Retirement Income Visions

Contractual vs. Situational Fixed Index Annuity Income Calculation Variables

Last week's post, 10 Fixed Index Annuity Income Calculation Variables, introduced ten potential variables that are used to calculate the income, or lifetime retirement paycheck ("LRP"), amount that you will receive when you purchase an income rider with your fixed index annuity ("FIA").

It's important to emphasize that all ten variables won't apply in every situation. Six are contract-dependent and four are situational. Situational variables, by their nature, occur after the fact, and, as such, often cannot be anticipated when deciding which FIA(s) to purchase. Having said this, each variable needs to be taken into consideration by a retirement income planner when analyzing and selecting FIA income riders and products that may be appropriate for a particular situation.

Contractual Variables

Contractual variables are addressed in various sections of a FIA contract. The six contractual variables are as follows:

1. Premium bonus availability
2. Income account value interest rate
3. Number of years income account value interest rate is in effect
4. Maximum lifetime income withdrawal percentage
5. Surrender charge schedule
6. Premium bonus recapture provision

Variables #1 and #6, premium bonus availability and premium bonus recapture provision, are directly related. When offered, premium bonus provisions appear in the base contract since they affect the accumulation value regardless of whether an income rider is also purchased. Variable #5, surrender charge schedule, is also included in the base contract. Variables #2 - #4 are only applicable to income riders, and, as such, will be included in the income rider section of a FIA contract.

Situational Variables

Situational variables, although they will trigger one or more contractual provisions, arise as a result of an action on the part of the contract owner. The four situational variables are as follows:

1. Initial and subsequent investment amounts
2. Lifetime payment election date
3. Accumulation value withdrawal amounts and timing of same
4. Death of owner prior to commencement of income payments

The first three situational variables are controllable by the contract owner while variable #4, death of the owner prior to commencement of income payments, is unpredictable. Variables #1, #3, and #4 affect both the accumulation value and the income rider payout. Variable #2, lifetime payment election date, is unique to the income rider.

Now that we have made the distinction between contractual vs. situational fixed index annuity income calculation variables, we will continue our exploration of each of these variables in the next several posts, beginning with contractual variables.

10 Fixed Index Annuity Income Calculation Variables

The last five weeks' posts have focused on what you don't receive (Your Fixed Index Annuity Income Rider – What You Don't Receive – Parts 1 and 2 and Annuitization Tax Treatment of Nonretirement Distributions) and what you do receive (5 Things You Receive From a Fixed Index Annuity Income Rider – Parts 1 and 2) when you purchase a fixed index annuity income rider.

As stated in Part 1 of 5 Things You Receive From a Fixed Index Annuity Income Rider, there are three types of fixed income annuities that offer lifetime income payments: (a) single-premium immediate annuities, or "SPIA's," (b) deferred income annuities, or "DIA's," and (c) fixed index annuities, or "FIA's."

5 Things You Receive From a Fixed Index Annuity Income Rider – Part 2 of 2

Part 1 of this post last week made the point that fixed income annuity, or "FIA," riders are a dream-come-true for a retirement income planner like me since it enables me to offer a unique solution for meeting clients' income needs that isn't available elsewhere from other investment products. It emphasized that the five things you receive from a FIA income rider, when taken as a whole, cannot be duplicated by any other investment.

The first two features, guaranteed income and flexible lifetime retirement paycheck, or "LRP," start date were the subject of last week's post. This week we'll take a look at the other three features.

5 Things You Receive From a Fixed Index Annuity Income Rider – Part 1 of 2

As the saying goes, it's better to give than to receive. With this in mind, the last three week's posts focused on what you don't receive when you purchase an income rider with a fixed index annuity, or "FIA." With Christmas and Hanukkah just behind us as I write this week's post, it's time to take a look at what you receive from this optional addition to your FIA.

Let's start with some basic terminology. Although many life insurance companies refer to it as an income rider, you will also see the phrase, guaranteed minimum withdrawal benefit rider, or "GMWB" rider, for short. The latter terminology is simply another name for an income rider.

