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Money Matters for Seniors by Robert
Valentine
Equity Index
Annuity: Safe Place to Grow Your Money
By
Robert Valentine, Certified Senior Advisor
Aug. 28, 2002 -
Would you like an investment that pays gains based on the stock
market, yet helps protect your principal when the market declines?
It’s not every day that you find the opportunity for potential growth
with true safety in the same financial vehicle. Usually investors are
compelled to make one of two choices, either they give up a degree of
safety in exchange for a greater potential for growth or they accept
less growth in exchange for a higher degree of safety. Thanks to an
innovation in the insurance industry, you can have the potential high
returns available in the stock market and the security of a
guarantee—it’s called an equity index annuity.
Equity index annuities are excellent alternatives for investors
seeking safety in a low interest rate environment or a volatile
market. Here’s how they work, your return is based on the increase of
a stock or equity index, such as the S&P 500.
If stocks rise, you benefit from the increase. If stocks fall, you do
not lose any money, most contracts guarantee a minimum return,
typically 3%. This is what makes these newer products so attractive to
retired persons and to those approaching retirement.
Now, imagine this scenario: Suppose you and I take a trip to Las Vegas
for a week. I decide to make you the following offer. You can gamble
at one of the casinos as much as you like for the entire week and I
will guarantee you in writing that no matter how bad you do you will
not lose. In fact, I guarantee that you will walk away from the tables
with no less than what you started with, plus some interest. If you
win, you get to keep the winnings.
Would you take me up on the offer? I would imagine given that
opportunity, you would load up with casino chips as soon as possible.
So, what’s the catch? You can’t lose a dime, but the catch is, you
have to play for the whole 7 days, otherwise you may have to give back
a small portion of your chips. In other words, if you invest with the
intent to hold your investments for some time down the road, index
annuities can be a powerful investment. This brief example is
simplified, but in very basic terms, this is the concept behind equity
index annuities.
Obviously, there is no such thing as a free lunch, so the company that
issues the annuity will limit the maximum returns that you receive
from a rising market in return for the downside protection they
provide. This limit depends on the particular indexing method that the
annuity company uses. The most common method used to limit returns is
something called the “participation rate.” For example, the insurance
company may set the participation at 90% (some companies are as low as
50%), which means the annuity would be credited with 90% of the growth
experienced by the index. If the index gained 10%, your gain would be
9% for that year. Essentially, your trading 100% of the market risk in
order to receive a share of the market gain.
In addition to the different participation options, there are index
annuities that use an “annual reset” method for crediting index-linked
interest. This valuable method allows you to lock in gains permanently
in an up market. In volatile markets where the index declines, the
annuity simply resets locking you in at the now lower index level. In
fact, some index annuity renewals have been reset at very attractive
levels. The lower the reset is, the more opportunity there is for
future growth.
Let’s take a look at another tough time in the market and see how the
index annuity would have performed utilizing the annual reset method.
One of the best examples of a prolonged bear market was the 1970’s, in
the 1973-74 downturn stock prices fell more than 40%. The S&P 500
closed at an all time high towards the end of 1972 and it wasn’t until
1980 that these levels were retraced. So, if you bought at year-end in
1972, it would have taken about 7 years to break even using the
traditional buy and hold technique. Utilizing a 90% participation
index annuity with the annual reset method from 1972 to 1979 would
have resulted in a return for those seven years of approximately
70%—even though the index had not yet returned to its former high.
In today’s market environment it’s hard to beat an annuity that only
goes up. Many seniors who fled the stock markets, locked in gains and
purchased equity index annuities. They are now waiting for an upturn,
which will produce further gains for them, not just a recovery to
former highs. The use of these vehicles has allowed them some comfort
during market declines.
Due to the complexity of equity index annuities I strongly suggest you
consult with a knowledgeable investment advisor to see how they might
fit into your financial plan.
Endnotes
1. The S&P 500 is an unmanaged broad
based market index often representative of the stock market as a
whole. An investment may not be made directly in the index.
2. Equity indexed annuities are long term
investments subject to possible surrender charges and 10% IRS early
withdrawal penalty prior to age 59 ½. Current interest earnings
linked to the growth of the equity market. Minimum return, principal
value and prior earnings guaranteed by issuing insurance company,
subject to their claims paying ability, when held to the end of term.
Risks include inflation and default risk.
Robert Valentine, columnist for SeniorJournal.com is a Certified Senior Advisor in Huntington
Beach, CA. He can be reached at (877) 732-2637.
About author
This article was submitted by Robert
Valentine of Financial and Retirement Management. Robert (CA Insurance
Lic #0C23496) is a Registered Representative of and offers securities
through Securities America, Inc., a Registered Broker/Dealer, Member
NASD/SIPC. Advisory services offered through Financial and Retirement
Management, a Registered Investment Advisory firm. Robert is a Certified
Senior Advisor in Huntington Beach, CA. Several of his articles on
financial planning matters that concern investors have been published by
SeniorJournal.com. Robert
can be reached at (877) 732-2637.
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