Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Finding Higher Returns with Low Risks

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Market volatility and uncertainty spur the search for investment alternatives. Index fund investors broke even or lost money the last 10 years, depending on what the markets did in the latest week. Investors need their portfolios to grow if they are to meet retirement goals, but many investors want to avoid the risks and volatility of traditional growth assets such as stocks.

Investors seeking growth with lower risk and volatility can turn to structured products such as equity-indexed annuities. EIAs offered by insurers are the big sellers, but banks and other financial institutions offer similar investments. These can be good additions to the portfolios of some investors-if they understand the details and costs of the products-and their limits.

An EIA first promises safety of principal and often a guaranteed minimum return of 1% to 3% annually, depending on the insurer and current interest rates. An EIA offers the potential for a higher return based on a stock market index. The account will receive the stock-based return when the indexes have positive returns but will not share losses when the indexes decline. Because of the guarantee the account can earn a positive return when stocks lose money.

Here are the key provisions to understand when considering an EIA or similar investment. Understanding these points ensures you understand the investment and will not be surprised by results over the years.

Index. The insurer determines the index used to determine the account’s returns. The index can change.

Participation rate. Some EIAs credit the policy owner with the full return for the year as determined by the return formula; others have a ceiling participation rate. For example, the credited return might be 75% of the return computed under the valuation formula.

Return ceiling. An additional way of limiting the return in EIAs is an explicit limit on one year’s return. Ceilings generally are 7% to 10%. For example, an EIA might say the account earns 75% of the return under the formula, up to a maximum return of 8% each year.

Return formula. The annuity is not invested in stocks, and the investor is not earning stock returns. The account is credited with interest, and the amount of interest is based on stock market returns. The combination of the index’s returns and the return formula determine the interest credited. There are over 30 different formulas used for computing interest for EIAs. Many investors assume that an index’s return for the year will be credited to their accounts. That point-to-point valuation is rare. Most EIAs use some kind of averaging method. Because stock returns for a year tend to be bunched in a few days, credited returns under the formulas can be far less than the index’s return for the year.

Here are some examples of formulas.

Averaging. Under this method, the ending values of the index for each period are added. The total is divided by the number of periods. The difference between the index’s beginning value and the average value is the return for the year. Usually months or days are the measuring period. Insurance analysts estimate that in a bull market, this method credits the account with about half of the index’s actual gains.

The averaging method tends to be offered with higher annual caps and participation rates. It also reduces the damage from funding an account a few days before a major market drop. Also, if the index rose for much of the year but suffered a major decline near the end, the averaging method credits those early gains.

High Water Look Back. This method is infrequently offered. It provides that the account value credited at the end of the contract will be the highest of the values on the contract anniversary dates. For example, suppose an EIA is owned for 10 years. The index rose steadily during the first nine years, giving a rising account value. The index tumbles the last year. When the contract is terminated, the account is credited with the value on the second-to-last anniversary date instead of the lower value on the last anniversary date. Note that the credited value is not the highest value during the 10 years but the highest on the anniversary dates.

Point to Point. This is the method most people assume is used. The difference between the beginning and ending values of the index over the period are used to credit the account. Point to Point likely will give a higher return in a bull market than the other methods, but it exposes the owner to more risk in a declining market and higher volatility than the other methods. It also is likely to be accompanied by lower caps, participation rates, and other limits than some of the other methods.

Annual Reset. The annual reset method prevents bad years from taking away gains. The gains from one year establish a new account floor. Future losses cannot bring the account value below that level.

Suppose Max Profits put $100,000 into an EIA. After five years, the account value is $150,000. The sixth year the index declines 10%. The account value still is $150,000 at the end of the sixth year.

The annuity owner might be able to select the reset period. An annual reset method can be good in trading range markets but likely will be accompanied by lower annual caps on returns and lower participation rates.

Investors also should look at two other key points in the formula. Some formulas look at only changes in the index and do not count dividends paid during the year. Also, some measure returns over the years as simple interest instead of compound interest.

Tradeoffs. The return formula, participa-tion rate, and return ceiling need to be considered together. Generally, insurers make trade offs between the three. EIAs with less than 100% participation and with restrictive valuation formulas tend to have higher return ceilings of 10% or so. Typically an EIA that allows 100% participation will have an annual return ceiling of 7% to 8%. If an insurer or broker is focusing on one of the features, be sure to study the others.

