Defined Liquidity vs. Cash - Net Returns

Your true liquidity cost isn’t 7% - the amount assessed by the annuity contract, but 3% - the difference between what you would have earned in the cash vehicle and would earn if you liquidated the annuity.

At the end of the second year the return from your cash instrument would be about 6%, but even after paying the annuity’s liquidity cost the annuity would have a higher net return. The true liquidity cost of the fixed annuity is not 7%. It’s 3% at the first anniversary and 0% by the second anniversary.

The cost of liquidity - be it a surrender charge or a early withdrawal penalty or a “b” fee - isn’t the nominal charge, but the net return after the cost when compared with the alternative instrument.

The ultimate liquidity cost isn’t as easy to predict with an indexed annuity because future earnings beyond the minimum guarantee are unknown; instead we’re comparing finite liquidity costs with probabilities of higher earnings. However, the worse case actual costs can be computed and at some point the indexed annuity will make the owner whole.

The defined liquidity aspects of term end point-to-point indexed annuities which measure index movement over a period of several years may be more appealing to the risk averse investor than a direct investment in an indexed fund. Granted, an index annuity owner doesn’t participate in the reinvested dividends as with an indexed fund nor does one currently receive all of the upside, but the index annuity owner knows that principal cannot be lost if the annuity is held to the end of the measuring period.

In addition, the owner always knows the annuity’s liquidity cost and may liquidate the annuity if a better opportunity presented itself. As an example, suppose you purchased an index annuity today with an initial liquidity cost of 7% and the index dropped 20% over the next few months. The indexed fund investor is down 20% and can either wait and hope for future growth or liquidate and receive 80 cents on the dollar. The indexed annuity owner has the option of staying put and waiting for the index to climb again, the minimum guarantee to make him whole, or liquidating the annuity and receiving 93 cents on the dollar.

Liquidating the annuity and taking the loss may seem extreme, but this example illustrates that the annuity owner always knows the maximum liquidity cost of the vehicle. There were individuals at the end of 1999 that purchased NASDAQ 100 indexed funds and NASDAQ 100 based indexed annuities. If the most the indexed annuity owner can lose is 7%, today, which would you have rather owned?

People keep too many dollars in cash instruments because they want liquidity. Unfortunately, cash instruments offer lower yields than most financial vehicles. Over time these people may drown in a sea of liquidity because their returns haven’t kept them afloat with the rising tide of inflation.

Vehicles with defined liquidity have higher returns than these cash instruments. The main difference is the higher returns come with a known cost. People should determine their cash needs and then allocate these directed dollars within the time and cost constraints of the defined liquidity vehicles to increase their overall returns.

Annuities Have Temporary Liquidity Costs
A fixed annuity typically deducts a surrender charge if the contract is liquidated 
prior to the end of a predetermined period. However, it may be more accurate to replace the term
“surrender charge” with temporary and voluntary liquidity cost. Surrender charge implies an ongoing expense and has resulted in agents referring to annuity products as having a “seven year term” or being a “ten year product “ 
with the stated years representing the period during which liquidity costs are assessed. In fact, the expense associated with liquidating the contract usually disappears after an agreed upon duration and the “term” of 
an annuity is from date of purchase until the maturity date.

Indeed, a forty year old owner’s annuity may have a fifty year “term” and may also have a seven percent cost, but only if the contract is voluntarily liquidated in the next eight years. There are indexed annuities that measure index movement over a multiple of years whose ending point coincides with the last year of the temporary liquidity cost, but the annuities typically don’t require the annuity balance to be distributed at this measuring point. 

Quotations for the Insurance Industry    3/01      

New IRA Minimum Distribution Guidelines    3/01       
On January 11, 2001 the Internal Revenue Service issued new proposals that simplify mandatory retirement plan distributions. The regulations apply to distributions taken on or after January 1, 2002 but may be used now.

The Old Way
This area has been governed by complex distribution regulations proposed in 1987. The 1987 proposal required the IRA owner to mandate a distribution pattern that could not be slowed after the owner became 70 1/2. The previous year’s balance was used to determine the minimum required distribution based on the age of the owner and primary beneficiary, and different methods could be used to calculate life expectancy. When a surviving spouse beneficiary died before the owner it often caused an acceleration of the taxes owed at both deaths.

The IRS recognized this and explains in the new regulations that “In general, the need to make decisions at age 70 1/2, which under the 1987 proposed regulations would bind an individual in future years during which financial circumstances could change significantly, was perceived as unreasonably restrictive. In addition, the determination of life expectancy and designated beneficiary and the resulting required minimum distribution calculation for individual accounts were viewed as too complex.”

New Proposal
Beneficiary selection at the Required Beginning Date (RBD) is no longer irrevocable; you can change beneficiaries as often as you like.

Normally, your required minimum distribution calculation will be unaffected by the selection of beneficiary. With one exception, all calculations will be based on the account owner’s age less ten years as published in the IRS tables. An exception is made for a spousal beneficiary that is more than ten years younger than the account owner - the couple can use a joint life expectancy table that uses the younger age.

