THE TRUTH ABOUT FIXED INDEXED ANNUITIES Annuities are like magnets. Most people seem to be either attracted to them, or repelled. As you sit down to read this, where do you stand? In my experience, it s rare to run across someone who doesn t already have an opinion about annuities. The key word there is opinion. Is what you know based on fact, or is it based on what someone told you? Here we ll give you facts only. Then, you decide. The truth about annuities is that they are like every other financial product out there; they have advantages and disadvantages. There are no bad financial products (as long as they are registered and approved for sale in your state), only improper or poor use of them. All products have perceived positive and negative aspects to them. If you know the advantages, then you can begin to know whether or not it would be of interest to you or help you financially. If you know their disadvantages, then you can be aware of the negative aspects of these particular products, as well. Ultimately, you will need to weigh out the pros and cons, the pluses and minuses - what we call the Checks and Balances - of this particular product to determine if this product, or any other financial product for that matter, is in your best interest, or if it s really just in the best interest of the person selling them to you. The Basics Annuities come in many different varieties. Because there are so many different kinds of annuities, there is a lot of confusion. When someone tells you annuities are great, what KIND of annuity is he/she referring to? Or what if someone tells you annuities are terrible investments and you should NEVER own one? Same thing; which type of annuity is he/she referring to? Let s look briefly at the history of annuities. Annuities date their use all the way back to the Roman Empire; however, in modern times, annuities, as we now know them, began in 1759 by a Pennsylvania company for the benefit of Presbyterian ministers and their families. Over the past 250 plus years, annuities have gone through many changes, but their original premise holds true: favorable accumulation, and guaranteed income. There are no other products quite like an annuity. At its most basic, an annuity is an interest bearing account issued (only) by an insurance company. 090111 1 2010 Checks and Balances TV, LLC
In exchange for your lump sum deposit or periodic deposits, the insurance company can and will guarantee either an immediate or deferred income. If the income is going to start as soon as the annuity is purchased, it s called an IMMEDIATE ANNUITY because the annuity income will start right away. If the income is not going to start until some, as yet undetermined, time in the future, then it s called a DEFERRED ANNUITY. Triple Compounding Interest Fixed and Variable annuities have a tax advantaged benefit not seen in other investments; we call it triple compounding. Triple compounding of interest simply means your initial investment or principle earns interest; your interest earns interest, and the dollars you would have paid in taxes earns interest. This basic fact about accumulating wealth suggests that you are better off paying taxes on your money when you are ready to use it, not while you are attempting to grow it! The 4 Basic Annuities Available Today There are four main choices when it comes to annuities today Immediate, Fixed, Variable and Indexed. Each has its own pluses and minuses, pros and cons. It s important to understand how they work, their place in an individual investment plan, and if you should consider depositing any of your hard earned savings into them. In this report we will focus on Fixed Indexed Annuities. Deferred Annuities Think of a deferred annuity as something similar to a bank certificate of deposit. A deferred annuity is essentially a tax advantaged savings account issued by an insurance company. Deferred annuities always earn interest, not dividends or capital gains. Before discussing the different types of deferred annuities, let s look at the things that most deferred annuities have in common. Be Aware of Surrender Charges Most deferred annuities come with early withdrawal penalties called surrender charges. Usually surrender charges disappear after a period of time. They vary in length from as little as 3 years to as long as 20 years or even longer for some tax sheltered annuities that are offered to the employees of nonprofit institutions such as schools or hospitals. 2 2010 Checks and Balances TV, LLC
Some annuities have what are known as rolling surrender charges. A rolling surrender charge means there is a new surrender period assessed with each investment you make. That means your surrender charges only end X years after your last deposit. I m not a big fan of these, and thankfully they are less common than they used to be. The amount of the early withdrawal charge is usually expressed as a percentage of the account value or of the original deposit. These percentages range from an average of 4% or 5% to as high as 20% or even more on some tax sheltered annuities (TSA s) that are sometimes offered to teachers and other employees of non-profit organizations. In non-tsa s the higher surrender charges, like 20%, are usually only found in annuities that credit an immediate up-front premium bonus of between 5% and 