lend themselves to plan for a predictable known future lifetime or joint lifetime stream of income. Whether you're talking about a savings account, CD, bond, stock, mutual fund, or exchange traded fund, this feature is generally unavailable.

Finally, a discussion about retirement income wouldn't be complete without mentioning Social Security. Social Security is a wonderful provider of monthly retirement income for those individuals who qualify to receive it. Of all non self-funded plans, it comes closest to duplicating the pension aspect of a defined benefit plan. Unlike most defined benefit plans, the monthly benefit can increase as a result of cost of living adjustments. Unfortunately, the uncertainty that surrounds the Social Security system makes it difficult to plan for this benefit, especially for younger individuals.

Given (a) the scarcity of traditional defined benefit pension plans, (b) the inability of 401(k) plans, employee and self-employed retirement plans, and many nonretirement investment vehicles to provide for a predetermined monthly lifetime income beginning at a specified age, and (c) the inadequacy and uncertainty of the Social Security system, it behooves each and every one of us to create our own pension plan.

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

2011-11-14T01:00:00-08:00

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.

Don’t Neglect Your Fixed Index Annuity Fixed Account

2011-11-07T01:00:00-08:00

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

Guaranteed return
Pre-determined return
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.

Diversify Your Fixed Index Annuity Indexing Methods

2011-10-31T01:00:00-07:00

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:

Select multiple methods
Choose a blended index if available
Purchase multiple fixed index annuity contracts
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.

Which is the Best Fixed Index Annuity Indexing Method?

2011-10-24T01:00:00-07:00

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:

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:

Contract date
Stock market index
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.

Fixed Index Annuity Indexing Method with a Trigger

2011-10-17T01:00:00-07:00

The last three posts introduced three fixed index annuity indexing methods that are used to determine the annual amount of interest that is credited to a fixed index annuity:

With each of these three methods, the amount of interest that's credited during a particular contract year is unknown ahead of time, must be calculated, and generally changes year to year. Like all indexing methods, if the result of the calculation is negative, no interest is credited.

There's a fourth indexing method that's not as widely used as the other three methods known as trigger indexing. The basic difference between trigger indexing and the other three indexing methods is that the interest rate isn't calculated using trigger indexing. It's instead a predefined percentage that's triggered by a specified event. The predefined percentage is credited in each contract year during which the value of the specified stock market index at the end of the year is greater than or equal to its value at the beginning of the year. The amount of the change in the index during the year is irrelevant.

As an example, let's assume that our fixed index annuity contract has a value of $300,000 at the beginning of the current contract year, trigger indexing has been chosen as the indexing method, and the trigger index interest rate is 4%. Let's further assume that the value of the index used to determine interest crediting was 1,100 at the beginning of the current contract year. So long as the value of the index is at least 1,100 on the last day of the contract year, $12,000 (4% x $300,000) will be credited, resulting in a value of $312,000 at the end of the current contract year. If the value of the index is less than 1,100 at the end of the contract year, no interest will be credited.

Let's contrast trigger indexing with its closest cousin, the annual point-to-point cap method. Both methods compare the change in the value of a specified stock market index at the end of a contract year to the value of the index at the beginning of the year. As we just learned, whenever the change isn't negative, a specified interest rate will be credited using the trigger indexing method. In our example, even if there's no change, 4%, or $12,000, was credited.

With the annual point-to-point cap method, the amount of interest that's credited is dependent on the amount of the percentage change during the year and furthermore, is subject to a cap rate, or preset limit, on the percentage. Assuming a cap rate of 4%, so long as there's an increase in the index value during the year, interest will be credited, however, it will be limited to 4% in the event that the amount of the change is 4% or greater.

So which indexing method should you choose? Ah, the topic for next week's post.

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

2011-10-10T01:00:00-07:00

We continue our miniseries about fixed index annuity indexing methods that began on September12th with a discussion of the monthly average indexing method. The previous two posts, What's the Point-to-Point? and Monthly vs. Annual Point-to-point Fixed Index Annuity Indexing Method introduced the annual and monthly point-to-point methods, respectively.

In order to help you understand the monthly average indexing method, we will compare it to the monthly point-to-point, or monthly sum crediting method as it is otherwise known. Per last week's post, there are three steps associated with the latter method that are performed each contract year:

Calculate twelve monthly percentage changes in selected stock market index.
Apply the product's cap rate to each of the twelve monthly percentage changes.
Add the twelve monthly capped percentage changes together to determine the annual interest amount to be credited.