Upon death of the account owner non-spousal beneficiaries will be required to take the required minimum distribution over their life expectancy.

The new rules let the surviving spouse keep the proceeds and rollover the IRA to their own IRA or disclaim the IRA to their children or others.

Kind & Simple
No longer will most distribution amounts need to be calculated on the age of the account owner and beneficiary. The recalculation/no recalculation decision is eliminated. No longer can the death of a beneficiary after the RBD cause an acceleration of taxes. The need to satisfy the separate incidental death benefit rule is eliminated. The IRS predicts that minimum distributions for most people will be reduced.

Beneficiary
The proposal allows the beneficiary to be determined as late as the end of the year following the year of the account owner’s death. This permits after death estate planning and grants a high degree of flexibility. People will be able to use their own life expectancy to calculate distributions from inherited IRA’s.

All in all, the proposals are a win for taxpayers and will enable people to pass along a greater portion of their qualified plans to family and others. The freedom to change beneficiaries at anytime is a great benefit.

Information obtained from sources believed accurate but not warranted and is not tax or legal advice.
 Consult an advisor for your personal situation.

Prepare For A Nasty Spring    4/01  

Falling traditional fixed annuity rates, a stock market that may not have bottomed, and nervous consumers - the perfect environment for indexed annuities. From a rational economic point of view indexed annuities are the correct answer for today. However, current psychological condition of the consumer may mean a rough few months ahead for indexed annuity sales.

Newton’s Fourth Law - A Prospect At Rest Will Stay That Way Unless Shoved

Index annuities offer the potential for higher returns than other savings vehicles without stock market risk to principal and credited earnings. They are ideal for consumers that do not have the temperament or time horizon for pure equity investments and are an alternative for savers that have seen interest rates drop 1% to 2% in the last year. But, people are in denial.

I’ve heard from investors that can’t bring themselves to admit their losses. I’ve heard from savers who have cash sitting in low interest money market accounts because they didn’t lock in the higher rates of a few months ago. Consumers are traumatized and it will take time for them to heal and be receptive. In the meantime, when faced with an unpleasant reality many people choose to do nothing.

Index annuity sales will take off as confidence about an upward direction of the market builds and low interest rates force people towards alternatives, but it could take a while until the economy, media and psyches are all in alignment.

Renewal Rate Integrity    4/01   
Almost two-thirds of the index annuities on the market may change the participation rate and/or yield spread and/or cap on each contract anniversary. If you further include annuities that may change some aspect of the interest crediting formula prior to the end of the surrender period the total percentage of index annuities with an element of “trust me” in receiving future interest rises to over 70%.

We asked indexed annuity carriers to provide us with their renewal rates. To date, four carriers have furnished us with their renewal rate histories. As we anticipated, market conditions at certain renewal periods forced some caps to be lowered or yield spreads to be increased. However, all four insurers have at some point in time improved renewal rates, by either raising the participation rate or lowering the yield spread or raising the cap, when compared with their initial contract rates.

The integrity of the insurance company is more important than the crediting method used in determining which index annuities ultimately credit the most interest to their contracts. Our analysis has found that although the nominal or stated rate of index annuities is quite broad, the net effective participation in index movements is tightly grouped - everyone is buying options in the same market. Even though index annuity returns will not be identical because products have different loads and other variables, the treatment of customers at renewal is of supreme importance.

The listing of these carriers doesn’t mean that the other insurers offering indexed annuities haven’t raised renewal rates. We’ve only received renewal rate histories from these four companies and everyone of them had gone back to at least some of the time to their policy owners with a better deal at renewal.

Why Stocks Go Up & Down    4/01   
Mary has decided that an ice cream shop at the edge of Yourtowne would be a good business. It would take $10,000 to start the business, but she only has $1,000. Mary forms a corporation and issues ten shares of stock. Mary invests her $1,000 to buy one share and finds nine other people willing to invest $1,000 each for a share. The corporation now has $10,000 in capital and Mary’s Ice Cream, Inc. opens.

At the end of the first year, after paying all operating expenses and taxes, Mary’s Ice Cream, Inc. has $2,000 left over in profits. The investors decide to pay out $1,000 in dividends to shareholders and retain $1,000 in the business to spend on a new freezer.

Corporations issue stock in the form of certificates in exchange for money, property or services. Each certificate represents a share in the ownership of the corporation. In the investment world total profits (or losses) are divided by the numbers of shares of ownership to reflect the proportionate financial interest of the investors.

To determine the income or loss that each share represents the net income ($2,000) is divided by the outstanding number of shares (10) which produces a number known as the earnings per share ($200).

A corporation may also pay out some of the profits as dividends to the shareholders. To determine the dividend that each share receives the total dividend ($1,000) is divided by the number of shares (10) and thus is known the dividend per share ($100).

The Price/Earnings or P/E Ratio tells us how many year’s worth of earnings a share of stock is selling for. The investors paid $1,000 for a share. The earnings per share are $200.  If we divide the share price by the earnings per share we see that a share of stock sold at five times earnings. Another way to say this is that the P/E Ratio is 5.

