- Fig 1 - A volatile S&P means FIAs climb! - chart by Dale Marshall
Many investors are unaware of the power of loss and how it affects their investments. It's a critical concept to understand, though, because it explains the spectacular results of fixed index annuities (FIAs). Essentially, the gain necessary to recover from a loss of principal is greater than the loss itself, when expressed as a percentage of principal. Thus, if an investment loses 25% in a year, it'll need to gain 33.3% just to break even. If it loses 50%, it'll need to double – that is, gain 100% - just to break even. An actual gain in value is postponed until that break-even point is reached.
Market Indexes and Index Funds
Index funds are funds that fluctuate in accordance with the market they're based on. Because of the breadth and diversity of the equities included, many investors and others look to the Standard & Poor's Index of 500 Stocks (S&P500) as a reliable barometer on the state of the US economy, and many also invest in funds based on the index's performance. Index funds exactly mirror the performance of the index they're based on. Investors in an S&P 500 fund can expect positive returns over the long run based more or less on the performance of the American economy as a whole.
How Fixed Index Annuities Differ from Index Funds
What FIAs do is remove the power of loss from the earnings equation. When the underlying index loses value, the FIA's value remains steady. When the index gains value, the FIA also increases. Thus, over two years, the index could lose value in the first year and gain in the second. In index fund would mirror the index's performance, but the FIA would only gain. Likewise, if the index gains in the first year but loses in the second, the index fund's performance would be identical, but the FIA would retain all the gains of the first year and “sit out” the losses of the second. This is the ratchet and reset concept – once gains are posted to an FIA, they're locked in. The principal value is increased by the amount of the gain, and future gains are calculated based on this new value.
Fixed index annuities, then, don't have any losses to recover before posting actual gains!
Consider the following scenario, illustrated in Figure 1: equal investments (say, $1,000) in an FIA and in an index fund. Both are based on the performance of the S&P 500. In the first three years, the S&P 500 declines a total of close to 40%, following which it posts mostly gains. At the end of a ten-year period, though, it's still close to 25% below its starting point. The index fund investment is also almost 25% below its starting point, but the FIA, not having experienced any losses and thus not having to make them up, has almost doubled.
Historical Performance of Fixed Index Annuities
Savvy investors will already have recognized, though, that this is no hypothetical scenario. At the end of 1999, the S&P 500 was at $1,469.25. It then recorded three straight losses, followed by a string of gains that brought it virtually to a break-even point at the end of 2007. There was another disastrous decline in 2008, though, so that at the end of ten years (12/31/2009), the value of the index was $1,115.10, fully 24.10% below its value on 12/31/1999.
The significance of these figures is this: those who purchased FIAs during most of this period gained, and in most cases their FIAs significantly outperformed not only the market, but all other funds: standard equity portfolios, index funds, mutual funds, even bond funds. This is borne out by research originally undertaken to demonstrate that FIAs were bad investments over the long term; in fact, the farther back researchers went, the more definitively their hypothesis was refuted! Index fund investors after ten years were still 25% below their initial investment, while those who'd purchased FIAs had almost doubled their money during the volatile first decade of the 21st century. This is what's meant by the term “FIAs give you all the advantages of market participation with none of the downside risk!”
Figure 2 illustrates the difference in performance between the S&P 500, index funds based on that index, and FIAs, for the fifteen years started 1994, and figure 3 shows the same comparison for the entire two decades started 12/31/1990. In each case, the charts illustrate definitively that the same amount of money invested in a fixed index annuity returns a dramatically higher return than the same amount invested in an index fund.
In a consistently positive economy, FIAs performance will be no better than index funds; in a volatile economy, though, a fixed index annuity is a safe investment with the potential for explosive growth!
NEXT: Caveat emptor! What to watch for when purchasing a fixed index annuity!
Dale Marshall - After a fairly long, often rewarding and frequently frustrating career in the corporate and semi-corporate world, I passed age 45 and ...