10%. Surrender Charges Have a Positive Benefit for the Policyowner Most people greatly dislike surrender charges and why not? Who likes to pay a penalty to access your money? In reality though, surrender charges serve several positive purposes. First, from the insurance company s perspective, these types of early withdrawal penalties allow them to invest your money for the long run knowing they won t have to return it to you in the short term. This is for your benefit; simply put, they can invest your money in a way that will earn you more money. The second benefit eliminates any future uncertainty about account losses! If you compare the maximum potential surrender charge in the first year of an annuity to the maximum loss you may have actually experienced in your investment portfolios over the years, you ll find you have probably lost a lot more than say, a 10% surrender charge. A surrender charge is there to discourage you from taking all of your money out early. The only reason you d likely do so is in some sort of an emergency, and emergencies come up when they come up. Their timing is usually terrible. If your emergency came up at a bad time and your money was invested in a stock market based account, you d have no control over how much you might be down at that moment in time. And there is no limit on how far down you might be. In your annuity account, however, you know in advance that your maximum penalty is X% in the first year, and then you know that those charges decline to zero over time. Penalty-Free Withdrawals Surrender charges in most annuities only apply to amounts that you withdraw that are greater than 10% of your account value per year. This is known as the penalty-free amount. It varies among annuity companies and policies, but a 10% penalty-free amount is very common. Surrender charges are also almost always waived if the annuity owner (or the annuitant) dies, becomes sick and needs to go into a nursing home or if diagnosed with a terminal illness. Some annuities even offer a waiver of surrender charges if the owner becomes unemployed. Finally, many annuities will waive the surrender charges if the owner decides to convert the annuity into an income stream over a minimum of five or ten years (i.e. immediate annuity) after the annuity has been in force for (typically) five years. 3 2010 Checks and Balances TV, LLC
The Almost Painless Real-Life Surrender Charge I like to say that annuities are really a liquid account. Not as liquid as money in a checking, savings or money market account, but liquid in the fact that you can liquidate it or cash it out anytime you want. Now, you may incur a surrender charge or penalty on a portion of your principal or interest earnings, but you have access to it. With every annuity there are some simple rules of the game you have to be aware of. Let me give you an example of what I ve seen over the years. Rarely do people come into my office and tell me they need to completely cancel their annuity because they need all of the money. Usually, after the account has been in force for five years or so, they come in and tell me they need to take out a portion. Let s say they originally deposited $150,000 five years ago, and now they come in and need to withdraw $35,000 to buy a new car. Over the first five years, let s assume they earned $41,000 of interest increasing their account value to $191,000. The first 10% of their account balance of $19,100 comes out penalty free. This means the difference of $15,900 would be subject to a surrender charge. Let s assume that their policy had a 10% penalty in year one, declining 1% per year to zero over ten years, so in the fifth policy year they have a 6% surrender charge: 6% of $15,900 is $954. In other words, in order to access the whole $35,000, they paid a penalty of only $ 954 which is in reality only a 2.7% penalty on the total withdrawn amount. When you put it in those terms, it doesn t sound or feel nearly as bad because it s not! And by the way, that assumes they have no other accounts to take any money from. In this case, if they need $35,000 to buy the car, they could have taken the $19,100 from the annuity and the $15,100 from a different account in order to completely avoid all penalties. So far, we ve discussed what most deferred annuities have in common. Now let s look at 3 different types of deferred annuities: fixed annuities, variable annuities and indexed annuities. Let s start by discussing fixed annuities. Fixed Indexed Annuities A fixed indexed annuity (FIA) is a hybrid between a variable annuity and a fixed annuity. You will receive stock market linked growth when the stock market rises (subject to certain limitations), and the safety of knowing you won t lose any of your principal or previous year s gains if the market declines. It s important to know you are not invested in the stock market nor are you invested in any stock market index. You own an insurance policy that earns interest much the same as you would if you owned a CD down at the bank. The big difference is stock market linked growth means your actual interest earnings are tied to the returns of a market index. Because you are not invested directly in any stock market, FIA s can never have negative interest and can never lose money due to stock market losses. Even if the index drops sharply, you will not lose money. 4 2010 Checks and Balances TV, LLC
