Fixed Indexed Annuity

What does it mean to index?

• When your money is indexed in an annuity with a life insurance company, the insurance company guarantees your balance will never go down.
• It means your money is not in the stock market so if you get a return on your money it’s because an index like the S&P moved upwards.
• Both the upward and downward movement is capped. On the down side the lowest it can go is zero and on the upside each contract is different, but caps typically range in high single digits.

Just before the big downward movement in the stock market I chatted with two different people about their retirement money. The first person I spoke with was Ralph. He had a handsome sum of money to invest and wanted my opinion.

After explaining the difference between investing and savings, and how an indexed annuity works, Ralph reasoned that he would keep his money in the stock market until a downturn and then pull it out. Ralph wanted to invest his money.

The other person I chatted with was Gertie who had most of her money in a 401(k) account fully invested in stocks. She wanted a little more security and a reasonable rate of return. She couldn’t afford to lose any of her principle.

When do you want your money, I asked. Oh, I won’t need it for some time, perhaps seven or eight years. Gertie chose to save her money and protect it.

Gertie rolled her money into an indexed annuity just before the big crash hit. One year after the rollover, Gertie visited my office for her annual review.

Her first question as she sat down was “How much did you make me last year?”

I smiled at her, grabbed a scrap piece of paper and wrote a big 0. Looked into her eyes, smiled and asked, “How’s that make you feel?” “Great, and thank you.”

We spent the remaining time talking about her trips visiting the grandchildren, her health, and other things important to her.

What we didn’t discuss is the thirty percent drop she would have incurred had she not protected her money.

20/20 hindsight is awesome when you get it right. I wonder how Ralph did with his timing?  It’s never too late to protect your money.

There are only three things you can do with money

1. Spend it (a cash flow system)
2. Save it (protected money)
3. Invest it (potential money)

The majority of effort in our society is placed on investing.  But is this the best strategy? Let’s look at how the financial planning industry represents their returns.

The common mantra is to put your money into the stock market and leave it there. Why? Because it always comes back and the average for one hundred years is over seven percent, or so the saying goes.

In fact, the Dow Jones Industrial Average (DJIA) for the past 100 years is 7.26%.

Let’s see if that fairly represents the situation. If you were to put $1,000 into the DJIA in 1909 what would it look like in 2008, 100 years later?

You can check this with online calculators or your own financial calculator. Take $1,000 as your present value (PV), 7.26% as your interest rate (INT), 100 years as your term, and solve for future value (FV) compounded annually.

The value of your account in 2008 is $1,106,061. (If you got $1,391,484 you compounded monthly.)

However, had you actually invested $1,000 in the DOW in 1909, your account balance would be $142,954. What happened? That’s $963,107 less than it should be. Let me illustrate:

Let’s say you invest $10,000 with Sue, your Financial Advisor and she earns your account a 10 percent return. You made $1,000 and your new balance is $11,000. Easy math.

Year two your account drops 10 percent. How much did you lose? If you said $1,100 you’re right and your new balance is $9,900. That’s $100 less than you started. So what is Sue’s average rate of return for your account?

Year 1 = 10%                        Year 2 = (10%)            Average = 0%

How do you feel about those numbers? Is the average an accurate representation of what happened to your account balance?

Something seems out of whack here and that’s because your ending balance is lower than your beginning balance. Yet she represents your average rate of return as 0 percent, when it is actually less than 0 percent.

You see there is a difference between average rate of return and actual or compound rate of return. The DJIAs actual rate of return for the past 100 years is 5.09%.

Assuming a 15 percent tax bracket, your actual return is 4.61 percent. Since nobody works for free, let’s add in a 1.5 percent management fee (much less than average) and the DJIAs rate of return is 3.51 percent.

In other words, if you could have put your money into an account that averaged 3.51 percent or higher and was tax favored, you would have out produced the DJIA since 1909.

The longer the recession grinds on, the more people realize the marvel of indexed annuities. Imagine all of your money intact today, never losing sleep over it, and having complete control over the entire amount.

Is there a bad time to purchase a Fixed Indexed Annuity (FIA)?

[A] On August 21, 1987 the S&P hit an all time high of 355. By December 4^th [D] it had fallen 37 percent to 224. Traders were jumping out of windows on Wall Street. (Not really, at least I didn’t see any. This is a metaphor indicating they were having a bad day.)

Had you picked up a FIA on August 21, 1987 (you couldn’t by the way, because they didn’t exist) you would not have lost a penny.

From December 4, 1987 until March 24, 2000 [D – B] traders were jumping from street level into their 2^nd and 3^rd story offices. (Not really, at least I didn’t see any. This is my way of saying they were having a great decade.)

Between March 24, 2000 and October 4, 2002 [B – E] the S&P declined 48 percent. In other words, investors who lost money would need a 100 percent return just to break even. Between terrorists and the tech bubble bursting, traders couldn’t figure out which way to jump through their window.

Indexed annuity savers would view zero as a hero as far as rates of return are concerned. They didn’t lose a dime in their annuity savings account.

On October 12, 2007, the S&P hit another peak of 1,500, only to drop 43 percent again [C – F].

Fixed Indexed Annuities is one of the reasons a good spending plan coupled with the right savings vehicles, remove the need to ever put your money at risk by investing.