(Forbes) -- If you are fewer than ten years from retirement, the performance of your investment portfolio is at a vital stage. You may still have the majority of your portfolio in stocks at this point with the goal of increasing your money as much as possible.
But stocks move in two directions, and a severe downturn in the markets could affect you more than you may realize.
A key issue is that a lot of people don’t stop to think through the mathematics of gains and losses.
For example, if you start with $100,000 and gain 50% in the first year, you will have $150,000 at the end of the year. If you lose 50% the next year, you will be left with only $75,000.
Of course, the arithmetic average return that you received comes out to zero, but you’re down $25,000! You will need to earn at least 33.3% the following year just to break even again. Even if that happens, you will only be right back where you started—except that you have effectively spent three years to earn nothing.
The goal of avoiding losses is why indexed annuities have become a popular strategy in the financial industry. These unique vehicles pay interest at a rate based on the performance of an underlying benchmark index, such as the S&P 500. When the index rises, the annuity holder is credited with interest according to a specific formula. But when the benchmark declines in value, the annuity contract will avoid a loss.
The possible fees and expenses of fixed indexed annuities (FIAs) are something to keep in mind, as they could drag down returns on an annual basis. In most cases, there will be a limit on the amount of interest that is paid based on a specific formula, such as a cap, spread, or percentage.
An example of a cap would be when an insurance company pays 100% of the gain in the benchmark up to a specific, absolute limit, such as 10%. If the benchmark grows beyond this limit during the crediting period, the insurer pockets the excess growth. A spread is an amount an insurer keeps of the benchmark’s initial gains before crediting the contract with interest.
For example, if the spread is 2%, then the insurer will only pay interest in excess of 2% to the contract. So, if the benchmark grows by 7%, the insurer will credit the contract with 5% of the interest. If the benchmark rises by less than 2%, then no interest will be credited for that period. And, of course, there is the flat-percentage option, where the insurer pays a set percentage (such as 80%) of all gains posted by the benchmark during the crediting period, with no other fees or limitations.
Virtually all indexed annuities have a back-end surrender charge schedule that can last for several years. However, some insurance companies will allow you to withdraw a certain percentage of your contract each year without incurring a surrender charge or penalty – usually anywhere from 5% to 15% per year.
The true beauty of indexed annuities lies in their reset feature. Let’s build on the previous example of gains and losses to see how this works.* Say you purchase a $100,000 indexed annuity contract on January 1st with an annual crediting period. Let’s say the benchmark for that annuity rises 15% by December 31st.
The contract has a spread of 1.5%, so you earn 13.5% interest for the year, leaving you with a balance of $113,500 in the contract.
The next year, the benchmark drops by 20%. You will not make any money that year, but you won’t lose any of your principal to the market downturn. Once your interest earnings have been posted to your contract, you cannot lose it, and the previous year’s interest earnings remain untouched. During the third year of the annuity contract, the benchmark rises by 13% by year’s end. You will make another 11.5% of interest after the spread, on top of the 13.5% you earned during the first year of the contract. Your hypothetical contract value should now stand at $126,552.
If you own a stock or mutual fund that declines in value, you’ll have to wait for it to go back to its purchase value and continue rising before you can make any profit on it. Indexed annuities do not have this limitation.
Once a new crediting period begins, the contract’s gain is calculated based on where the benchmark is at that point, even if it’s much lower than it was at the previous crediting period.
The above scenario can be compared to simply investing the same amount of money directly in the underlying benchmark over the same period of time.
You will get the entire 15% gain in the first year, leaving you with $115,000.
The 20% loss in the second year leaves you with $92,000. The 13% gain in year three then leaves you with $103,960— about $23,000 less than you would have in your annuity contract.
This illustration should help you see that indexed annuities can have a place in your retirement portfolio. Indexed annuities could be a positive alternative to other low-yielding instruments and potentially provide you with higher returns over time. Remember that every situation is unique and certain annuity products may be better suited for you than others. Do your homework and learn about the features and expenses for any contract you consider purchasing.
