How to Get More – But Not Lose Anything – PART II Deferred Fixed Index Annuities

 

How to Get More – But Not Lose Anything – PART II Deferred Fixed Index Annuities

What if I said that you can earn more interest when the stock market goes up, but have no principal or interest taken away when the stock market goes down? Would that interest you? This is the second in a series of articles that stands for that proposition.

The previous installment of this series explained how fixed index interest works and calculates. That method is what creates the positive result of safe growth of interest that ties to selected stock market indexes (such as the S&P 500). The result increases interest without the risk of market loss. To review that installment, go to the prior article published on March 27, 2015.

Fixed Index Annuities and Indexed Universal Life Insurance policies both use the Fixed Index interest calculations to add interest and build the account until you are ready to start taking payments. Each has several other features and benefits that make them unique.

This installment will focus on Fixed Index Annuities.

"Annuity" is a phrase with several definitions and variations. The basis of an annuity is it provides a series of payments. That series can start immediately or defer to a time in the future. There may be a limited number of payments or they can last for the rest of your life.

My focus is on how to use a Deferred Fixed Index Annuity for safe growth of your retirement account and to have an income for the rest of your life.

A "Fixed Index Annuity" is a form of "deferred annuity". You put principal into the contract right away. Payments start later; based on a higher future balance. That higher balance includes the earnings during the deferral period; plus your first deposit. Because of the tax rules about annuities, taxation on that growth happens only on distribution payments. If the money is in a qualified plan or IRA, the entire payment is taxed; and at ordinary income rates. That is the price of getting the tax deduction at the beginning when you contributed to the plan years ago. If the money is "Nonqualified" (it was what you had left after-tax on what you earned) then the tax rules let you get your "investment" back tax-free. This calculates with a statutory "exclusion ratio". That divides each payment into the nontaxable return of principal and the taxable portion of earned interest.

ASSET PROTECTION. In Florida, annuities that you own individually are protected from your creditors. The sheriff cannot "levy" on annuities when a judgment against you is collected. If the annuities are in an IRA or qualified plan, Federal rules give even extra protection.

This is important for several reasons. First, even though Certificates of Deposit have guarantees from loss by the FDIC if your bank goes bust, they are not protected from your creditors. You might set them up in "tenancies by the entirety" with your spouse. That works. But if your spouse dies before you; the protection goes away. Stock brokerage accounts are protected to a degree by SIPC. However, they are also subject to the claims of your creditors. Again, there are some steps you can take (such as setting up a qualifying irrevocable trust in certain states) which can protect stock brokerage accounts. But, by themselves, the sheriff could come get them if you have a judgment against you.

Florida law automatically makes annuities unavailable to sheriff's to collect on if you have judgments against you. Simple.

Now, you cannot put money into an annuity if you already have a claim against you. They call this a "fraudulent conversion". You are taking collectable money and converting it to money exempt from collection to avoid a creditor. So, if you want asset protection get the money safely into annuities as quickly as makes sense for you.

GUARANTEES. Many people live with historically low interest rates to get FDIC protection for their certificates of deposit. When you learn more about the guarantees an annuity can give you, with much higher interest, you may well be more comfortable. See, the issuing company (an insurance company or an annuity company) guarantees your principal. In a deferred fixed index annuity, the company also guarantees the interest you earn.

Is this guarantee worthwhile? There are at least a couple of reasons you can rely on the guarantee of a company that issues an annuity.

First, your State's Insurance Commissioner regulates the companies that offer annuities. This includes audits and other oversight. They also regulate how annuities are sold to you. The Insurance Commissioners do not want long-term annuities sold to people for whom they are not suitable. In a moment, I will point out their long-term nature. So, if you need early liquidity (access to the cash you put in), a deferred annuity may not be smart for you. Rules help guarantee (or at least influence) that you do not make an unwise purchase in that case.

Second, Insurance Commissioners demand that an issuing company has enough reserves set aside to pay its obligations to you and other annuity and life insurance contract owners. That means if the company goes under in its general finances, your money is set aside and safe.

Third, if a company does go under, the tradition is that other companies come in and buy up the contracts that are still outstanding to contract owners. The benefits get paid one way or the other.

So, with all these protections, the contractual guarantee of a life insurance or annuity company is very strong. There are few instances of anyone losing their money in a fixed interest annuity. [NOTE: "Variable Annuities" are a tax deferred way to invest in mutual funds. So, there is a potential for market loss in those instruments. However, we do not recommend "Variable Annuities" here.]

LIQUIDITY. Your principal earns interest in a deferred annuity. The first installment of these articles points out how that can be more than typical interest because what you earn is tied to a stock market index like the S&P 500. When it goes up interest is added to your account. If it goes down, nothing is taken away.