The higher the P/E Ratio, the more confident or bullish investors are that earnings will continue to grow; the lower the ratio, the more pessimistic investors are about future earnings growth.

P/E Ratios indicate optimism about future earnings growth. A high P/E Ratio says investors are very confident that earnings will increase

A high or low P/E Ratio by itself doesn’t mean a stock is better or worse than another. You need to compare the stock against other stocks in the same industry.

Mary’s Ice Cream, Inc has a P/E Ratio of 5. To get an idea as to whether the current share price reflects the true value of the company we’d need to compare this stock with the shares of other ice cream companies.

Dividends represent a portion of the total return that you get from stock ownership, but they are not automatically paid when a company has a profit. Companies in mature industries - utilities would be an example, tend to pay out more of their earnings in dividends.

Mary’s Ice Cream, Inc. continues to do well. By the end of the fifth year the corporation’s earnings per share are $800 and the dividend is $400.  One of the investors wants to sell his share. What is a share of stock in Mary’s Ice Cream, Inc. worth?

The price of a share of stock depends upon what someone is willing to sell it at and another is willing to pay. The price is based on the current and potential earnings of the company.

The long term performance of individual stocks, and the stock market overall, is based on actual earnings. If earnings continue to grow the price of a stock - or value of a stock index, will trend upward reflecting the economic facts. However, on any given day the price of the stock may be higher or lower than its long term value based on emotions and assumptions.

What would happen to the share price if I told you that a new municipal swimming pool is being built right across the street from Mary’s Ice Cream, Inc. Hundreds of hot, hungry, thirsty children will cross the sidewalk in front of the store every day. An investor might pay a little more for a share of the corporation because their assumptions about future earnings would have increased.

What if I told you that another ice cream shop was thinking of opening up right next door to Mary’s. An investor might offer a little less for a share of stock than they normally would have because if the rumor’s true, future earnings could be harmed. But, if the rumor wasn’t true the price of the stock would return to near its long term value.

The daily movements of the stock market react the same way. A rumor or announcement of events that could increase earnings - like the possibility of lower interest rates on business loans, causes stock prices to move up. Negative rumors or events - like recession fears, cause stock prices to move down.

In the final analysis, stock prices and returns are based on actual earnings over time. If the earnings of a company grows over time the price of the company’s shares will grow. If you believe that the nation’s economy will continue to expand, stock indexes will increase in value.

Quarterly Index Annuity Sales    4/01    

Bear Markets - It’s Now or Later 5/01       
It’s official. However you define it we’ve met a bear market. Now the question is when do you get back in?

Interest in equity index annuities is increasing due to the protection from market risk benefit. Consumers realize that an index annuity will provide at least a minimum guaranteed return, but minimizing loss is only one consideration in financial planning. The other half of the equation is maximizing gain.

I went back and looked at the last three S&P 500 bear markets. The question I asked was what would the ultimate gain be if we could have purchased the index on the day the S&P 500 dropped 20% from its previous high, if we held the index until nine years after that point. Or, what would have happened if we bought the index six months after it reached the low point of that particular bear market and held it to the end of the same nine year point.

Bear #1
The S&P 500 closed with a value of 140.52 on November 28, 1980. It didn’t close above that level until November 3, 1982 spending almost two years in the financial wilderness. The first time the index closed down more than 20% from the initial high was on March 3, 1982 with a value of 110.92. If we could have purchased the index on March 3, 1982 we would have realized a gain of 234% if held until nine years had passed.

The low point was set on August 12, 1982 when the index closed at 102.42. To be certain that the bear market was over we would have waited until Lincoln’s birthday in 1983 to get in. At the market close on March 3, 1991 we would have been up 151%

Bear #2
The 1987 correction was rapid. The S&P 500 peaked at 336.77 on August 25, 1987 and the first day the index closed down 20% was October 19; the nadir was hit in December. If you could have purchased the index on October 19, 1987 you would have been up 212% on October 19, 1996. However, if you waited until June 3, 1988 to buy you were up 163% by that October day in 1996.

Bear #3
The 1990 market was a “bear lite” kind of correction. The October low point was reached the same day the index closed down almost 20% from its July high point.  If you could have purchased the index when it was down 20% you would have seen it increase 352% by October of 1999. If you’d waited six months your gain was 254%.

In these instances you would have been far ahead if you had simply decided to ignore intuition, hunches and market experts and bought the index when it first closed 20% below the previous high. Waiting until everyone was sure that the bear market was over reduced ultimate returns.

Since 1956 the S&P 500 has experienced nine periods when values declined more than 20% - or very close to it, from a previous high. The following graph shows values of the index at each previous high and bear market low, the values when the index first declined 20% from the previous high, the value six months after the market low, and the final index gain or loss using an end point nine years after the day of the 20% decline

The buy on the 20% decline strategy versus waiting 6 months would have produced higher returns in seven of the nine markets. Even after including the horrendous 1973-1974 bear market, the buy on the decline method resulted in a 28% higher average return than if you waited six months after the ultimate low to enter.

