No risk, just reward
By Karlan Tucker
The fixed indexed annuity (FIA) is perhaps one of the most innovative and effective financial tools invented in modern times. We have been taught our whole lives that in order to get a reward, you have to take a risk. Although there was a time when this was true, it's no longer the case. The FIA offers the perfect balance of reward -- with no market risk. This product must have been created with the kind of volatile markets we have been experiencing over the past decade in mind. When opportunity presents itself by a rising market, the FIA captures it for life. When the markets turn down, this vehicle protects not only our principal but also all previously captured gains.
In investing, when you put up the capital and take the risk, you understandably want the reward. However, all too often the reward is fleeting, in the form of paper gains, and all too soon to be lost. The FIA makes generating money enjoyable again because you are assured of the reward. The unknown factor, of course, is what size the reward will be. This is not a lot different than placing your money in a stock or mutual fund and also not knowing what the reward will be. However, in an FIA you can know there won't be any losses, and that provides peace of mind.
The FIA has become a very popular tool for protecting and growing nest eggs, as evidenced by more than $115 billion1 being placed in these innovative products.
In the past, your clients have likely fallen into one of two camps in regard to money: Either he or she was an investor willing to risk their principal in the stock market (for the opportunity of a better gain than traditional safe vehicles), or they were a saver (unwilling to risk principal; accepting a modest return). Both positions offered a unique set of challenges. The investor had the challenge of volatility, making up for losses and knowing when to take his or her winnings off the table. In extended down markets, the ability to take income from the portfolio can be greatly hampered or even eliminated. The saver has the difficulty of making a return sufficient enough to compensate for inflation, and typically having to accept low returns for the lack of risk being taken.
The creation of the FIA filled the need for a product that positioned itself squarely between the typical choices of both the investor and the saver. The FIA protects the principal by placing it outside the volatility of the market in a conservative bond portfolio. This portfolio is typically anchored in U.S. government treasuries. To get a better yield without taking significant credit risk, the balance of the portfolio is then typically invested in the highest quality corporate bonds with a very small amount -- typically less than 10 percent -- in either higher yielding bonds or commercial mortgages. The purpose of the bond portfolio is to provide a safe place to park the principal; and it accomplishes this very effectively, as evidenced by the fact that no owner of an FIA has ever lost any principal or interest due to either the failure of the issuing financial entity or market risk.
Next, the financial entity takes a "spread" from the gross yield of the bonds, resulting in the net yield. The spread is used by the insurance company to pay its expenses and to generate a profit for both itself and its shareholders.
The net yield is then either given to the FIA owner though the fixed account performance, or can be used to purchase call options in an index of their choice. The choice of indices is wide -- from the S&P 500 or Dow Jones to bond indices, as well as European indices.
Many owners of FIAs prefer to participate in the market because there is no downside risk to their principal. This is accomplished by using only the renewable resource of yield to purchase an option that controls a position in an index equal to the size of their principal.
For example, if your client placed $100,000 in an FIA, the option purchased would have a value of $100,000. In this way, his or her principal is represented in the market without actually putting it there. When the index rises annually on your client's anniversary date, the option captures a return. The return is then placed in the conservative bond portfolio for safekeeping, never to be lost to future market volatility. Since the FIA is a tax-deferred vehicle, your client's gain is captured without triggering a taxable event.
The FIA typically allows an annual 10 percent withdrawal without any fees or penalties. In fact, FIAs have no required fees, loads or commissions taken from the investor's growing principal. The compensation to the agent is paid out from the company's spread and is never deducted from the account value.
Today's FIAs offer income features that will allow for a minimum growth during the deferral phase of up to 8 percent compounded annually for a maximum of 20 years. Some also offer the potential for annually increasing income during the distribution phase by linking to the fixed account or an index with the increase in income being equal to the performance of the chosen strategy. These income features do not require annuitizing the principal, but allow your client to stay linked to the performance of the stock market as well as taking an income stream that you can't outlive. Any principal remaining in your account at death is inheritable by your beneficiaries. These income features typically have annual fees between .45 and .65 basis points. On a $100,000 account, that would be annual fees of $450 to $650. These are the only fees associated with an FIA.
If you are an investor, the FIA solves many problems while preserving the opportunity for growth generated by the stock market. No longer do you have to make up for losses; you can't even have market losses. You and your client will solve market-timing issues of when to buy or sell by capturing his or her gains annually on autopilot. You remove emotion from investing because your consumer never has to sell the very vehicle responsible for the growth in order to turn paper gains into realized gains. You may now be able to realize gains without triggering a taxable event, since all FIAs defer the taxes on gains until the client pulls them out for personal consumption.
There's never a bad time to take income, because your client's account will always be at its highest level (minus any prior withdrawals), since it's insulated from market losses. Your client's ability to generate a sustainable income for life is dramatically enhanced, since the insurance company takes the small annual fee of .45-.65 basis points and uses it to re-insure the risk of him or her living longer than life expectancy tables predict.
Savers can now enjoy market-linked performance without the risk typically associated with market returns. Higher returns than traditional vehicles like CDs and government bonds offer should allow for a better standard of living and the ability to fight inflation.
FIAs can be appropriate for both qualified -- IRAs, 401(k)s and 403(b)s -- and non-qualified (already taxed) dollars.
While account values grow most efficiently by avoiding even one down year, participating in only a portion of the up will generate accounts that compare favorably over time with accounts that participate in both the up and the down. In my experience, FIA owners gladly trade some of the up for none of the down.
Remember: The FIA is a highly recommended vehicle designed to protect and grow your nest egg with the perfect mix of no market risk, just reward.
1As of 2007, per LIMRA International, Inc.
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