The ‘Secret’ to Deciding on a Successful Crediting Method
Actuaries design the crediting methods available to you to give the carrier a strong profit (in the long run) from the growth in the index you use. This is not bad, per se, since they also guarantee against market losses and guarantee income for even extraordinarily long lives, even when your cash value exhausts. So, is there a secret to picking the likely best interest crediting method? Yes, if you are right about how volatile the index is likely to be over the coming year until you can switch crediting methods. Looking back at past performance, compared to the resulting interest credited for differing crediting methods, I have observed distinct patterns.
• If the market is more volatile than average from month to month, yet there is at least average growth by the end of a policy year, then the best method to have picked is annual point-to-point. This is typically so because it ignores the uncapped losses that occur along the way.
• If growth in the index is relatively calm and its growth is average or better, then monthly point-to-point captures all of those upswings and very few get limited by the cap.
• If there is growth, volatile or not, followed by a serious market correction (erasing most gains but finishing the year somewhat positively), then the best method is annual monthly averaging because the gains prior to the collapse are part of the interest calculation, even though the market topples near year-end.
Overall, if gains are strong and somewhat consistent throughout the year, then monthly point-to-point captures most of that growth for the year. This crediting method does not consider any monthly losses. Monthly losses do count against you in that there is no limit to the loss recorded for a month if your formula counts change each month.
How can carriers guarantee that equity-indexed interest will be zero or higher? Is your agent curious enough to know what backs such guarantees; that they’re not too good to be true?
A Big Secret
These EIA contracts are designed to use your money to earn the carrier strong returns by means of the carrier buying call contracts on the indexes that their EIAs tout. They use the money to buy call options from entities that have large portfolios, such as pension plans and certain banks. Buying calls with durations that match the interest crediting in the policy enables the carrier to pay interest if the index increases enough for it to pay interest; no loss to the carrier if the index failed to produce a gain. This method of behind-the-scenes investing secures reliably better gains for the carrier than bonds, mortgages, realty, and other assets. The carrier has reserves to cover transaction costs and lost call premiums while investing over the long haul to capture most of the long-term returns of these indexes. The upside is not limited; the downside does not harm the carrier, because it just lets the call expire. The dividends of the stocks in the indexes do not come to either the policy owner or the carrier because these call contracts are for the right to buy the stock, not the right to receive the dividend (i.e., the owner of the stock who sold the call to the carrier still owns the stock and so receives the dividends). The dividend lost is not generally huge: The Dow and S&P 500’s average dividend rate for the last sixty-five years was typically around 3%. Because this is fairly stable, the non-dividend index rate of change (used in EIA policies) is approximately the same as the growth rate including dividends.
EIA carriers share the call profit with the policyholders by means of a crediting formula that the policyholder picks. But since the upside of the call price is not limited and the downside is limited to the carrier’s loss of the call premium, they must have a reserve to replace lost call premiums and continue the process. The crediting formula provides better yields than bank and government bond yields in most years (depending upon the volatility and interest crediting method the policy owner picked). Calls can be laddered to help the carrier capture the longer-term upward bias of the index. This, plus the return sharing effect of these formulas (interest crediting methods), earn the carrier a good return most years. It earns money on its reserves and this technique limits its losses on the call premium it spent. The carrier (and policy owner) do not have to buy stock in the index; that could result in big losses. All of this combines to enable the carrier to confidently guarantee no losses to the policy owner while paying a superior return on the greater of the income account value or the cash value. The income account value only has meaning if the policy owner opts for lifelong guaranteed withdrawals. The long-term nature of all of this—especially with regard to the need to realize the long-term rates of return on the indexes rather than a period in which volatility hurts the carrier’s reserves—is why carriers have surrender charge schedules and also how they can offer strong, lifelong income guarantees. Again, there is no possibility of market loss to the policy owner, but the return trails the long-term potential of stocks. But the value to the consumer is not in rate of return; it is in the long-term guarantee of income. All of this reinforces my advice that consumers should split their money between income-and-principal guaranteed EIAs and some form of at- risk portfolio that captures a far better return over the many years of their investing lives.
There is much more to know about annuities, such as the income at retirement and how to pick the best ones, and the tax treatment. One must also understand that a market value adjustment could be applicable in both VAs and EIAs when moving money from the fixed-rate account to the indexes or VA separate accounts (because fixed-rate accounts are backed by bonds and these can gain or lose value with interest rate changes). But the foregoing are the main factors producing cash value for consumers; income guarantees are discussed in the retirement planning chapter. Remember, annuities are long-term investments that are not designed for funding college or anything other than retirement. If you own a VA, your investment strategy should mirror the asset allocation prescribed by the model for your retirement investments, not the asset allocation for shorter-term investment objectives such as saving to buy a business or saving for college.
Life Insurance as an Investment
This is purely a tax management and retirement planning strategy. It is one of the last remaining true “tax shelters.” But remember to have a genuine need that is lifelong for such coverage before you use it as an investment vehicle.
Best Mutual Funds
I have come to love technology. In the last ten years, brokerages (but not direct purchases at fund families for those who dislike brokers) have developed software that helps brokers find you great funds to consider, given your goals. These systems are also tied to compliance monitoring so that the process records and recommends whether the client should consider front-end load versions (lowest ongoing fees), back-end surrender charge versions (called B shares), or level-load (but no front or back-end charges) versions; it helps with special share variations as well. This is another reason that brokers can be very valuable and worth their fees, compared to the consumer just cutting them totally out. In fact, in the last ten years, financial planning fees, including quarterly updates and asset allocation adjustments, can be wrapped into asset management fees. Wells, Ameriprise, and Merrill shine. No more non-disclosures or losing out on “rights of accumulation” because all of this is tied in to compliance monitoring (at these and many other brokerages).
It stands to reason that no mutual fund family, even with a great reputation like American Funds, Fidelity, Vanguard, MFS, etc., can possibly have the best managers for every asset class even most of the time. Hence, using a managed account—kept in sync at least quarterly with the optimized portfolio recommendations for each purposed segment of your holdings—is the best course. But for taxable accounts, switching funds keeps you paying taxes on harvested gain; quite a dampener of your overall return. The tax management chapter has some tips on this, but for this chapter, consider tax-controlled exchange-traded funds (ETFs) and buy-and-hold strategies for individual stocks. Again, to do this right, you’ll need to diversify and use the brokerage’s talented research team. But it’s well worth it. Look at trading this way: If you were considering someone to advise you on your investments, and they had essentially the same resume as your own, would you hire that person? Even if you are a corporate CFO or a CPA or tax attorney, you should resist the natural tendency to assume that you can handle this. Even your broker needs help from that research unit, but at least he or she does not present him or herself as a fund manager.
Municipal Bond Funds
Of course, these cannot be used in retirement or IRA accounts. But they are discussed in the tax management chapter and are useful as an income generator for any current income need. That is, when you come to the payout phase for college funding or other income need, consider switching into these funds and taking federally tax-free income. Be careful, though: These funds come in risky to conservative varieties, from leveraged versions and risky issuers to stable municipal issuers. It is possible, due to purchase and sell timing, to get gains allocated to your shares when you did not get to buy in cheap. If you bought the shares after the manager purchased the individual bonds that were a great deal and destined to grow in value, then you bought in at a higher price; yet the manager might sell those bonds just prior to your selling your shares. Result: You get the capital gains recognized (a 1099 for phantom income) but you did not benefit in a share price increase!
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher. To read other articles of this book, click here. To buy this book, click here.