In all but one of the bear markets the buy on the 20% decline method means you would have watched the index sink further before it bottomed out, but in all but two corrections buying early generated higher gains than waiting until the next bull market had been formally announced.

A year from now we will know when the next bull market began and the bear market ended. Perhaps it’s already happened, or maybe it’s yet to be. This bear market has lasted over thirteen months which is near the median length of previous hibernations. By the way, the S&P 500 first closed 20% below its previous high in March.

All information is for illustrative purposes only and is not investment advice. "S&P 500" is a trademark of The McGraw-Hill Companies Inc., and must be licensed for use. S&P Index-linked products are not sponsored, endorsed, sold or promoted by Standard & Poor's and Standard & Poor's makes no representation regarding the advisability of purchasing these Products. Information is from sources believed accurate but is not warranted.

Most Company Web Sites Have Uninviting Front Doors   5/01
The Advantage Group did the first study on insurance company web sites in 1999. Our conclusion then was that most of the sites weren’t worth the time it would take an agent or consumer to access them.

I recently revisited the sites of the insurance companies offering index annuities. Almost every site requires agents to obtain password access to gain deeper entry into the portal. Many of the carriers provided me with a password and let me explore.

However, if you don’t have a password the first impression of almost every index annuity carrier web site is that of a six inch thick steel door with a sign posted above the doorbell that says “entry denied”.

The front page of a typical company site has a couple of general “who we are” paragraphs, an agent login button and links to a few generic pages that offer information like “we’re an insurance company and we sell insurance”. If you click the products link the site will usually connect you to a page that may list a few products and provide extremely brief summaries; although there was one site that regardless of the page linked to always responded with ”call us for details”. In short, most company web sites convey absolutely no marketing or recruiting value.

Web sites are 24 hour marketing portals. A prospective agent may hear about a company and in this browser based age their first look at the company will be through the carrier’s web site. However, most of the time the web site won’t provide any useful information about the company or the products. There are a few exceptions.

The sites for ING USG Annuity and Integrity Life provide “demo rides” showing the kind of web information agents will receive after they are appointed. Conseco, Jackson National and SunAmerica also provide a hint of the treasures that await new agents. But, the best first impression is made by the web site of Standard Life of Indiana.

StandardAgents.com provides complete product descriptions, sales ideas, product interest rates, real industry news, financial market information, and forms and supplies, all without requiring a password. It is an inviting site with useful information. The site made me want to talk with Standard Life of Indiana to see what else they offered. Take a look, it shows how a first impression should be made.

The Bear Market Ended April 4, 2001     5/01
A year from now it may very well be determined that the low point of the 2000-2001 bear market was reached during the first week of April. This isn’t a guarantee. Recent positive stock market momentum could be a bear rally with further hardships yet to come. However, I would not be surprised if the market, by fits and starts, eventually pushes past the previous highs.

If we are now in the next bull market, what did the millennium bear ultimately look like?

2000-2001 Millennium Bear Market

The bear market was terrible for the NASDAQ, moderate for the Dow Jones Industrial Average and typical for the Standard & Poor’s 500.

This is the tenth bear market for the S&P 500 in the last fifty years. If early April was the end, the millennium bear had a duration of almost thirteen months placing it in fifth place on the list. The decline from the previous high was 27.77% making it the sixth hardest bear market. All in all, the millennium bear didn’t cause the long term pain felt with the bear markets of the ‘70s and early ‘80s, nor was it as gentle as the 1990 expanded correction.

The Millennium Bull
In the last few weeks the S&P 500 has moved up from the low. How long will it take to blow past the previous high?

If we ignore the awe inspiring 73-74 bear market which took 90 months before the level of the previous high was regained, previous markets averaged twelve months after the low to enter record territory with recovery time ranging from three to twenty one months.  If past times are any indication, the S&P 500 could be back over 1500 as early as this Fall and probably not later than next May.

Most Index Annuities Posting Zero Returns  5/01     
Annual reset point-to-point index annuities have yet to post a positive index related return for 2001. In fact, the last time an annual point-to-point structure would have credited a positive index return was during the second week of last November.

Annual reset structures using averaging are faring a little better with some contracts eking out 2%, 3% and even 4% returns for brief periods in February. But, the bear has proved too powerful and these structures have also been smitten.

Term end point annuities have seen any paper gains achieved since late 1998 - early 1999 erased.

It won’t get any better very soon. The S&P 500 has increased from 1103 at the start of April to around 1250 by the end of the month. However, even if this rally continues the index was at the 1400 to 1500 level last year pretty much through December. At best, some index annuity structures may hit passbook savings or money market equivalent rates this year even if we are now entering the next bull market.

Where’s The Pony?
The good news is that nobody died. Term end point annuities should have sufficient time remaining in their periods to overcome this adversity and still post respectable returns. Annual reset structures are calculating tomorrow’s new index gains from today’s lower initial points.

This market highlighted the principal protection benefit of index annuities. A zero return doesn’t sound quite as bad when compared with the alternative of a 27% or 67% loss.

