As you well know your investments or savings cannot simply stand still in very low yielding vehicles. Sooner or later you begin to eat away at your principal and thus, there is less available to sustain your lifestyle. In most cases, people will likely live much longer after retirement than past generations. As such, very low yielding investment and savings vehicles are not an attractive opportunity. So, many individuals have to invest more aggressively. Even the older generation must look to more aggressive areas to compensate for their current needs. However, the risks and consequences are simply too high for many, especially if time is not in their favor to easily replace lost principal due to fluctuations these more aggressive avenues inherently bring.
So, what is the answer?
You need a vehicle that can grow at higher rates than those offered in traditional CDs, money markets and such, without the volatility and loss potential of stocks and bonds.
The problem is most people do not know the types of investment or savings vehicles that offer such a combination. Fortunately, such a vehicle does exist that not only has the opportunity to safely increase returns over the years, it also has several additional benefits that cannot be found in those vehicles mentioned above.
This savings vehicle I am speaking about is called Equity Index Annuity (EIA).
What are Equity Index Annuities?
First and foremost, they are tax-deferred retirement savings vehicles. Simply put, they offer the opportunity for higher returns than those found in CDs, money markets and similar traditional savings vehicles- and they grow without the consequences of current taxation. Secondly and just as important, they never expose your principal to the fluctuations and volatility of more aggressive investments like stocks and bonds.
How is this done?
Equity Index Annuities allow the individual to have the opportunity to "index" their interest growth to a stock market index. So, as opposed to traditional fixed vehicles that have a set return, you can take advantage of some of the annual growth of indexes like the S&P 500 or the NASDAQ 100. It is not essential for me to go into the specifics as to how an Equity Index Annuity is constructed here. For brevity and anecdotally, I contend that it is not instrumental for an individual to understand the way medicine is made to benefit from its use. Be it as it may, insurance companies (which are the only ones allowed to offer Equity Index Annuities) have constructed a way for you to benefit from the growth of those indexes.
Here's where it becomes even more compelling. The insurance companies have constructed a way to increase your interest earned using the stock index growth WITHOUT ever exposing your principal (and previously earned growth) to loss! That's right, you never suffer any loss no matter what happens that given year with those market indexes. As such, you have the opportunity to gain index growth but NEVER the risks associated with it.
Yes, there are certain restrictions and limitations to Equity Index Annuities. First, since they are considered retirement vehicles by the IRS and thus grow tax-deferred, you cannot simply withdraw your funds without tax consequences. If you withdraw from any annuity prior to the age of 59 ?, the IRS imposes an additional 10% early withdrawal penalty. Secondly, most Equity Index Annuities do limit or "cap" the upside of growth to a degree. However, Equity Index Annuities are not all built the same and as such, they have there own set of rules as to how much growth is capped or set. Although most set some form of upside caps on growth, it is a small price to pay to ensure that your principal (and previously earned growth) is never at risk.
Above the IRS limitations, Equity Index Annuities do have varying limits regarding liquidity. Once again, they are constructed differently based on individual s objectives and needs. Individuals that need the most liquidity usually also give up potential growth and some benefits. On the other hand, the less liquidity required by the individual, the more potential offered and more liberal the benefits offered. Similarly, just as the longer the term of traditional savings vehicles like CDs are, the higher the interest they pay, the benefits increase in Equity Index Annuities to the proportion of liquidity required. However, all the Equity Index Annuities I recommend do offer some degree of liquidity flexibility.
With that said, although they do have boundaries on immediate total liquidity and a limitation on the upside potential, the benefits of growth beyond that of traditional savings vehicles without the risks associated with more aggressive investments is substantial. We all know that, in most aspects of investing and savings, we have a balance between risk and reward. Equity Index Annuities are simply savings vehicles that have been constructed in such a way as to tip a bit more returns in your favor without also tipping risk in your direction.
As with most other financial vehicles, Equity Index Annuities are sometimes marketed in such a way as to overstate their potential returns and benefits. Unfortunately, this misplaces individual s expectations. It also burdens these great retirement savings vehicles with the unsavory belief that if they appear "too good to be true- they must be", thus saddling Equity Index Annuities with misconceptions and confusion by the public. Individuals have been indoctrinated with the belief that there is no free lunch with investing and rightfully so. Too many individuals have been burned time and time again by unscrupulously sold financial vehicles that promised too much and delivered too little. As such, individuals have grown weary of any investment or savings vehicle that offers higher return opportunity without the risks inherent with such growth potential.
However, if you look under the hood of Equity Index Annuities, you will see why they are able to achieve the higher returns while they are able to also protect your principal. There is no magic here and like I said previously, there are limitations and restrictions one must contend with. Equity Index Annuities are simply very ingeniously constructed retirement savings vehicles that took the principals of traditional fixed annuities and applied the aspects of growth associated with equity investing, thus providing savers and/or investors higher potential returns without ever exposing their principal to risk. Thus, Equity Index Annuities have the similar levels of safety of typical savings vehicles like CDs and money markets, yet have the potential the higher return potentials that one would associate to equity style investing. NOTE: Many individuals and investors commonly mistake Variable Annuities, which are investment vehicles and regulated as such, with Equity Index Annuities simply because they are both annuities. Variable Annuities use mutual fund style sub-accounts to grow and as such, subsequently these funds can go down in value too. Equity Index Annuities do NOT. There are NO investment sub-accounts and no mutual fund structures used in Equity Index Annuities. The indexed styled returns of Equity Index Annuities are accomplished without actually ever exposing you in the markets directly, thus eliminating any need for sub-accounts or mutual fund hybrids.
