"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 11th 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 21st. With its close of 10,817.65 on Friday, the Dow is down 1,906.76, or 15%, in 21 trading sessions since July 21st. This has included six trading sessions with changes of 420 – 635 points from the previous session close, with four of those being declines.
So how do fixed index annuities have the potential to grow each year and overcome the volatility associated with the stock market? As alluded to in the modern version of the traditional English nursery rhyme at the beginning of this post, there are two ways: (1) minimum guarantees, and (2) indexing strategies. The remainder of this post will discuss minimum guarantees with a presentation of indexing strategies beginning next week.
Every fixed index annuity contract includes a minimum guarantee section. This is one of the first things that I discuss with my clients when reviewing a fixed index annuity. I explain to them that, while the objective of investing in a fixed index annuity isn't to plan for the guaranteed minimum value, it's comforting to know that this is the minimum amount that will be received if they terminate their contract or if they die. An investor in a fixed index annuity would receive the contract's guaranteed minimum value only if it's greater than the contract's cash surrender value.
How is the guaranteed minimum value calculated? While this varies by life insurance company and product, in addition to potential withdrawals which reduce the minimum value, there are generally two components used in the calculation: (1) percentage of premium, and (2) interest rate. The percentage of premium that's used will generally be 87.5% to 100% and the interest rate will range between 1% - 3%. As a rule of thumb, 1% is typically credited on 100% of premiums while interest rates of 2% - 3% are generally credited on 87.5% - 90% of premiums.
I have prepared Exhibit 1 to illustrate two examples of the calculation of the guaranteed minimum value of a fixed index annuity. Contract A calculates its minimum guarantee using 87.5% of the premium and an interest rate of 2% while contract B applies an interest rate of 1% to 100% of the premium. While contract B immediately grows by $1,000 and its minimum value is $101,000 at the end of year 1, the minimum value of contract A of $89,250 is $11,750 less than contract B. Per Exhibit 1, although contract A gets off to a slow start, contract A's minimum value catches up with, and overtakes, contract's B's minimum value beginning in year 14.
In summary, the minimum guarantee feature is the security blanket for a fixed index annuity. 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. Next week's post begins a discussion of indexing strategies, the key for potential investment growth.