In a year where there is a loss in the index, the FIA will simply not credit you any interest earnings that year. With a declining stock market, you will simply smile and say, zero is my hero! Stock Market Indexes and the FIA There are many different indexes that can be used in FIA formulas, but the most common is the Standard & Poor s 500. The S&P 500 is made up of the stocks of the 500 largest U.S. companies representing every major industry in our economy. As such, it s a broad measure of our stock market and economy. If your FIA interest is tied to the S&P 500 and it s up, you ll have a chance to earn some interest. If it s down, you won t earn anything for that year. Other indexes include the Dow Jones Industrial Average, the Russell Small Cap and Mid-Cap indexes, the MSCI EAFE (an international stock index), and even some bond indexes. Not all indexes are available on all products; indexes being offered are at the discretion of the issuing insurance company. Participation Rates, Earnings Caps and Spreads/Fees FIA interest is calculated using one or more of the following variables: a participation rate, an earnings cap and a fee or spread. A participation rate is simple to understand. It is nothing more than the percentage of the growth in the index you earn. For example, if the index increased by 8% and you have a 100% participation rate, you earn the full 8%. If the participation rate was 50%, you would have earned 4% (half of the growth in the index). An earnings cap is just what it sounds like: a limit on how much you can earn. Think of it as a glass ceiling. If the index rose 12%, and you had an 8% earnings cap, you would earn 8%. By the same token, if the earnings cap is 8% and the index rose 6%, you would earn the full 6%. You earn everything up to the earnings cap and nothing more. Last are spreads or fees. These are deducted from the index growth, not from your principal. For example, if you have a 2% fee or spread and the index rose 8% you would earn 6%. Putting Participation Rates, Earnings Caps and Spreads/Fees Together A typical FIA might have a participation rate of 100%, with an earnings cap of 8% and zero spreads/fees. This is a very common scenario. In many cases, the insurance company guarantees they can never lower the participation rate or add fees. The only variable they can change from year to year is the earnings cap. They might guarantee they can change the cap up or down, but never below 4%. Again, this is a very common arrangement. Let s look at how this could work. If the index you chose increased 9% over the last 12 months of your policy year, after we apply the above formula you will earn 8%. You earn 100% of the return up to a cap of 8%, and there are no spreads or fees. 5 2010 Checks and Balances TV, LLC
Different Ways of Calculating Index Growth So far we ve talked about how to apply the formulas to index growth, but we haven t talked about the different ways to calculate the index growth itself. These take several different forms. I ll tell you what the most common are and then explain them. Annual Point to Point looks at the change in the index from the first day of the annuity year to the last day. If the index started at 1,000 on the day the policy was issued, and ended at 1,080 on its first anniversary date, that s an 8% gain. (By the way, this is the simplest method to understand and remember out of all the interest crediting formulas to follow.) Annual point to point is most effective in a fast growing stock market. Monthly Averaging looks at the value of the index on the same day of the month each month following your annuity issue date. As such, the growth is calculated by adding up the 12 monthly index values, dividing by 12 and comparing the resulting average to the value on the first day of the year. If the index was 1,000 on the first day, and 1,080 on the last day but AVERAGED 1,075 over the course of the twelve months, then the growth would be 7.5%. Monthly average is most effective in a rising stock market you think might drop towards the end of the next 12 months. Monthly Sum (aka Monthly Cap) simply adds up the changes in the index from month to month over the course of the year and credits interest at the end of the year. There is always an earnings cap on monthly growth. For example, if the index grew 3% from month one to month two, but the monthly cap was only 2%, the insurance company would add 2% to the formula for that month. In any month where the index loses value, that too is added to the formula. But beware: there are no caps on monthly losses. For example, if the index loses 3% from month to month, you will have to include the full 3% in your formula. This means a few big losses from month to month could have the effect of wiping out your gains for the rest of the year. At the end of the year, you add up all the monthly gains and losses, and the result is your interest rate for the year. Note: if the answer is a negative number, you will simply not earn interest in that year. Remember, FIA s can never have negative interest. The worst you can do in a FIA is not earn any interest in that particular period. Monthly sum is best used in a slow but steadily growing stock market. Daily Averaging is just like monthly averaging except instead of adding up the value of the index at the end of each month, it s added up for each day the stock market is open and then averaged out. Daily averaging can be effective when there s a lot of upward volatility in the stock market because it captures all the daily gyrations. 6 2010 Checks and Balances TV, LLC