To give you an idea on how indexed annuities have actually performed a study was conducted comparing them to alternate investment and savings opportunities readily available including index funds, Variable Annuities, stock funds and CDs. This study incorporated the five year period beginning September 30, 1998 and ending 5 years later on September 30, 2003. Since Equity Index Annuities credit their growth differently, some had higher returns than others. As such, the focus in that study was placed on the Equity Index Annuity concept as a group and not individual EIA results (the same applied for Variable Annuities). Regardless, the results were very respectable for Equity Index Annuities as opposed to the other savings and investment vehicles available. In fact, so respectable, that no other investment or savings vehicle came close to matching the returns offered by Equity Index Annuities during this period. Even more important, these returns were achieved without ever placing principal at risk.
Additional points of interest
To further expand some of the points made above, all annuities were originally structured as retirement savings vehicles, thus, like other retirement vehicles like IRAs & 401(k)s, they were granted tax-deferred status by the IRS. Also, since they are exclusively offered by insurance companies, they are heavily regulated to assure their inherit safety. And since Equity Index Annuities are built by insurance companies, there are also certain benefits offered within that are similar to other insurance bases products, such as income benefits and other guarantees. In fact, annuities themselves are the only investment or savings vehicle that can guarantee a lifetime income stream to investors. Some Equity Index Annuities even offer enhanced benefits to that income so that if you were to become disabled or are confined to a nursing facility, you will receive higher income and/or a faster return of your principal and interest. As opposed to Variable Annuities, Equity Index Annuities offer many additional benefits without additional cost or fees to the individual. Note: I am not adverse to Variable Annuities and I recommend them frequently for the proper situations. However, I do want to differentiate so as to avoid confusion over them as is commonly done in the media.
Also, since all annuities are treated like retirement vehicles, the government has provided regulations to protect them from many forms of civil litigation. Also, as I mentioned above, all annuities grow tax-deferred and once annuity payments are chosen by the individual, they are structured to be taxed on a last in, first out basis (LIFO). One must consider that consequence, as interest would be paid out first. Yet, free withdrawals typically come from principal and thus not taxed. There are many ways to structure income to best benefit the individual and these should be discussed before purchase.
One of the most important aspects of deferred annuities in general is the fact that they are the only source of interest that is not considered for Social Security taxation. In other words, annuity interest, no matter how large, is NOT considered like all other sources of interest in the computation of provisional income and will not impact taxation on your Social Security payments. No other income or interest paying sources, including municipal bonds, are exempt from this. Another important aspect of annuities in consideration of taxation is the way they are treated as an asset. Once an annuity is annuitized (in payout), it is no longer considered a lump-sum asset; it has become a stream of income, thus enhancing inheritance tax and asset based consequences. NOTE: Although, I have discussed the income aspect of Equity Index Annuities here, you are not required to have your money returned to you as monthly or annual payments- you may also elect to receive a lump-sum distribution. You simply have to be aware of the taxation aspects and individual annuity s distribution structures.
Unfortunately, I have not had the opportunity in this forum to expand upon some of the other very valuable benefits offered by an Equity Index Annuity. This was simply an essay to give you a basis of understanding as to "what" an Equity Index Annuity is and some of the key benefits involved. Every Equity Index Annuity has its own set of benefits and liquidity standards. Many of these are similar in context but most are customized to offer a wide range of choice based on the individual's savings and retirement goals and objectives.
In conclusion, I could not, in the space available, itemize and detail some interesting components of the individual Equity Index Annuities I favor such as premium bonuses (some pay up to 10% right up front), the caps on growth (some cap growth potential to 10% annually, some cap on a monthly basis), the indexing methodology (some calculate monthly, others annually) and the actual index they base their growth from (some use the S&P 500, others the NASDAQ 100, some both). However, almost every Equity Index Annuity I favor also offers a fixed component choice (i.e. a fixed interest rate they pay). They all also have an internal rate of return that they will guarantee (i.e. a certain return regardless of the index chosen to provide growth). The ones I most highly recommend do offer liquidity choices, premium bonuses, generous caps on growth, and most importantly, they are offered by some of the most respected and financially sound insurance companies in the world. This is essential, as any insurance company can offer and market the most aggressive features and benefits but if they're not financially sound, concerns mount as to their ability to support these promises and guarantees. Although, to this date, no individual has lost any principal due to the failure of an insurance company, the high current public interest in Equity Index Annuities may cause some insurance companies to be excessively liberal with their benefits in order to attract business and thus, possibly jeopardize the insurance company s profitability and long-term viability. That is why I only suggest purchasing from the most financially sound insurance companies possible.