Consumers now understand the concept of market loss and may not want to continue using the postman as their financial advisor. In tough times people look for guidance, safety and a hand to hold. This is an excellent time for agents to tell the index annuity story.

1st Quarter EIA Sales Level  6/01
In spite of a miserable stock market and fire sale interest rates on traditional fixed annuities index annuity sales remained level with the previous quarter.

First quarter sales were $1258 million compared with sales of $1258 million in the fourth quarter of 2000. Sales were down sharply when contrasted with the record $1500 million sold in the first quarter of 2000.

The EIA Sales Leader for the first quarter was once again Allianz.

The quarter was marked by the departure of one of the pioneers in the arena when GE Capital withdrew their index annuity from the market. American General also pulled their index annuity off the shelf. These departures were balanced with the entry of Oxford Life onto the field and the reentry of Delta Life.

Bonus products were introduced by LSW and Midland National; Clarica added an averaging product. ING USG quit the Choice Index. Jackson National added a seven year version of their ELITE 90 annuity and is closing the ten year product. ReliaStar pulled the Series I version of their EIA.

In the first quarter products with a surrender period of more than ten years represented over half of the market. Index annuities with surrender periods of ten years or longer represented 76% of first quarter sales versus 64% for the same period last year. There were more sales of annuities with surrender periods of twelve years or longer than all annuities with surrender periods of less than ten years combined.

In the previous two quarters products with an agent commission of 11% or more represented over 40% of sales, but in the first quarter this segment dropped to 31% of total sales. One year ago 42% of the annuities sold had an agent commission of under 8%; in the first quarter only 25% of the policies sold paid a commission of under 8%.

Insurance agents continue to dominate distribution. capturing over 96% of index annuity sales. Annual reset methodologies represented 86% of total sales and crediting structures using some type of averaging have similar market penetration. Although ten carriers have introduced multiple index products, the S&P 500 is still the index used for 96% of index annuity sales.

The average index annuity sales premium reported was $33,116; average premium ranged from $11,306 to $53,7000. The average fixed annuity premium was $33,452; average premium ranged from $10,675 to $52,116. The average index sales premium was similar to that reported in the previous quarter.

Source: Advantage 2001 Equity Index Sales & Market Report

Index Life Insurance 6/01      
Equity Index life insurance sales have reported over $60 million in premium for each of the last three years. Total EIUL premium for the first quarter of 2001 was $18.8 million with AmerUS as the leader .

We identified twelve companies that offer equity index life insurance. The current companies and life products are:

Equity Index Universal Life is for people that need life insurance and desire permanent protection. They want greater flexibility and greater control than is available with traditional insurance. In addition EIUL owners: Like the opportunity for higher potential interest with equity linked returns; Don’t like the volatility and risks of VUL; Want the certainty of knowing they’ll earn at least a minimum return in both good times and bad.

EIUL is available as a flexible premium personal insurance plan with premiums paid monthly, quarterly or yearly. EIUL is available for estate planning purposes as survivorship life and as a single premium insurance instrument

CDs Also Have Bearish Moments  6/01        
You would have been better off over the last couple of years if you’d kept your money in certificates of deposit. Over the last two years CDs would have generated over an 11% total positive return; contrast this with the losses of the stock market over the same term.

Every time a bear appears in the stock market CD buyers come out and smile and smugly remark that “while they may not earn as much in their bank accounts at least they’re protected from that nasty volatility affecting stocks.” Although it is true that certificate of deposit principal is protected from market risk the interest earnings can wildly fluctuate.

Since 1970 there have been eight times when CD interest rates fell more than 20% from the previous high in the cycle. On average, the lowest rate in these cycles was 50% of the previous high.

If you’d been retired and using CD interest to help pay the bills you saw your income cut in half on eight separate occasions - once as early as by the time of next renewal. Bank instruments do provide stability of principal, but the trade-off is return volatility.

Equity index annuities provide protection of principal from market risk. Because the additional interest beyond the minimum guarantee is linked to the movements of a stock index, index annuity returns also fluctuate. However, over time equity markets have produced significantly higher average returns than fixed rate instruments.

In the ‘90s the S&P 500 index had an annual return of 14.86% - and this includes the 150 point drop in the final year of the decade. During the ‘90s six month certificate of deposit rates averaged 5.26%. - the interest rate on the final CD at the end of the decade was 24% less than the rate earned on the first.

Today, CD interest rates are 4% to 5% and the stock market is lower than its been in over a year. Both bank instruments and equity instruments will continue to be volatile. However, it may make sense to have volatility work for you over the long term while protecting the principal with an index annuity.

Overall Index Annuity Returns Are Strong  6/01
The chart below pretends that every month since 1997 you had purchased: the annual reset point-to-point annuity with the best first year return, the annual reset point-to-point annuity with the worst first year return, and annual reset annuities averaging index values generating the best and worst first year returns.

You can see that the interest credited to these annuities is all over the board. In general, actual credited interest was in the double digit area when the index was heading up and at or near zero during the millennium bear market. What is interesting is that if you add up all of the returns and average them out you find that these index annuities delivered actual annual first year interest of 7.3% to about 9.5%.