Annuitization Tax Treatment of Nonretirement Distributions

Per last week's post, there are four things that you don't receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities. The first three, i.e., annuitization, immediate payments, and ability to receive payments over a fixed period, were discussed in last week's post. The fourth thing – annuitization tax treatment of nonretirement distributions – is the subject of this week's post.

Before we discuss tax treatment of distributions, I want to talk briefly about taxation of annuities during the accumulation stage before any distributions are made. Similar to IRA's and other qualified retirement plans, unless they're immediately annuitized, all annuities, including fixed income annuities, enjoy tax-deferred growth. That is, until distributions are taken, there's no taxation. This is true whether the annuity is held within a nonretirement account, a traditional IRA or other qualified plan, or a Roth IRA.

Your Fixed Index Annuity Income Rider – What You Don’t Receive – Part 2 of 2

Per Part 1 of this two-part series, before we talk about what you receive when you purchase an income rider with a fixed index annuity, it's important to understand what you don't receive. As stated last week, this needs to be placed in the context of fixed income annuities. If you haven't done so already, I recommend that you read last week's post before continuing with this one.

There are four things that you don't receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities:   

1. Annuitization
2. Immediate payments
3. Ability to receive payments over a fixed period
4. Annuitization tax treatment of nonretirement distributions

Your Fixed Index Annuity Income Rider – What You Don’t Receive – Part 1 of 2

As stated in last week's post, while a fixed index annuity has several unique conservative and desirable investment features, assuming your goal is to create a lifetime retirement paycheck, you need to apply for an optional income rider when your retirement income planner submits your application. As pointed out last week, income riders are currently available with less than 40% of all fixed index annuities.

What exactly do you receive when you purchase an income rider with your fixed index annuity? How does it work? How can it be used as part of a retirement income planning strategy to create a lifetime retirement paycheck?

Add an Income Rider to Your Fixed Index Annuity to Create a Retirement Paycheck

As stressed in the last three week's posts, Where Have All the Pensions Gone?, A Retirement Paycheck is Essential, and No Pension? Create Your Own, we need to know that when we stop working, we will receive a predetermined monthly payment, i.e., a retirement paycheck, for the rest of our life, and, if married, our spouse's life. Furthermore, due to its inadequacy and uncertainty, this monthly payment needs to be in addition to whatever Social Security benefits we may receive.

Per last week's post, No Pension? Create Your Own, a retirement income planning strategy that's becoming more widely used the last few years is the addition of a rider, or endorsement, to a fixed index annuity to generate a retirement paycheck. The concept of fixed index annuities isn't new to readers of Retirement Income Visions™. This topic has been featured for the last five months, beginning with the July 11, 2011 post, Shelter a Portion of Your Portfolio From the Next Stock Market Freefall.

No Pension? Create Your Own

Last week's post, A Retirement Paycheck is Essential, emphasized that it's imperative for each and every one of us to have a retirement income plan. The cornerstone of a retirement income plan is a retirement paycheck. Specifically, we need to know that when we stop working, we will receive a predetermined monthly payment for the rest of our life, and, if married, our spouse's life. Furthermore, this monthly payment needs to be in addition to whatever Social Security benefits we may receive.

Given the fact that the majority of us won't receive a pension from an employer's defined benefit plan that our parents' generation took for granted (see the November 21, 2011 post, Where Have All the Pensions Gone?), it's incumbent upon us to create our own retirement paycheck. This isn't an task and generally requires the assistance of an experienced retirement income planner.

A Retirement Paycheck is Essential

Last week's post, Where Have All the Pensions Gone? made the point that given (a) the scarcity of traditional defined benefit pension plans, (b) the inability of 401(k) plans, employee and self-employed retirement plans, and many nonretirement investment vehicles to provide for a predetermined monthly lifetime income beginning at a specified age, and (c) the inadequacy and uncertainty of the Social Security system, it behooves each and every one of us to create our own pension plan.

