Every one who plans to retire has to face one troubling question: "Will I outlive my retirement?" It's a real and frightening, possibility. Consider these facts from the recent U.S.... Census:
Proper planning is the only way to make sure your income lasts as long as you do. That's where an annuity can help.
Simply put, an annuity is a contract between you and an insurance company allowing you to invest money now (in several payments or all at once), and receive a series of income payments later. You generally have the option to receive those payments for your entire life, or for a specified period of time.
There are two different types of annuities
Variable Annuities: enable you to participate in the risks and rewards of the world's stock and bond markets. You direct your payments into a range of investment options with philosophies ranging from very aggressive to the very conservative, and your returns reflect the performance of those options. Most variable annuities also offer a fixed account option, which provides a steady rate of return by the insurance company for a specified period of time.
Fixed Annuities: offer more conservative investors the comfort of principal protection and stable returns guaranteed by the insurance company.The company invests your money for you, and guarantees you a fixed rate of return. At certain intervals (generally every one to three years) this fixed rate may go up or down to reflect the overall market conditions. There are three kinds of fixed annuities:
The approach that most indexed annuities follow is to tie the contract's interest rates to some percentage of the appreciation in the chosen index over some period of time. (This percentage appreciation is known as the participation rate.) Underlying the contract for its term is a guaranteed minimum interest rate, usually 3 to 4 percent. (For this reason, the contract owner's principal is secure.) At the end of the term, the greater the participation rate index gain or the guaranteed minimum interest rate is credited to the contract.
Most indexed annuities are issued for terms of 5 to 10 years. At the term's end, an owner can cash out his or her contract, annuitize the funds or renew with another contract.
The real challenge with indexed products is understanding how they work. A number of designs are available on the market today, and no two work the same. Basically, however, insurance companies follow these steps:
Insurers use a number of approaches to calculate and apply index gains to their indexed annuities. Essentially, each represents a different design. Among the more popular designs are:
Point-to-Point: With this type of product, the value of the index to which the annuity is linked is marked at the time the contract is purchased and again at the end of its term. The difference in the index value between these two points is the basis for the amount of increase that will be credited to the annuity.
For example, assume Annuity A is tied to the S & P 500 and uses a point-to-point interest crediting methodology. If the S & P 500 were at 1000 when the contract was purchased and at 1100 at the end of the product's term, the index gain is 10 percent. If the contract's participation rate is 80 percent, the annuity will be credited with an 8 percent rate of return.
Annual Rate: With an annual reset design, the index to which the annuity is tied is marked at the beginning and end of each contract year. The difference in the index value each year is the basis for the amount of interest credited to the product.
For example, assume Annuity B is tied to the S & P 500 and uses an annual reset crediting methodology. Let's further assume that the S & P 500 was at 1000 when the contract was purchased and at each of these levels upon contract anniversaries:
For example, Annuity B will be credited with some percentage of that year's gain in the index. Like most indexed annuities, Annuity B has a floor of 0 percent, meaning no less than 0 percent will be credited in the years when the index experiences losses.
High Watermark A high watermark annuity measures the difference between the index value from the time the contract is purchased to the point when the index reaches its highest level. In the five year contract, for example, the highest of the index's value on all five anniversary dates would be the high mark.
For example, assume Annuity C is tied to the S & P 500 and uses high water interest crediting methodology. The S & P 500 was at 1000 when the contract was purchased and at each of these levels upon entering contract anniversaries:
Year 3 marked the index's highest value during the contract's turn - 1450. Measured from the point of purchase to this level, the gain is 45 percent. The amount of interest credited to Annuity C will be some percentage of this.
Low Watermark: A low watermark product measures the difference in the index value between the anniversary date on which the contract reaches its lowest mark at the end of the contract's term. This difference is the basis for the amount of interest credited in the annuity.
For example, Annuity D is tied to the S & P 500 and uses a low watermark crediting methodology. Assume the index performs as shown in the example above. The index low point, which is reached at the end of the first contract year (1200), is compared to the index point at the end of the term (1375), and the gain 14.6 percent - becomes the basis for crediting a rate of return to the annuity.
It's easy to see why indexed annuities have become so popular. They offer potential for market-linked rates of return with a guarantee that the principal will be protected. In this way, they bridge the gap between declared-rate fixed option (which are subject to inflation risk) and higher interest variable options (which are subject to market risk). With an indexed annuity, consumers who do not want to risk principal still can receive market-based earnings -- likely to be higher than those offered by other guaranteed products -- without risking principal.
The above excerpt is from the book “Annuities” by David Shapiro CFP, CLU, ChFC and Thomas F Streiff CFP, CLU, ChFC, CFS
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