Annual Reset Locking in Your Gains Interest in a FIA is typically credited on each policy anniversary. Once interest is earned, it is credited to your account and is yours, just like in a CD. Also at the end of each year the value of the index is reset. This can be very powerful and, believe it or not, it s MOST powerful after a bad year in the stock market. Annual reset means the ending value of the index this year becomes the starting value of the index next year. There are also annuities that reset every two years, three years, four years and even seven years. The advantage of longer reset periods is usually they have more liberal caps. The disadvantage is you can easily miss a nice return from year to year hoping to get a better return in the long run-only to potentially receive a lower return or even no return having waited so long to lock in your gains! I am a firm advocate for annual reset FIA s because I have seen them work so well for my clients! Here s a hypothetical example of how an annual reset could work with a FIA that has an 8% earnings cap, a 100% participation rate and no spreads or fees. Notice from 2011 to 2012, the index lost 180 points. The FIA didn t make any money that year nor did it lose any. Therefore, in the following year it only recovered 100 points, and you still earned interest of 8%. You don t need to wait for the index to go back to its previous value before you start earning interest again. You earn right away! Index Value Index Change Annuity Interest FIA Account Value Index Fund Account Value 8/1/2010 1,000 $ 100,000 $ 100,000 8/1/2011 1,080 9.00% 8.00% $ 108,000 $ 109,000 8/1/2012 900-16.67% 0.00% $ 108,000 $ 90,833 8/1/2013 1,000 11.11% 8.00% $ 116,640 $ 100,926 8/1/2014 1,080 9.00% 8.00% $ 125,971 $ 110,009 In the example above, I also included what the hypothetical stock market index account value would be had you owned the index itself. Although the stock market index account was worth $1,000 more before the loss, after the loss, it was worth almost $18,000 less than the FIA account! And the year following the loss, even though the market earned 11.11% versus the annuity which was capped at 8%, the annuity was still worth more. An FIA can never experience double compounding in reverse! In fact, it can never experience a stockmarket loss in the first place! In this scenario, the index account could not catch up over the first four year period, and it would need to earn about 24% at the end of the next year just to equal the value in the annuity after it earned capped earnings of 8% for that year. 7 2010 Checks and Balances TV, LLC
Bonuses Many FIA s offer an up-front bonus to the buyer. These bonuses range from 1% to as high as 11% of the amount you deposit. Some bonuses are a one-time, lump sum bonus and others may credit the bonus on future deposits as well. Lastly, some insurance companies put a vesting schedule on the bonus you receive so if you cancel the policy before the end of the surrender charge period, you may have to forfeit some or all of the up-front bonus. Are bonuses worth it? Depends on the use. As a way to overcome past fees or charges, or to help recoup market losses in other accounts yes! However, be aware that all bonuses come with a catch. The catch is this: the higher the bonus, the longer the surrender charge period. So, if you want a shorter term annuity, then the answer to are bonuses worth it would be no! FIA Riders Aside from the fee deducted from interest in a spread index crediting method, FIA s generally don t have any fees that are deducted from your account value. I m not saying there are no fees; any additional fees that may be deducted are usually tied to an additional benefit or rider on the policy. The most common rider on a FIA is a LIBR (lifetime income benefit rider). These riders typically charge a fee of between 0% and 1.20%, and in return for that fee, you will typically receive both a guaranteed growth rate on your income account value, as well as a guaranteed withdrawal rate for your lifetime. There is no such thing as a typical LIBR rider because each company has its own unique benefits, but if I had to generalize, I d tell you usually for no less than 10 years the insurance company will guarantee your income account value will grow by 5-10% per year. I d also tell you at any point after the first year, you could tell the company you wanted to begin to take lifetime maximum withdrawals, and then you could withdraw that amount for the rest of your life even if the account ran out of money. The amount you can withdraw is based on your age at the time you trigger this benefit, and it is, generally, your age divided by ten, minus 1. [For example, if you are 60, then your age divided by 10 is 6. Subtract one from that and you get 5 which means you can withdraw about 5% for life without ever having to worry about running out of money. At age 75, would mean about 6.5%. At age 80 would mean about 7% and so on.] Usually the withdrawal rates change every five or ten years, so from 60-64 you could withdraw 5%; from 65-69 you could withdraw 5.5% and so on. If you are married, you can usually get a withdrawal rate that will pay for the longer of you or your spouse s life, but that causes the maximum withdrawal to be reduced by 0.5% to 1%. A big difference between FIA income riders and VA income riders is FIA income riders do not force you to annuitize your account value. In plain English, that means if you had an account value worth $120,000 and you have taken income withdrawals of $20,000, assuming you earned no interest over that time, you d still have full access to your $100,000 account value. 8 2010 Checks and Balances TV, LLC