With this week's post, I want to expand upon and clarify the conclusion in last week's post. I understated the point when I said that it behooves each and every one of us to create our own pension plan. It isn't simply beneficial or worthwhile to create our own pension plan – it's imperative that we do so. To do otherwise is to leave our retirement exposed to too many variables beyond our control and, in turn, risk that we will outlive our retirement assets.

Where Have All the Pensions Gone?

If you aren't receiving a pension from a former private sector employer, there's a pretty good chance that your employee benefit package doesn't include this once-cherished perk. According to a study by Towers Watson & Co., as of May 31, 2011, only 30% of Fortune 100 companies offered a defined benefit plan to new salaried employees. That's down from 37% at the end of 2010, 43% in 2009, 47% in 2008, and 83% as recently as 2002. This is a far cry from 1985 when 90% of Fortune 100 companies offered a traditional pension plan to new employees.

While defined contribution plans, predominantly 401(k) plans, have replaced defined benefit plans in the private sector, the pension aspect is lacking in the majority of such plans today. Specifically, with limited exceptions, these plans generally don't provide for a predetermined monthly payment that an employee can expect to receive beginning at a specified age for the rest of his/her life and his/her spouse's life if married.

How to Get Interest Credited to Your Fixed Index Annuity When the Market Declines

Last week's post, Don't Neglect Your Fixed Index Annuity Fixed Account, made the point that you're not guaranteed to receive interest crediting with the majority of fixed index annuity indexing methods due to the fact that interest is only credited when the result of the calculation is positive. Per the post, one way to obtain interest crediting in the event of negative performance of your chosen index or indeces, is to allocate a portion, or perhaps all, of your fixed index annuity to the fixed account.

Per last week's post, to the extent that you choose the fixed account, you will receive three benefits unavailable from traditional indexing methods: (1) guaranteed return, (2) pre-determined return, and (3) opportunity to offset a portion or all of an income rider charge in the event of a negative indexing method return. While the predetermined annual return is generally very favorable to that of a one-year CD, it is nonetheless modest, typically in the range of 1% to 2% these days.

Don’t Neglect Your Fixed Index Annuity Fixed Account

Last week's post, Diversify Your Fixed Index Annuity Indexing Methods discussed four basic strategies that you can use to diversify your fixed index annuity indexing methods to reduce the pressure of picking the "winning horse" and improve your chances for obtaining interest crediting in a particular year. One of the strategies, allocation of accumulation value to the fixed account, is the topic of this week's post.

Per last week's post, unlike indexing methods that are generally tied to the performance of a stock market index, the fixed account credits a predetermined fixed interest rate for the percentage of your fixed index annuity that is allocated to this investment choice. The fixed account offers three advantages over traditional index crediting methods 

1. Guaranteed return
2. Pre-determined return
3. Opportunity to offset a portion or all of an income rider charge in the event of a negative indexing method return

Diversify Your Fixed Index Annuity Indexing Methods

Per the conclusion of last week's post, Which is the Best Fixed Index Annuity Indexing Method?, no one can predict how a particular fixed index annuity indexing method will perform during any contract year. Differences in contract dates, stock market indexes, and cap rates, combined with the unpredictability of the stock market itself, makes it extremely difficult, if not impossible, to forecast the best performing method for any contract year.

Given this reality, there are four basic strategies that you can use to diversify your fixed index annuity indexing methods to reduce the pressure of picking the "winning horse" and improve your chances for obtaining interest crediting in a particular contract year:

1. Select multiple methods
2. Choose a blended index if available
3. Purchase multiple fixed index annuity contracts
4. Use the fixed account

Which is the Best Fixed Index Annuity Indexing Method?