Depending upon the point-to-point annual reset annuity you owned, and whether it had a maximum cap on interest and what that cap may have been, your mean first year returns ranged from 7.50% to 9.35% for the period. Depending upon which annual reset annuity you bought and the averaging method and rate used, your mean first year returns ranged from 7.32% to 9.45%.

If you had consistently picked the worst performing index annuities month after month - and the names of the annuities with the lowest returns changed depending on the month you’re looking at, you still received an average interest rate significantly higher than certificates of deposit yielded over the same period.

Another point is that these returns are after the effects of the worst bear market in a generation. For the final six months of the chart the stock indices produced negative annual returns, and yet overall, annual reset index annuities still credited interest that was, on average, 50% to almost 100% higher than other traditional savings vehicles.

A final point is even though some crediting methods didn’t average values and may have had caps, and others averaged index values, the end result is that the range of first year returns during an extremely volatile market period is the same for both point-to-point and averaging methods.

Selected Highlights Of The 2001 Tax Act 6/01

Containing a mind numbing 444 pages of tax law changes and explanations the Economic Growth and Tax Relief Reconciliation Act of 2001 (HR 1836) was passed by Congress May 26, 2001 and signed by President Bush June 7, 2001. The Act greatly increases the ability of Americans to save for retirement by increasing contribution limits on qualified plans, eliminates the estate tax, and provides significant financial incentives for education. However, most of the individual tax breaks aren’t fully realized for a few years.

This summary addresses a few of the highlights of the Act. It is not intended to be comprehensive in any subject area and although the information is believed to be accurate as far as it goes, it is not guaranteed or warranted. One should always contact their tax advisor for their individual situation.

Christmas in September

In 2000 if your taxable income was in excess of: $6,000 - single individuals, $10,000 - heads of households, $12,000 - joint filers, you will receive a one-time check of : $300 - single, $500 - heads of households, $600 - joint filers, probably in September. This special credit reflects the effect of the new 10% tax bracket carved out of the old 15% one.

Even if your taxable income was a million dollars last year the most you’re going to get is $300, $500, or $600, depending on your filing status. If you made under these amounts last year your check is reduced by 5% for every dollar below the thresholds. You won’t get anything if you didn’t have a taxable income last year or if you were claimed as a dependent on someone else’s return. The tax credit is not taxable; you will not report the check on your Form 1040 as taxable income. Of course, if you live in a state that gives you a deduction for federal taxes paid they will probably want an adjustment on this tax rebate.

Income Tax Bracket Changes
The most significant delayed benefit will be realized by those filers with incomes over $300,000 as the maximum tax rate goes from the current 39.6% to 35% in 2006. In addition, the higher income taxpayers that currently have lost the deductibility of personal exemptions and up to 3% of their itemized deductions eventually are treated like everyone else regaining full deductibility by 2010 and getting back a third of the deductibility beginning in 2006.

The new 10% bracket applies to the first $6,000 of income for single taxpayers and $12,000 for joint filers. All of the rate tables are adjusted for inflation (the 10% table won’t be adjusted for inflation until 2009). The bottom line is the Act means sizable tax reduction for big income earners and big tax payers; modest benefits for the little people.

No Change In Capital Gain Tax
The current capital gain rates were unaffected, although there will probably an attempt to adjust these rates as well. However, striving for long term capital gains tax treatment should become less meaningful for most people as ordinary tax rates fall. By 2006, the difference between ordinary income rates and long term capital gains rates for folks with a taxable income of $160,000 or less will be 5% or 8%. Even people in the highest brackets will have less of an incentive for coveting long-term capital gain rates.

One effect of the Act is the old argument that “mutual funds are better from a tax viewpoint 
because variable annuity withdrawals are taxed as ordinary income” becomes weaker. 

Now, not only do variable annuities permit you to enjoy realized portfolio gains without generating an end of year Form 1099, and permit you to sell, buy, and adjust portfolio positions without fear of immediate tax consequences, and watch money inside the annuity grow on a tax-deferred basis, but the ordinary income taxation of these variable annuity benefits has been reduced.

Annuities & Life Insurance

The annuity benefit of tax deferral became (pick one) less important or more important. You could argue that a general reduction in rates lessens the importance of tax deferral, or you could say that with lower effective taxes in the lower income brackets, tax deferral today means deferring higher taxed dollars for use at retirement when you’re at a lower tax rate.

Kiddy Kredit
The child tax credit gradually doubles over the next ten years increasing to $600 this year, $700 in 2005, $800 in 2009 and $1,000 in 2010. The Act also increases the credit for adoptions.

Marriage Relief
The tax “penalty” against married filers almost goes away by 2009, but nothing happens until 2005. The relief is accomplished by gradually increasing the married standard deduction to be double that of a single taxpayer and gradually expanding the 15% tax rate income levels to double those of a single taxpayer. The schedule is as follows:

HOPE and Lifetime Learning tax credits remain the same. A taxpayer may take either the deduction or the credit, but not both. It appears to make more sense to take the HOPE tax credit, rather than the deduction, if your taxable income is under $80,000. The Lifetime Learning Credit is probably better than the deduction if you’re under $60,000 to $70,000 in income.

