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A Sure Cure for Sleepless Nights for Investors

   What Goes Up But Doesn't Go Down? 
     By Gene Walden

One of the true benchmarks of successful investing is how well the investor sleeps at night.
       Two of the biggest causes of nighttime tossing and turning are fear and greed. In a falling stock market, fear of further losses can lead to a lot of sleepless nights. On the other hand, in a steadily rising market, greed can cause investors who are not in the market to fret over the profits they’re losing as the market moves up without them.

It’s only natural that investors want to be in the market on its way up and out of the market on its way down. If only it could be that easy.

Now there is actually an investment that offers the best of both worlds. When the market is moving up, your investment is moving up with it. But when the market starts to drop, your investment doesn’t budge. It goes up, but it never goes down—leading to restful nights no matter what the market is doing!

It is called a “high watermark equity indexed annuity.” It’s almost like going to a casino where you can bet all you want and never lose. If you win, you keep your winnings, if you lose, you don’t have to pay off your losses. And if you start to win again, you hold onto all of your winnings.

This is how it works specifically:

 

  • Tied to the market. The high watermark equity indexed annuity is tied to the S&P 500, which is a stock index that closely mirrors the performance of the overall stock market. This is not a new concept. For many years, “variable annuities” were popular with investors because they moved up and down with the stock market. Variable annuities did well in the 1990s because the stock market was setting new highs every year. But when the market crashed, investors saw the dark side of variable annuities. As the market sunk so did the value of their annuities. Many investors lost a huge share of their life savings, and swore off variable annuities forever.
     
  • No downside. The high watermark annuity differs from the variable annuity in one important aspect—when the market drops, the high watermark annuity stays at the high watermark. It doesn’t drop with the market. It comes with a guarantee that you absolutely can not lose any of your principal as long as you keep your money invested for the full contract term.
     
  • Tax-deferred. Like all annuities, your money grows tax-deferred in a high watermark annuity. In other words, you pay no taxes on your gains until you cash in the annuity. Annuities typically have contract terms that vary from five to ten years. At the end of the term, many investors choose to roll over their annuity into a new annuity so that their money can continue to grow tax-deferred. When or if you ultimately draw the money from an annuity, the gains are taxed at your ordinary income rate.
  • No loss years and no cap. The best equity indexed annuity we’ve found after extensive research guarantees that your investment will climb in the years that the market rises, but will never decline in years when the market falls. And it has no cap—in a great year, your annuity could climb 20 to 30% or more. Some high watermark annuities offer guaranteed minimum returns—in other words, no matter what the market does, you’re still guaranteed to walk away with a small profit. However, those guaranteed returns tend to be so low (less than 1 percent per year, in many cases) that the value they add is negligible at best. And generally, annuities that guarantee you something at the bottom take off something at the top, such as limitations on your growth potential through caps or other performance formulas designed to limit the annuity's growth. 
  • Setting the high watermark. How is the high watermark determined? In a positive year in the market, your growth is determined by calculating the average of the monthly S&P 500 values over those 12 months. If that average is 10 percent, your principal rises by 10 percent. Let’s say you’re in the fifth year of a 10-year annuity contract. The market has been going up steadily, and in the fifth year, the market reaches yet another new high. Your investment is locked in at that new high watermark. If the market crashes in year six, your investment would stay at that fifth year level. If the market moves up again in year seven, your principal moves up with the market again.

  • Withdrawal policy. Annuities are designed as long-term investment vehicles. Generally, if you draw your money out early, you will lose some of the growth and incur a penalty that can cost you as much as 10 percent of your initial investment. The best way to avoid those penalties is to only invest money that you’re not going to need in the foreseeable future. 

  • Insured. The best equity index annuities provide a life insurance provision that guarantees that in the event of your death, your beneficiaries will receive the full principal plus earnings accrued to date. Your beneficiaries can take the money as a lump sum or keep the annuity in force and let it grow to the end of the term.

  • Fees. In up years, your account may be subject to an annual fee of 1.5 percent or more. That fee may vary depending on costs related to the management of the account and the cost of option spreads used in the portfolio. In years when the market declines, you would not be assessed a fee. Your principal is locked in at the high watermark level set the previous year.


                       Tracking the Growth

             Let’s look at specifically how this annuity would work. Let’s say you put $100,000 into a 10-year annuity. Here’s an arbitrary example:

    •         Year 1: Market is up 11.5% (based on the monthly averaging calculation formula). You are assessed a 1.5% fee. You gain 10%, which puts you at $110,000.

      ·          Year 2. Market drops 20%. You stay at $110,000

      ·          Year 3. Market drops 10%. You stay at $110,000

      ·          Year 4. Market is up 22%. You’re assessed a 2% fee. You gain 20%, which puts you at about $132,000.

      ·          Year 5. Market is up 8%. You’re assessed a 2% fee. You gain 6%, putting you at about $140,000.

      ·          Year 6. Market is up 12%. You pay a 2% fee. You gain 10%, putting you at $154,000

      ·          Year 7. Market drops. You stay at $154,000.

      ·          Year 8. Market is up 22%. You’re assessed a 2% fee. You gain 20%, putting you at $185,000

      ·          Year 9. Market drops. You stay at $185,000.

      ·          Year 10. Market up 12%. You pay 2% fee. You gain 10 percent, putting you at about $203,500.

       

      So even during a decade when the market dropped four out of the 10 years, you more than doubled your original investment.

                   While high watermark equity indexed annuities may not be suitable for your entire portfolio, they provide an excellent alternative to low-yielding bonds, CDs and bank savings.

                  They also might help get you a better night’s rest.

Postscript

One investor read this article and emailed us two questions on the topic. If this article raised other questions for you, please email your questions to gwalden@mn.rr.com, and we will do our best to get you the answer.
QUESTION: This may sound like a dumb question but what are these annunities invested in? 
Gene: Definitely not a dumb question, but the answer is a little complex. Most of these types of annuities invest in options that are tied to the S&P 500. The S&P 500, as mentioned earlier, is a stock index of 500 stocks that are representative of the overall market. The S&P 500 index tends to mirror the movement of the market--as the market goes up, the S&P 500 goes up; as it goes down, so does the S&P 500. When you own "options" on the S&P 500, if the S&P 500 moves up, your options move up as well. To truly understand the innerworkings of options and futures would require about a 3-day course. But in short, as the market moves up, so does the value of those options--and thus, so does the value of your annuity.

QUESTION: Are there a variety of types of businesses that are putting this type of annunity out to the public now? 
Gene: Annuities are generally offered by insurance companies, and many of the insurance companies have products similar to the one described in this article, but there are big differences from one company's product to another. I've researched these extensively, and I would recommend against owning most of them. Either the upside growth is limited by caps or their formula for calculating the annual growth is slanted against the investor. They all look good in the brochures, but when you read the fine print--or actually talk to the company's lawyers, as we've done to get the root of some of these--you find that some of the inferences in the marketing literature is very misleading. We have found one or two companies with equity indexed annuities worth owning that really work the way this article describes. And I am, unfortuantely, prohibited from publishing their names here, but if you email me (gwalden@mn.rr.com), I'll be happy to name names.  
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Gene Walden is the best-selling author of more than 20 books on investing, including such classics as The 100 Best Stocks to Own in America, 100 Ways to Beat the Market, and If Not Stocks, What? .
 If you’re interested in learning more about high watermark equity indexed annuities, please contact Gene Walden at at gwalden100@comcast.net or 952-926-0964.
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