How is a Fixed Indexed Annuity taxed? The good news about a fixed indexed annuity is that while it s in the deferred stage, your principal and interest earnings grow tax deferred. The bad news is that once you begin taking money out of this account, you will be paying ordinary income taxes on the gain or interest earned. (Of course you ll only pay taxes on the amount you pull out, not what you leave in the account.) Many stockbrokers and financial advisors like to say that you should have the bulk of your money in stocks or mutual funds, because they enjoy capital gains, not ordinary income tax rates. The tax rate comparison is true. But be careful, capital gains tax treatment could be considerably lower than your current tax bracket, or it might not be. It all depends on what income tax bracket you re in now and what tax bracket you may find yourself in the future. Also, to enjoy capital gains tax treatment you have to be willing to have your money at risk in the stock market. So, you might be stuck with potentially severe losses in the market from time to time, just to realize capital gains tax treatment, if you decide to sell some or all of this account sometime in the future. What About Required Minimum Distributions? If your fixed indexed annuity is held inside of a retirement account such as a 401-(k), 403-(b), IRA, or other qualified account, then you will be subject to Required Minimum Distributions (RMD s). Which simply means that you will be forced to take out a minimum amount from this account every year, beginning in the year you reach 70 ½ years of age. The truth is, you could take this RMD every year from another qualified account if you had one, and didn t want to take any money out of this account. But either way you look at it, whatever money you have in a qualified account, Uncle Sam is going to get his tax money from it, at least by the time you turn 70 ½. The Advantages and Disadvantages of Fixed Indexed Annuities The main advantage of fixed indexed annuities is that your money in this type of account is not at risk based on stock market volatility or loss. You only participate if the stock market increases, never if it decreases. The other creative aspect of FIAs, and a real consumer benefit, is the annual reset feature. This is the only account in America, that I know of, that locks in any gain you realize on your policy anniversary date. The disadvantages of fixed indexed annuities are, first of all, that you don t receive any dividends on the stocks that make up any of the indexes. Secondly, any withdrawals of interest earnings will be taxed at your ordinary income tax bracket, not at capital gains rates, which may or may not be a true 9 2010 Checks and Balances TV, LLC
disadvantage. It will all depend on what your current tax bracket would be and what the current capital gains rates are at the time of your withdrawal. Next, you must also be aware that you don t normally receive 100% of the gain in the index you ve chosen. You will participate in the increase of the market, but no capture all of the gain, normally. I say normally because if you have an 8% earnings cap on your annuity this year (and 100% participation rate and zero spread or fee) and the S&P 500 (if that s the index you ve chosen) increases 6% from last year s policy anniversary date to this year s policy anniversary date, you WOULD receive 100% of the gain, resulting in a 6% increase to your account which would be locked in and added to your principal. Another potential negative to watch out for are the moving parts of the indexed annuity you are considering. What I mean by moving parts is that every year, on your policy anniversary date, the insurance company can elect to increase or decrease 3 important aspects of your FIA, that could positively or negatively affect next year s performance. Those 3 moving parts are: the Participation Rate, the spread or fee and the earnings cap. I highly recommend that you ONLY buy an FIA that, by contract, can only change ONE of those moving parts each year and not two or three. Watch Out For The 10% Penalty Even if your annuity is not an IRA or other similar retirement account, early withdrawals from annuities before you are 59 ½ years of age may be subject to a 10% penalty tax on the interest gain within the annuity. Because the tax code gives annuity special tax benefits (like tax deferral), they want you to leave your money in them for the long run. But there are ways around that penalty tax, which a well trained, competent, professional annuity advisor can help you with. Other Annuity Considerations: Section 1035 Exchanging Your Old Annuity for a New One Section 1035 of the IRS tax code allows you to avoid paying taxes when you move from an older annuity to a newer one that has better benefits. Why would you do that? Like a car, the car you re driving today may not have the options and features you want and need that ARE available on a newer vehicle. Same thing with annuities. A newer model annuity may have enhanced income benefits, or bonus features that your old policy just doesn t have. A 1035 exchange allows an insurance company to transfer your money out of an existing annuity into a brand new annuity, without paying taxes on any of the interest you earned in the first annuity. 10 2010 Checks and Balances TV, LLC