As with all indexing methods, if the result of step #3 is 0 or negative, no interest is credited during that contract year.

There are four steps used with the monthly average indexing method as follows, with the first step identical to the monthly point-to-point method:

Calculate twelve monthly percentage changes in selected stock market index.
Add the twelve monthly percentage changes together.
Divide the total of step #2 by twelve.
Apply the product's cap rate to the result obtained in step #3.

The best way to illustrate the monthly average indexing method is with an example. Exhibit 1 shows the monthly prices for the 16^th of each month beginning September 16, 2010 through and including September 16, 2011. This is the exact time period that was used to produce Exhibit 1 in last week's post. Using the monthly prices, the dollar and percentage changes are calculated and shown in the next two columns, respectively.

Unlike the monthly point-to-point cap method that applies a cap rate to each of the twelve monthly percentage changes, the changes are simply added together to arrive at total monthly percentage changes. The total is then divided by twelve to arrive at an average percentage change. In this example, total monthly percentage changes of 9.2% is divided by twelve to arrive at an average percentage change of 0.8%. Since 0.8% is less than the assumed cap rate of 4%, the amount of interest credited for the contract year is 0.8%. Once again, if the result was 0 or negative, no interest would be credited.

Per Exhibit 1, even though nine out of twelve months experienced positive changes, with 3% or greater changes for six of the nine months, the sizeable negative changes (5.9%, 4.7%, and 9.4%) for the three negative months offset a large amount of the positive changes to result in a relatively small average monthly change of 0.8%. Although not a significant amount, it's nonetheless greater than the interest of 0% that would have been credited using the monthly point-to-point cap method for the identical time period per Exhibit 1 of last week's post. Assuming an accumulation value of $150,000, the amount of interest that would be credited using the monthly average indexing method would be $1,200 ($150,000 x 0.8%).

Of the three methods presented in this post and the previous two posts, the annual point-to-point method would have resulted in the highest interest crediting for the contract year beginning September 16, 2010 through and including September 16, 2011. Per the example in the September 26, 2011 post, What's the Point-to-Point?, the assumed cap rate of 4% would have been the amount of interest credited using the annual point-to-point method. Assuming an accumulation value of $150,000 the amount of interest that would be credited using this method would be $6,000 ($150,000 x 4%).

As stated at the conclusion of last week's post, it's important to keep in mind that no indexing method is always going to be superior to another. Each method will result in different interest crediting depending upon market performance during a particular contract year as well as the cap rates associated with each product.

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

2011-10-03T01:00:00-07:00

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

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

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

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

Exhibit 1 shows the monthly prices for the 16^th of each month beginning September 16, 2010 through and including September 16, 2011. Using the monthly prices, the dollar and percentage changes are calculated and shown in the next two columns, respectively. Once the monthly percentage changes are determined, the assumed cap rate of 1.8% is applied to each month's percentage change to determine the monthly capped percentage change which is displayed in the final column. The 12 monthly capped percentage changes are then added together. If the result is positive, then this is the annual interest amount that is credited to the contract. If, on the other hand, the result is negative, no interest is credited.

Per Exhibit 1, even though nine out of twelve months experienced positive changes, with 3% or greater changes for six of the nine months, the combination of the monthly cap of 1.8% plus the sizeable negative changes (5.9%, 4.7%, and 9.4%) for the three negative months resulted in total monthly capped changes of -6.4%. Since there was a loss, 0% interest was credited.

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

It's important to keep in mind that no indexing method is always going to be superior to another. Each method will result in different interest crediting depending upon market performance during a particular contract year as well as the cap rates associated with each product.

What’s the Point-to-Point?

2011-09-26T01:00:00-07:00

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.

Fixed Index Annuity Indexing Method Similarities

2011-09-19T01:00:00-07:00

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:

Reliance on a stock market index
Measurement of percentage changes between two points in time
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 19^th of a particular month. When the 19^th 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.

Introduction to Fixed Index Annuity Indexing Methods

2011-09-12T01:00:00-07:00

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.

Contract Date – The Driver of Fixed Index Annuity Performance

2011-09-06T01:00:00-07:00

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 6^th vs. if it begins on February 23^rd, 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.

Indexing Strategies – The Key to Fixed Index Annuity Growth

2011-08-29T01:00:00-07:00

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.