Worried About the Markets? One Investment Option That Could Be Right for You

With the stock market at all-time highs, I have been receiving a lot of questions about whether it is time to position portfolios more conservatively in anticipation of the next economic recession.  This question is typically followed by why the individual doesn’t think the market could possibly go any higher.  They ask about the trade war with China, the upcoming US presidential election, the impeachment proceedings, the extended length of the current bull market, or several other headlines.  While these headlines are valid risks in the market, we have typically made the decision to maintain our current allocations.  My reasoning behind this strategy is that it is impossible to time the market and although the short-term is likely to be volatile, the market has proven to be very resilient over its history in the long term.

While this is a beneficial strategy for most clients, this option may not be suitable for everyone.  For certain individuals, any loss in their portfolio whether short-term or long-term is unacceptable and would add stress.  They want guaranteed safety and are looking for better returns than their money market or CD accounts at the bank.  For these individuals, there is an investment option that can provide safety of principal and at the same time, tends to provide a better rate of return than a CD.

What is an Equity Indexed Annuity (EIA)?

The investment vehicle described is called an Equity Indexed Annuity.  All Equity Indexed Annuities have the following features:

1. The investment is offered by an insurance company with a guarantee that there will be no loss of principal during the length of the contract.

2. The contract is funded with a one-time premium payment.

3. The annuity works the same whether the money to fund the contract comes from a retirement or non-retirement account.

4. The rate of return is dependent on the performance of a selected market index so there is no guaranteed amount of interest that will be received.

When does it make sense to use an EIA?

There are typically three scenarios in which it makes sense for an individual to consider an EIA contract:

1. When an individual is unwilling to accept or cannot emotionally handle short-term losses in their investment portfolio.

2. When an individual has a substantial amount of cash in savings/CD’s and they are looking for a better rate of return without the risk of losing principal.

3. When an individual is trying to create a stream of guaranteed income for the remainder of their life.

This article addresses the use of an EIA contract as an investment vehicle covering the first two scenarios.  A future article will cover the use of an EIA contract to create guaranteed income.

How Does an EIA Work?

As an example, an individual contributes $100,000 into an EIA.  The annuity uses the S&P 500 index with a participation rate of 50% that locks-in at the end of each contract year. In this case, if the index returned 10% during the first year of the contract, the annuity holder would get 5% credited to the account.  After this first year, the annuity balance is now $105,000 and is locked-in so they are guaranteed that the annuity value will never drop below $105,000.  In the second year of the contract, the S&P 500 index has a down year and loses 10%.  Even though the market had a down year, the annuity value remains at $105,000 because that is the locked-in value.  In the third year of the contract, the S&P 500 index bounces back and returns 15%.  The annuity will be credited with 7.5% and the new locked-in value will be $112,875.  This same process continues each year until the end of the contract.

What rate of return can I expect from an EIA?

There is no guaranteed rate of return in an EIA contract, but an average expected annual rate of return is 4% to 6%.

What terms do I need to be aware of when comparing my EIA options?

There are terms that are unique to an EIA contract.  A brief description is provided below:

Strategy Term:

The length of time from when the contract starts to each subsequent lock-in.  The new lock-in value at the end of the term will be higher if the index performed well or will remain the same if the index was negative.

Crediting Index:

The market index that was selected for the contract.  Annuities may have one crediting index that is used or may include multiple crediting indices.  As an example, a contract may allow an investor to allocate 50% to the S&P 500 index and 50% to the Russell 2000 index.

Participation Rate (also called Equity Indexed Allocation):

The percentage of the crediting index return that will be added to the account during each strategy term.  For example, if the crediting index has a participation rate of 60% and the index returns 10% during the strategy term, the contract value will increase by 6%.

Cap Rate:

The maximum rate of return that will be credited to the contract during a strategy term.  For example, let’s assume the crediting index has a cap rate of 8%.  If the crediting index was up 20% and the participation rate is 100%, the investor would expect to receive a 20% increase in the contract.  Given that the contract has a cap rate of 8%, the contract will only receive an 8% increase.

Strategy Spread:

The annual percentage rate that will be deducted from the crediting index return.  For example, if the crediting index was up 10% and the strategy spread is 1%, the value of the contract will increase by 9%.

Declared Rate:

The guaranteed rate of return on money not allocated to an index.  For example, a contract may allow an investor to allocate 50% into the S&P 500 index and 50% into the declared rate investment.  The declared rate investment will act like a CD with a guaranteed rate of return not dependent on the market.

That seems like a lot to keep track of, can I see an example?

An individual contributes $100,000 into an EIA contract on January 1st, 2020.  The terms of the contract are as follows:

In addition to these contract terms, the annuity does not have any caps and has a surrender period of nine years.

In the first three years, the value of the annuity remains $100,000.  On January 1st, 2023, the growth of the index is calculated to be 15%.  Given the Equity Indexed Allocation of 100%, the contract will participate in the full 15% growth.  There is a strategy spread of 1% which will be deducted for each year so the account will be credited with a 12% increase.  The new locked-in value of the annuity is now $112,000.

This same process will continue during each three-year period until the surrender period of nine years is completed.  The individual will then have the option to continue the contract or withdraw their money.

Please note that if an index is negative during the strategy term, the strategy spread is not deducted from the contract value.  The annuity value will never drop below the original premium or the previous locked-in value.

How long do I have to keep my money in an EIA?

The surrender period is the amount of time that money must be kept in the contract to avoid paying a penalty for early withdrawal.  For most EIA contracts, the surrender period is between 7 to 10 years.  The penalty for taking money out of a contract prior to the surrender period can be significant.

Here is an example of a surrender schedule:

For this contract, an individual will pay a 9% penalty if they withdraw money within the first 3 years.  The percentage decreases until year 9 when the surrender penalty is no longer an issue.

The one feature that does help provide a safety valve in the case where an individual needs money from the contract, is called the “Free Withdrawal” feature.  Each contract provides a certain amount of money that can be withdrawn each year without having to pay the surrender penalties.

Here is an example of a Free Withdrawal schedule:

For this contract, an individual will be able to withdraw 7% of the annuity value each year starting after the 1st year with no surrender penalties.  This provision can be helpful if an emergency were to come up where a small portion of the contract is needed.

What is the cost of an EIA contract?

The costs of the EIA contract are the strategy spread as well as the difference between the index return and the caps/participation ratios.

How much should I contribute into an EIA contract vs. my other investments?

Individuals investing in an EIA should be relatively certain they won’t need access to their funds during the surrender period.  Any money needed for living expenses or short-term goals should be left outside of the annuity contract.

Conclusion

If an Equity Indexed Annuity appears to be a good fit based on the information provided, please schedule an appointment and we can review your options together.

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