In fact, you can also transfer money from a cash value life insurance policy into an annuity as well. When you use section 1035 to exchange an annuity or life insurance policy for a new annuity, not only does your money transfer-so do the records of all your deposits or payments. Last But Not Least Annuity Maturity Dates Much has been said and written in the media regarding annuity maturity dates and just how bad and unfair they (maturity dates) are to the owner of the policy. There have been many negative comments and stories in the press regarding this topic. Here are the facts; you be the judge Because an annuity contract is a CONTRACT, the contract has to state there be a date in the future requiring the owner to elect an annuity settlement OPTION to begin receiving payments by way of annuitizing the contract (i.e., receiving a monthly income). All that happens on the Annuity Date or Maturity Date is that the client will receive a letter from the company advising him/her of the settlement options. In many policies, this maturity date is not even triggered until you re over 100 years old. This simply means you are not FORCED to take anything out of your annuity, if you don t want to, until this maturity date (However, please be aware that if you have a qualified plan inside of an annuity like an IRA, 401(k), 403(b), etc., you will have to take a RMD every year, starting at age 70 ½). The stated maturity date in an annuity contract DOES NOT mean you have no access to your funds until that date! Nor does it mean you have to wait until that date to begin annuity payments. Most annuity contracts allow the owner to change the Annuity Date and most companies will allow a client to annuitize the contract anytime after the first contract year. And, remember, as we discussed earlier, most annuity contracts allow you to take up to 10% of the current value every year, after the first year. Wrapping it all up Did you start reading this with an opinion about annuities one way or another? What do you think now? While there are no perfect investments, annuities included, annuities can be powerful tools in your investment tool chest that can provide valuable benefits when used properly. From being the only investment on the planet that can provide a guaranteed income for life, to offering you the upside (with risk) of variable annuities to the market-risk-free upside of fixed indexed annuities, as well as lifetime income riders, annuities are certainly worth a look! If you re going to consider an annuity, be sure you find a competent professional annuity advisor who can help you navigate through all of the different variations out there. 11 2010 Checks and Balances TV, LLC
For more information regarding this topic or any other financial product or area of interest, email us at Info@ChecksandBalances.TV. Checks and Balances TV: Giving You the Truth You Need to Financially Succeed! Register Today for Full Access to CBTV! www.checksandbalances.tv/register CBTV helps you achieve financial freedom by providing balanced insight and unbiased financial advice so you can make informed financial decisions. Visit our website to access all the resources we offer in our Checks and Balances Financial Decision-Making System, the new system for Financial Freedom! Your 3 Steps to Financial Freedom: 1. Watch the Show! Tune in each week to discover how today s financial headlines impact you and what you can do NOW to be financially secure. 2. Download Financial Tools! Access our FREE financial tools and reports and sign up for our FREE weekly e-newsletter. 3. Take Action Now! Implement the tools and strategies you learn from CBTV. Only YOU can make it happen! (But we re here to help.) www.checksandbalances.tv CBTV shall have neither liability nor responsibility to any person or entity with respect to any loss or damage caused, or alleged to be caused, directly or indirectly by the information contained in this report. The information, methods and techniques described by the author are based on his/her own experience. Everyone s financial situation is different. This report is intended to be informational on the topic and should not be considered as legal, accounting or financial planning advice, and should not be used as a replacement to other professional services. CBTV shall be held harmless on the accuracy of the content within. Every effort has been made to ensure the information contained is complete and correct, however, in the event of an error or outdated reference, each report should be used only as a general guideline. Property of Checks and Balances TV, LLC, All Rights Reserved. 12 2010 Checks and Balances TV, LLC