By Julian Guilfoyle
“Retirement at sixty-five is ridiculous. When I was sixty-five I still had pimples.” -George Burns (1896-1996)
Most of us will not experience the longevity that Mr. Burns enjoyed, but as medicine continues to improve and our life expectancies rise, there is some truth to the notion that sixty is the new forty. The main negative consequence resulting from this is the potential for people to outlive their assets. When index annuities were created in the mid 1990s, they were partly designed to address this very issue.
Index annuities are complex financial instruments designed to provide the benefits of both fixed and variable annuities. People who have index annuities participate in the gain of an index; the most popular being the S & P 500. Just as important, they do not experience loss when the index goes into the negative. Index annuities became increasingly popular after the tech boom of the late 1990s when the bubble popped and investors were devastated. In the last decade they have grown further as the market has been hit with the events of 9/11, the housing bubble, and just a month ago, the decline in our country’s credit rating.
For younger people beginning to plan for retirement, it still makes a lot of sense to invest directly in the stock market. They can withstand the wild swings of the market because they have a lot of cycles still to go. For retirees or people nearing retirement, this is not the case. There is a breakeven point at which individuals need to move from growing their assets to preserving and protecting the assets they have accumulated. When you reach this point, index annuities are a sound way to invest. When you are contemplating the purchase of an index annuity, make sure you understand at least the following:
1. What are participation or cap rates?
The Participation Rate refers to the amount of gain in the index that will be credited to the annuity. For example, if the participation rate is 75% and the index experiences a gain of 10% percent, the annuity will be credited 7.5%.
A Cap Rate refers to the maximum interest the index can gain. If the index has a gain of 10%, and the cap rate is 6%, the annuity will be credited 6%.
2. What indexing method is used?
There are different ways of determining the performance of the index. The major methods are as follows:
- Point-to-Point – Compares the change in the index between two points in time. For example, if the index annuity has a monthly Point-to-Point measurement, the gain or loss will be credited monthly. If it is a one-year monthly cap strategy, each month’s performance is added together for the year. For instance, if the rates are as follows:
The interest accrued in this year would be 6% (sum of each month).
- Annual Reset – Compares the change in the index on an annual basis. Thus, if the index in year 1 experiences a gain of 5%, this value is locked in and becomes the new contract value. If in year 2 the index falls 4%, the annuity is credited in year 2 is 0%, but keeps the year 1 increase of 5%.
- High Water Mark – Credits the highest interest rate received at each measured point to the following term. For example, if the highest interest rate for the year occurs in December at 8%, 8% is the interest credited. This is the value used for the following year.
NOTE: Different fees, caps and participation rates accompany each of the indexing methods, always make sure you are looking at the overall plan.
3. What are the surrender penalties?
Most index annuities contain penalties triggered by an early partial or total surrender of the annuity. In some cases, any interest that is not credited at the time of the surrender could be lost.
4. What fees could I incur?
Most index annuities contain fees for riders that can be attached to the base index annuity. Probably the most popular rider, the guaranteed income for life rider can ensure that you and/or your spouse do not outlive your assets. These riders generally contain a fee taken off the interest the annuity has gained. There are some companies that do waive these fees when the annuity produces no gain for the specified time period.
5. How does this fit into my overall strategy?
This is the most important area to consider. There is no product or strategy that can protect you from everything or address all of your concerns. You want to make sure that your advisors, both legal and financial, are communicating and coordinating your strategy to minimize taxation, address potential health care concerns, and avoid high administrative costs.
Only you, working with the best legal and financial team, can get your ducks in a row.