Education IRAs
The Act
-quadruples the contribution ceiling for Education IRAs from $500 to $2,000 beginning in 2002.

- the AGI limits for joint filers wishing to fund Education IRAs will jump to $190,000 - $220,000 

- contributions may also be made by corporations and tax-exempt entities

- permits Education IRA distributions to be paid for elementary and secondary school educational expenses 
   as well as colleges

When the estate tax is fully repealed in 2010 the use of stepped-up basis of estate assets is reduced.  Today, the heirs’ tax basis is the fair market value at death. Under the new law only the first $1.3 million of the estate is entitled to a stepped-up basis. However, an additional $3.0 million going to a surviving spouse receives fair market value at death.

This means that the first $5.6 million ($1.3 - husband, $1.3 - wife, $3.0 - surviving spouse) of a couple’s estate will be taxed at some basis other than original cost. It also means that record retention requirements could be a century or more. Imagine a man buying a piece of property at age 21, leaving that property at his death at age 81 to his age 21 grandchild, and the grandchild finally sells the property at age 91. To contest an inaccurate tax basis presented by the IRS, you’d need to produce a 130 year old bill of sale.

IRAs
If the 1982 $2,000 IRA contribution limit had been indexed for inflation, the current contribution ceiling would be $3,720. While the Act isn’t quite as generous, IRA limits do increase next year and older taxpayers will be able to contribute a little more.

The contribution limits will be adjusted for inflation beginning in 2009 in $500 increments.

A taxpayer age 50 or older by year-end may contribute an additional $500 above these limits from 2002 through 2005 and a $1,000 more in and after 2006. This amounts to a potential 50% to 75% increase in IRA sales revenues next year from a representative’s existing client base.

Low Income IRAs
Single taxpayers with an AGI of $15,000 or less and joint filers under $30,000 will receive a 50% tax credit for up to $2,000 in contributions to an IRA or qualified retirement plan. Single taxpayers with an AGI of $25,000 or joint filers with a $50,000 income will get a 10% tax credit in 2002.

Rollovers
Today, IRA distributions may only be rolled over to another IRA (unless the IRA is funded entirely from a pension plan distribution). In 2002, eligible rollovers from IRAs, 403(b) annuities, qualified retirement plans can be rolled to any qualified plan accepting the rollover. This greatly simplifies retirement planning and could be a windfall for 401(k) and 403(b) plan sponsors enabling them to gather more qualified assets under one roof.

Under current regulations, if you don’t complete a qualified rollover within sixty days the amount cannot be rolled over. The new law says you can petition the Secretary of the Treasury to waive the sixty day requirement for good cause.

Congress has also instructed the IRS to update the mortality tables used to calculate minimum required distributions to reflect current life expectancies.

Qualified Plans
The Act devotes a large number of pages to pension reform, and all for the better. Some of the highlights going into effect after December 31, 2001 are:

-Annual Compensation limits increase from $170,000 to $200,000

-Maximum Defined Benefit Limit increases from $140,000 to $160,000

-Contribution limit goes from $35,000 to $40,000

-25% contribution limitation goes to 100% of compensation

-Deferral limits on 401(k) and 403(b) plans increases from $10,500 to $11,000 in 2002
and $1,000 a year thereafter to a top of $15,000 in 2006.

-SIMPLE plan limits increase from $6,500 to $7,000 in 2002 and $1,000 a year
thereafter to a top of $10,000

-Cliff vesting reduces from five to three years, graded vesting reduces from seven to six years

-Congress provides tax credits for small employers wishing to start a plan

Elective Deferral Limits
The maximum deferral limits for 401(k), 403(b) and SIMPLE plans start increasing next year. After the last scheduled increase limits will be indexed for inflation in $500 increments.

Catch-Up Contributions
401(k) and 403(b) participants age 50 and older may contribute an additional $1,000 over the limit in 2002. The catch-up amount increases by $1,000 a year until it reaches $5,000 a year by 2006. For SIMPLE plans the catch-up amount is $500 a year increasing until it reaches $2,500.

Plans will not be required to permit catch-up contributions if they don’t want to. However, these extra contributions are not subject to nondiscrimination rules, so it makes sense to offer the benefit.

Small Employer Tax Credit       
If an employer with 100 or fewer employees elects to start offering a retirement plan in 2002 or later, they can receive a $500 tax credit to help offset administrative and retirement education expenses each year for up to three years.

The tax credit is only for employers that haven’t offered a plan for the last three years and is available for new plans starting after December 31, 2001. The credit is 50% of the first $1,000 of administrative and employee education expenses for the first three years of the plan.

Beginning next year, the IRS will no longer charge small employers fees for determination letters.

Summary    
The Act is complicated and wide ranging. It provides modest tax relief for most taxpayers and more significant relief for Americans earning six figures or more.

