August 25, 2011 by wcobserver
Anybody else recall a corny song by the Statler Brothers with the line “you can’t have your
Kate and Edith too, you rascal you..?” Of course, this is a take-off from the proverb that you can’t have you cake and eat it too (I always hate it when I have to explain jokes).
Okay, I’ll borrow another line from Elvis: I said all that to say all this… when it comes to our money, we really would like to have our cake and eat it too. We would like to enjoy some gains on our money without the risk which is inherent in most investments. We enjoy the security of guaranteed bank deposits, or guaranteed cash values, but we moan about the lack of returns. Getting good returns with safety almost seems to violate the law of gravity.
In the previous column about the Bear and the Elk, I mentioned I-Bonds from the U.S. Government as one possible exception to the rule. Now, let’s talk about another device, this time from the Private sector, named the Indexed Annuity.
Historically, Annuities have been classified as Fixed Dollar or Variable. One is like unto a turtle; the other a rabbit. A Fixed Annuity is a retirement savings contract issued by a Life Insurance company; the reserves of which are invested in debt instruments like bonds. With investment grade bonds, the company has a high degree of certainty it will be able to earn enough to provide the promised benefits and still earn a profit for the company. Said bonds may be a mixture of Government and Corporate.
Variable Annuities have choices to invest in equity accounts, such as stocks or real estate trusts; and consequently are more risky. The value of your Variable Annuity may go down just as quickly as a stock mutual fund.
So in our dreams, we would like to enjoy the safety of the Fixed Annuity and get some of the gains associated with Variable Annuity. Enter the Fixed-Indexed Annuity, which advertises some “upside potential without the downside risk.” It’s a little like a bullet-proof vest. The deal works like this; you agree to a 10 year contract which guarantees that you will at least get your money back plus a very small gain. The sweetener is that, if your chosen index (Say, the S&P 500) gains in value, you will get some of the gain in the form of extra interest credited…possibly as much as 8% or more.
You might ask “how can they do that?” Yes, it sounds too good to be true. Also, the marketing of these complex contracts have drawn criticism and the attention of financial regulators. Someone who would sell you this must walk you through a lengthy “suitability” questionnaire to be sure this is appropriate.
But the more basic questions may be:
1. Are they legitimate?
2. Would this be right for me?
The answer is yes to the first question, and maybe to the second. First, let’s explain the principles involved. Investment grade bonds underpin the guarantees, and a small fraction of the funds are invested in options or warrants. In the worst case scene, the market went down over your 10 year period but the company has enough bond investments to pay off the minimum guaranteed amount. If the chosen market index went up, you earn extra interest. Think of this as the cake and the icing. There are numerous variations on the theme.
Major cautions include: (a) this is a long-term investment, (b) it is not liquid, and (c) you should not tie up all your money this way.
A good time to consider something like this might be when you’re getting that big rollover from your 401-k, but don’t anticipate using any of it for several years. Having a major insurance company guarantee your principal while giving you a piece of the action may taste like a sweet deal to you.