Beginning with the August 22, 2011 post, How Does Your Fixed Index Annuity Grow?, fixed index annuity strategies, and, in particular, indexing methods, have been the focus of the last nine posts. The last four posts explained four methods, with the first three being the most widely used:

1. 1. Annual point-to-point cap method
2. 2. Monthly point-to-point cap method, or monthly sum crediting method
3. 3. Monthly average method
4. 4. Trigger Indexing method

Each of these methods is used to determine the amount of interest that's credited to a fixed index annuity each year. So which of these four methods is the best one? Is there one method that consistently produces superior results and should be favored over the others?

Fixed Index Annuity Indexing Method with a Trigger

The last three posts introduced three fixed index annuity indexing methods that are used to determine the annual amount of interest that is credited to a fixed index annuity:

1. Annual point-to-point cap method
2. Monthly point-to-point cap method, or monthly sum crediting method
3. Monthly average method

With each of these three methods, the amount of interest that's credited during a particular contract year is unknown ahead of time, must be calculated, and generally changes year to year. Like all indexing methods, if the result of the calculation is negative, no interest is credited.

There's a fourth indexing method that's not as widely used as the other three methods known as trigger indexing. The basic difference between trigger indexing and the other three indexing methods is that the interest rate isn't calculated using trigger indexing. It's instead a predefined percentage that's triggered by a specified event. The predefined percentage is credited in each contract year during which the value of the specified stock market index at the end of the year is greater than or equal to its value at the beginning of the year. The amount of the change in the index during the year is irrelevant.

Monthly Average vs. Monthly Point-to-Point Fixed Index Annuity Indexing Method

We continue our miniseries about fixed index annuity indexing methods that began on September12th with a discussion of the monthly average indexing method. The previous two posts, What's the Point-to-Point? and Monthly vs. Annual Point-to-point Fixed Index Annuity Indexing Method introduced the annual and monthly point-to-point methods, respectively.

In order to help you understand the monthly average indexing method, we will compare it to the monthly point-to-point, or monthly sum crediting method as it is otherwise known. Per last week's post, there are three steps associated with the latter method that are performed each contract year:

1. Calculate twelve monthly percentage changes in selected stock market index.
2. Apply the product's cap rate to each of the twelve monthly percentage changes.
3. Add the twelve monthly capped percentage changes together to determine the annual interest amount to be credited.

Monthly vs. Annual Point-to-Point Fixed Index Annuity Indexing Method

Last week's post, What's the Point-to-Point?, introduced the annual point-to-point cap method, which is the simplest fixed index annuity indexing method. This post will discuss the monthly point-to-point cap method and  will compare it to the annual point-to-point cap method.

The monthly point-to-point cap method, or monthly sum crediting method as it's otherwise known, is similar to the annual point-to-point cap method, with the following three differences:

1. The calculation involves the determination of twelve monthly percentage changes vs. one annual percentage change.
2. The limit, or cap rate, is applied to each monthly percentage change, or 12 times, vs. one time with the annual point-to-point cap method.
3. The monthly capped changes are added together to determine the annual interest amount to be credited.

What’s the Point-to-Point?

Per last week's post, Fixed Index Annuity Indexing Method Similarities, most indexing methods share three features: (1) Reliance on a stock market index, (2) Measurement of percentage changes between two points in time, and (3) Use of cap rates.

All three of these features are common to the annual and monthly point-to-point cap methods. The latter method is also often referred to as the monthly sum crediting method. These two methods are the most common indexing methods that are used to calculate annual interest crediting on fixed index annuities.

Fixed Index Annuity Indexing Method Similarities

As emphasized in the September 12, 2011 post, Introduction to Fixed Index Annuity Indexing Methods, it's important to keep in mind one of the basic tenets of fixed index annuity interest crediting that applies to all fixed index annuities, i.e., you only participate in gains, not losses. No matter which indexing strategy(ies) you select, if the annual calculation of the gain or loss results in a loss, you won't realize, or be credited, with any loss. 