The Act does kill the federal estate tax. However, due to Sunset provisions the tax will reappear in 2011 if a future Congress doesn’t act. In addition, the potential loss of stepped-up tax basis for some assets could replace today’s estate tax liability with tomorrow’s capital gains tax expense. The bottom line is unless estate planners want to rely on the generosity of a future Congress, the purchase of life insurance to cover estate cash needs remains a prudent course of action for many people.

Education is a big winner under the Act. The threshold income limits permitting the deduction of student loan interest were substantially raised. Private colleges may begin to offer pre-pay tuition plans just like state sponsored programs. The raising of Education IRA limits (and the list of potential contributors) makes these accounts a worthwhile market.

IRA purveyors will realize a 50% to 75% increase in their potential revenue base without adding new clients. Financial consultants should begin booking space for January IRA seminars today.

Qualified plans will become even bigger and attract more assets with raised contribution limits and the easing of rollover restrictions. Small businesses are better pension prospects than ever.

The Economic Growth and Tax Relief Reconciliation Act of 2001 offers incredible opportunities for financial service providers.

Index Annuity Returns Are A Matter Of Degrees   6/01

The last twenty years were a robust time for the stock market, even with the inclusion of four bear markets. If you look at seven year periods from 1981 until the end of the century - 1/1/81 to 1/1/88 through 1/1/94 to 1/1/01, you see that the average S&P 500 return, without reinvested dividends, for all of the calendar year periods was 12.95%. The way this is measured is the final value of the index is compared with the initial value seven years prior and a gross percentage gain is computed. From this total gain, the annual compounded rate can be determined.

Most index annuities measure index movements on an annual basis. A participation rate/yield spread/cap is applied each year, positive gains are credited as interest, negative years are treated as zeros. Because an annual reset index annuity doesn’t lose ground in down years, it doesn’t need to participate in all of the index movement to produce competitive returns. Over this twenty year era an annual reset point-to-point index annuity with a 93% participation rate would have produced the same average return as using 100% of the S&P 500.

However, there aren’t any annual reset point-to-point index annuities around with a 93% participation rate. Today, the typical unaveraged annual reset annuity, without a cap, has a participation rate of 50%. You can find index annuities averaging annual values with higher rates, but averaging always drives values to the middle. In this twenty year period an averaging index annuity with a 75% rate generated about the same overall return as a 50% annual point-to-point design.

At current rates no annual reset index annuity will produce sustained double digit returns

What does this mean? If the next twenty years duplicates the previous score, the typical annual reset index annuity will not average a 12% return, nor a 10% return, nor even an 8% return. At today’s rates, annual reset index annuity returns would average around 7%.

In the grand scheme of things a 7% interest rate isn’t bad for an instrument that protects principal and credited interest from market risk. Current bank rates are 4% to 6% and a 7% index annuity return would be competitive. However, what if you feel a potential average return of 7% isn’t enough?

One alternative is using an index annuity with a different crediting method. Term end point index annuities, measuring gain over multiple year terms, would have periods with double digit gains even at current rates, but interest is not usually credited until the end of the period. The other alternative is to select a good carrier and wait.

Most annual reset index annuities can change the participation rate and/or yield spread and/or cap prior to the end of the period, and usually on an annual basis. This flexibility means that future rates could be lower, but they could also be higher. One of the major costs in determining the degree to which the consumer participates in the index is the cost of the options providing the potential index-linked interest. From a long term point of view the current prices on these options are high. When option prices decrease insurance companies can buy more of them and participation rates and/or caps would go up and yield spreads would go down. It doesn’t take much a change in rates to increase returns.

Looking at these seven year periods over the last twenty years the average annuity annual return increases about 1% for each: 7% increase in a point-to-point crediting method rate, 11% increase in the rate when using monthly averaging, or 2% increase in a cap with an annual point-to-point design. A point-to-point design at a 60% rate or a monthly averaging design with a 90% rate generates average returns of over 8%; an additional 10% increase in rate pushes average returns over 9%.

The chart shows the hypothetical yearly returns for an annual reset index annuity, averaging monthly index values, using seven year periods. The numbers at the bottom of the chart represent the first year of the seven year periods (the first number represents 1/1/81 to 1/1/88 and the last 1/1/94 to 1/1/01).

Annual reset index annuities probably won’t get you long term double digit returns even if the stock market does a repeat of the last twenty years. However, because option prices are at relatively high levels today, future index annuity renewal rates can benefit when option prices fall. Higher renewal rates could push returns into the 8% and 9% range for some periods, which is pretty good for a savings vehicle which protects principal and credited interest from market risk.

What if the bottom drops out of the stock market?
Index annuity interest is linked to an equity index. If the market does poorly, so will the index annuity. But, annual reset annuities have two features that help when the index declines. First, every index annuity has a minimum guarantee saying you’ll get back at least your premium at the end of the period. Second, annual reset annuities reset annually meaning they can take advantage of bad times. If you look at seven year periods ending in the ‘70s the average annual S&P 500 return was 0.77%, but an annual reset point-to-point index annuity with only a 60% rate would have averaged a return during the same time frame of over 5% a year.