The trade offs require some consideration. The combination that intuitively seems the most attractive often isn’t. Suppose the index returns 10% one year. One EIA has 100% participation rate but a 7% cap. That EIA’s investors get credited with a 7% return. Another EIA has 75% participation rate but a 10% cap. Those investors get 7.5% credited to their accounts for the year.

Based on past market return patterns, an investor is likely to earn a higher return over time with a higher cap and a lower participation rate. That’s because an index’s returns each year tend to be far from the averages. Good years in the market tend to be very good years. If this pattern of returns continues in the future, the lower participation rate/higher cap EIA is likely to be the better choice.

Some EIAs have multi-year caps. For example, a policy might say that the return over two years will not exceed 15%, regardless of any other policy provisions.

Fees. After the return for the year is calculated, fees are subtracted and the net-of-fees return is credited to the account. Most EIAs charge fees only when returns are positive. But the more generous the EIA’s policy of crediting returns is, the higher the fees tend to be. An EIA with 100% participation and a high or no ceiling likely will have annual fees of 2% or more. That could be great if the index returns 20%. But when the market returns 10% or less, an EIA with a less generous crediting policy and lower fees would generate a higher net return.

Again, it pays to look at the interplay of fees, ceilings, valuation formulas, and participation rates under different return patterns. A period of steady, low returns would favor an EIA with low fees. A pattern of widely varying returns with the positive returns above 10% would be rewarded by 100% participation and no ceiling with higher fees.

Many EIAs allow fees and charges to be changed, and the maximum fees that can be imposed are quite high. Be sure to ask what current policy holders are charged. Also check surrender charges and minimum holding periods. The EIAs with the most attractive initial terms tend to be those with the highest penalties for withdrawing from the EIA.

Changes. Most EIAs retain the right to change any of these provisions. There might be a limit to the potential amendments, but the insurer can review the terms each year. A 100% participation rate can become 75%, or a 10% cap could decline to 8%. There’s not much the policy holder can do except realize that terms that are more attractive than those on other EIAs can change at any time.

Commissions. Most EIAs offer the selling agent or broker generous commissions of 5% to 9%. The higher commissions usually are on policies with high surrender charges or more restrictive terms. The commissions usually are paid directly by the insurance company.
Investment bonuses. Some EIAs offer bonuses. For example, an EIA might credit an extra 10% to the policy holder’s account for purchasing the annuity. Or 1% annually might be credited for each year the policy is owned. Such bonuses almost always come with higher surrender charges, longer required holding periods, and other restrictions.

Withdrawal phase. An EIA usually imposes a surrender charge if the investor withdraws all or some of the money before a minimum period has passed. An investor should know the surrender charge and surrender period before investing. An investor who is sure the money will not be needed for seven years or more often can find an annuity with generous terms that has a long “lock up” period or a high surrender charge. Other investors might want a minimal surrender period and charge in case their cash or investment needs change.

Also, even after the lock up period has passed, some annuities do not allow the investor to withdraw the account in a lump sum. They might require annuitization-a stream of fixed payments from the insurer. Others allow only a maximum amount of 10% or so to be withdrawn in any one year. Most EIAs, however, allow the entire account to be withdrawn or rolled over to another annuity. Don’t be dazzled by generous front-end terms that are taken away by limits on how money can be withdrawn.

Insurer safety. The only guarantee behind the annuity is the promise of the insurer to make the payments. Dealing with one or more insurers that have been around a long time and are in strong financial condition is important.

An EIA is neither a stock market investment nor a traditional fixed annuity. It can be appropriate for someone who is too conservative for the stock market but recognizes the need to try to earn higher returns than are available from interest-based vehicles such as fixed annuities, bonds, and certificates of deposit. The returns of an EIA will vary considerably from year to year. The good news is that, unlike a stock market investment, the return any year will not be less than zero. On the other hand, an investor won’t know until after the year what, if anything, the return for the year is. In addition, in years of strong stock market returns, the investor likely will be credited with a fraction of those returns.

More details about EIAs and key contract terms are available in the free report, Growth Without Risk by Matthew J. Rettick, available from WealthMasters, Inc., 3200 N. Dobson Road, Bldg. C, Chandler, AZ 85224; 800-223-9610.

A potential EIA investor needs to review different EIAs, study the contract terms, and understand the trade offs. Different EIAs appeal to different types of investors, and many investors will find all EIAs to be inappropriate for them. Also compare an EIA to a diversified portfolio of low fee mutual funds or to a balanced fund.

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