So how is interest crediting calculated? Fixed index annuity indexing methods have several things in common. With some exceptions, which will be the topic of a future post, most methods share the following three features:

1. Reliance on a stock market index
2. Measurement of percentage changes between two points in time
3. Use of cap rates

Introduction to Fixed Index Annuity Indexing Methods

As stated at the conclusion of last week's post, fixed index annuity interest crediting is determined on an annual basis by the performance of one or more chosen stock market indexes and indexing methods based on the original contract date. As a result, there are generally 365 possible measuring periods.

Since stock prices often change daily, there is a high likelihood that the price of a particular stock index, which can be based on stock prices of dozens, hundreds, or even thousands, of individual companies, will fluctuate on a daily basis. Consequently, individual fixed index annuity interest crediting can vary widely from contract to contract even if identical stock market indexes and indexing methods are chosen. Since performance is date sensitive, different indexing strategies may be superior to others within the same year, let alone from year to year.

Contract Date – The Driver of Fixed Index Annuity Performance

Last week's post began a discussion about the second way that fixed index annuities grow in addition to a contract's defined minimum guarantees – indexing strategies. It pointed out that there are actually two choices that you need to make when selecting a particular indexing strategy: (1) Stock market index and (2) Indexing method. Stock market indexes, including how they work and the different types that are typically available when working with fixed indexed annuities, was the subject of last week's post.

What is the purpose of an indexing method? An indexing method, together with a particular stock market index, determines the amount of interest that is credited to the value of a fixed index annuity on the contract anniversary date each year. Interest crediting is flexible and will vary for each fixed index annuity contract based on several factors.

Indexing Strategies – The Key to Fixed Index Annuity Growth

Last week's post introduced the two ways that fixed index annuities grow: (1) minimum guarantees and (2) indexing strategies. The minimum guarantee feature, which was discussed last week, is the security blanket that provides the foundation for growth of a fixed index annuity. Per the conclusion of last week's post, this is the minimum accumulation value that would be paid by the life insurance company to the investor if the investor terminates his/her contract, or to the beneficiary in the event of death.

As discussed in the July 18, 2011 post, Looking for Upside Potential With Downside Protection – Take a Look at Indexed Annuities, indexed annuities are a hybrid product, with returns directly tied to the performance of a stated stock market index. When you complete a fixed index annuity application, you need to choose, and allocate between, one or more indexing strategies.

How Does Your Fixed Index Annuity Grow?

"Mary, Mary, quite contrary, how does your garden grow? With silver bells, and cockle shells, and pretty maids all in a row." Applied to fixed index annuities, this popular English nursery rhyme might read as follows: "FIA, FIA, quite contrary, how does your accumulation value grow? With minimum guarantees, and indexing strategies, and not too many down years in a row." Please note that all references to "guarantees" are subject to the claims-paying ability of individual life insurance companies issuing fixed index annuity contracts.

With each passing week, Retirement Income Visions™ ongoing fixed index annuities series that began on July 11^th with Shelter a Portion of Your Portfolio From the Next Stock Market Freefall is proving to be very timely. Volatility has been the name of the game since the Dow Jones Industrial Average closed at its recent high of 12,724.41 on July 21^st. With its close of 10,817.65 on Friday, the Dow is down 1,906.76, or 15%, in 21 trading sessions since July 21^st. This has included six trading sessions with changes of 420 – 635 points from the previous session close, with four of those being declines.

Retirement Income Visions™ Celebrates 2-Year Anniversary!

Thanks to all of my subscribers and other readers, Retirement Income Visions™ is celebrating its two-year anniversary. Since its debut on August 16, 2009, Retirement Income Visions™ has published a weekly post each Monday morning, the theme of which is Innovative Strategies for Creating and Optimizing Retirement Income™.

As stated in the initial post two years ago, Retirement Income Visions™ Makes Its Debut, the importance of retirement income planning as a separate and distinct discipline from traditional retirement planning was magnified during the October, 2007 – March, 2009 stock market decline. Although the stock market experienced three positive and encouraging days this past week, the market volatility the last three weeks has only served to emphasize the need for a comprehensive retirement income plan.