By Matthew J. Knee, a Specialist at New Hampshire Financial Services, LLC
This is a phrase commonly used when financial professionals talk about fixed indexed annuities as a form of investment option for retirement savings plans. The term is derived from the guarantee of protection that these hybrid financial vehicles offer you during periods of downward facing markets – much like what we are experiencing right now.
These hybrid vehicles protect your money and guarantee that you will never lose any amount of account value. These vehicles also allow you to participate in the upside of a stock market index without suffering any losses due to poor stock performance or even serious losses.
For example: many of these hybrid vehicles are linked to the Standard and Poor 500 (aka: The S&P 500). When the S&P 500 was down over 38% in 2008 the owners of these indexed annuities were credited with a 0%. They did not record a loss, and they did not record a gain.
The first question we want to answer is “which would you rather?”.
Say there are two portfolios.
Example A is in an equity portfolio and Example B is using the hybrid features of a fixed indexed annuity. Both accounts have $500,000 in them. When the market dropped 38% in 2008 - Example A would reflect a loss of $190,000 – creating a total of $310,000, where Example B would reflect the account value staying strong at $500,000 reflecting no losses and no gains.
In 2008 and again today with the impact of Covid-19, you were most likely bragging about your ‘zero’.
But what about the growth of the Fixed Indexed Annuity?
Growth on a Fixed indexed Annuity is calculated several different ways. Most commonly, is an annual point-to-point. Each year on the anniversary of your purchase of this vehicle, the growth of the chosen index is credited to your account based on the participation and a new guaranteed floor is created which your account will now not go below. In addition, you do not need to wait for the index to reach its previous level to start reporting gains again. The growth that we commonly see after a correction is also credited to your account on the next anniversary date.
The participation rate that the annuity contract has to its linked index is variable based upon which company you choose and how long you chose to invest in these vehicles. This is why it’s important to work with an independent broker when making these decisions as they represent you through the marketplace and the planning process – not a specific investment or insurance company (see my article on the agent v. broker difference).
Participation rates can be varied anywhere commonly between 35% and 65% on the Standard and Poor 500 index - though there are both higher and lower rates. Again, it depends on the company you choose. But what does that mean?
For easy math, lets say the S&P 500 goes up 10% during your first contract year. At a participation rate of 80% you earn 8% interest on your account. At a participation rate of 35%, you would earn 3.5% growth.
For easy math, lets back track what a $100,000 investment would look like from January 1st, 1999 to January 1st 2020 comparing the average participation rate of 50% participation rate (green line), the S&P 500 index (red line), and a 3% fixed growth (blue line) used to demonstrate what you would need to keep your purchasing power in pace with inflation.
The fact of the matter is that because these hybrid vehicles do not participate in negatives and instead reflect a growth of zero, they have done the greatest amount of growth and have done so the safest way.
These are great tools to help take the risk of stock market loss off the table and smooth the volatility of the markets. We can clearly see how they also offer solid growth potential allowing a person to capture a portion of the market upside while insulating from market corrections.
Each tool a financial professionals use has its upside and downside, fact remains that there is no one-size-fits-all vehicle or solution.
So, is having the zero be your hero and never have a market loss due to a downturn a good fit for you?
The question you to ask yourself is if you are willing to accept a limitation on your growth potential in exchange for immunity to bear markets and market correction losses. Though the math is there to support a strong argument for the age range of 40+, the answer for retirees has been a resounding YES.
The reason lay in simple math. The relationship with safe money significantly changes for a person when there is no longer an income being generated. Without additional contributions being made, preservation and growth are the dominating factors of a retirement income strategy.
It is twice as hard to earn money in the market than it is to lose it.
We can see this in the example below.
$100k + 50% = $150k
$100k – 50% = $50k
$50k + 50% = $75k
Research shows that retirees who can avoid significant losses in their portfolio in he first 5-10 years of retirement have the greatest chance of never running out of money.
For a couple with a $500,000 portfolio who can comfortably withdraw $20,000 annually, in addition to their other guaranteed income sources such as social security, to meet their annual base income needs need only a 4% annual average growth to maintain their principal and lifestyle without the fear of running out of money.
But what happens if the market corrects and they lose 30% of their portfolio? Do they keep withdrawing the $20,000 with the hopes that the market rebounds and they record a 60% gain in one year to return to their acceptable level?
We don’t know what the sequence of returns is going to be in the future. Will the markets be kind to us or otherwise? The hard truth is that we do not know. I believe that it is best to be prepared, not scared.
Let us help you create your playbook to retirement.
As always, I hope you find my words informative and educational. If you are looking for more information, feel free to explore our website and browse our resources and blog section.
If you are looking for a more direct source of guidance, we also offer free no obligation consultations.