The result of these periodic additions of interest is an "account balance." That account balance is available to you, subject to surrender charges.

Surrender charges in a deferred income annuity are similar to those in Certificates of Deposit. The company's commitments to you call for it to invest in long-term bonds. If you take the money out early, those bonds may need to be sold; and perhaps at a loss. To make things more even, and to encourage you to keep your money in the annuity, there is a charge if you take the money out too soon. This is the "surrender charge".

As a result, a deferred fixed index annuity is not the way to go if you need access to the cash you invested. The surrender charges would lessen how much you can get out. However, if your circumstances change and the cash is need to deal with some emergency, you can get it subject to the surrender charge. In any case, you do not want to put money in a deferred fixed income annuity if you think you will need the money before the surrender charge period is over.

When the surrender charge period ends, you can take the money out without further penalty. At that same time, you can choose, instead, to start taking payments of income.

In the old days, people were afraid to start taking payments because they were afraid of this. If they died before their investment was used to pay them income, their heirs would lose out and the annuity company would take whatever was left. There are new choices.

First, when the surrender period is over you can withdraw all your money.

Also, an alternative for a "Guaranteed Life Withdrawal Benefit" lets you take payments, but not have your family lose the remaining balance if you die before you use the principal. A calculated amount is a remaining balance your family can take under a few choices.

Fully annuitizing the payment stream could offer you more in each payment. But then you give up saving any remaining balance for your family.

For these reasons, deferred fixed index annuities are recommended for a long-term hold. Let the account balance grow. Perhaps get an income rider (see below) to assure what your income will be when you start taking payments. If you hold onto the contract until the surrender period is over, then you grew a higher balance free from worries about creditors, and with guarantees not available in other investment contracts.

INCOME RIDER. Some annuity companies offer a feature called an Income Rider. For an extra charge you can get a guarantee of the amount your income payments will be. It is the amount on the schedule in the year you start taking them. When your goal is to guarantee an income, this feature can increase what that income might be.

This is how it works. The Income Rider offers you a schedule. When you target a year you want to start taking income payments, you will know what the payment will be starting then. It might be more than what the payments would be from the account balance you grew during the deferral period. If the account balance would support a higher payment, that is what you would likely select.

There is a charge for the income rider. This reduces how much your account balance can grow. But a comparison often makes the payment stream on a guaranteed income rider more attractive and worth the cost. That is a personal choice you make as you decide how much guarantee you want of the income you will receive.

DEATH BENEFIT. Typically, if you die before you start taking income payments from your deferred fixed income annuity, your heirs can get the contract balance. However, if you have started taking income payments, the full amount is not returned. Your family may get a remaining balance less the payments you took. Some companies assure your heirs would get something if you pass on before a certain period has occurred, like 10 years or 20 years.

Often the death benefit is some portion of the then remaining balance under the Guaranteed Life Withdrawal feature.

These features are important to many people. However, typically annuities do not offer a "death benefit" like in an insurance policy. Their death benefits are usually limited to some portion of the balance remaining on your passing. This may change in the future as companies innovate and add new features to their contracts.

TAX BENEFITS.

LONG-TERM CARE. It is expected that seventy percent of those who reach age 65 will need long-term care. There is insurance coverage to help with the costs. However, it can be expensive, limited in its benefits, and many people will not qualify for it. Some annuities provide an ability to have your payments increase by some multiple (such as a "double") if you need long-term care. The number of payments increased this way may be limited and reduce your overall payment stream. However, it provides extra cash flow at a time when needed.

LIFELONG PAYMENTS. First and foremost, deferred fixed index annuities are designed to provide, in some fashion, lifelong income. This is the main guarantee from the company and a key reason to buy one. If you take enough payments that your principal and account balance is reduced to zero, it does not matter. The promised payment for life continues. Everything else is about how much those payments will be.

WHO SHOULD GET A DEFERRED FIXED INDEX ANNUITY? This kind of contract is for the person with money beyond what they need to meet current or expected expenses before the payment stream starts. Safety is chief on their mind. So, the guarantees of regulated companies provide comfort. Index interest can provide more than other interest bearing investments; a lot more than Certificates of Deposit under current rates. They enjoy the protection from creditors. Most important, the deferred fixed index annuity offers growth without market risk, and lifelong income after the payment stream starts.

The deferred fixed index annuity is an important tool to guarantee we have a comfortable retirement; especially if we are fortunate to live a long time.

In the next installments I will describe how life insurance contracts that provide fixed index interest work. These are called Index Universal Life Insurance. Like anything else, there are pros and cons, depending on what you are trying to carry out. We will review those so you can best decide what suits you.

For answers to your questions or information on how this applies to you get in touch with me at scottfbarnett@scottfbarnettconsulting.com.