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Just Where Do You Invest in Today’s Head-Scratching Times?

Some financial experts, including Andrew Murdoch, president of Portland, Ore.-based Somerset Wealth Strategies, now recommend the purchase of a fixed-indexed annuity (FIA) – a fixed annuity pegged to a market index.
Some financial experts, including Andrew Murdoch, president of Portland, Ore.-based Somerset Wealth Strategies, now recommend the purchase of a fixed-indexed annuity (FIA) – a fixed annuity pegged to a market index.

Pity the poor annuity investor – or, for that matter, any investor. Almost across the board, investment prospects overall are the worst they have been in many years.

Interest rates tumbled to a record-low in July and remain deep in the basement, and the U.S. stock market –never for the faint of heart — is riskier than usual because it is overvalued amid depressed earnings and a woefully sluggish economy. Overseas stock markets in Europe, Japan and China are even less appealing.

You can buy a fixed annuity or a lifetime income annuity and lock in guaranteed rates, knowing at least they will not decline further. But that’s an underwhelming incentive. And if rates eventually rise, which seems the more likely scenario, you may come to regret your decision.

Another option, of course, is to do nothing, biding your time until the interest rate picture improves. Like the other alternatives, however, this is problematic as well. What if rates continue to decline to unheard-of levels – to the point that you actually have to pay a bank to hold your money? This is the case today in Japan and much of Europe.

The do-nothing option is particularly unappetizing for pre-retirees and retirees. Most people who pull back will park their money in a money market fund and earn almost nothing. This means you could easily wind up spending down more of your principal. If interest rates subsequently rise, you might then find yourself in a position in which your depleted funds are sufficient to make only smaller investments, gaining you nothing in the end.

So here is the question on the minds today of almost all investors: Is there any preferred course of action?

Happily, the answer is yes, although it is somewhat unconventional and requires a leap of faith in the stock market, at least over the long term. Some financial experts, including Andrew Murdoch, president of Portland, Ore.-based Somerset Wealth Strategies, now recommend the purchase of a fixed-indexed annuity (FIA) – a fixed annuity pegged to a market index.

FIAs offer principal protection. “So if the market falls, you lose nothing,” Murdoch points out. In addition, more FIAs now invest in low volatility indexes. These diversified vehicles invest in stocks, bonds, future contracts and commodities and use algorithms to guide asset allocation. This means you can still do well even if the stock market falters.

Also, with interest rates so low, the odds that the stock market will fare worse than interest-bearing investments – at least over time — are extremely. Low. Currently, five-year CDs typically pay less than 2 percent and a five-year fixed annuities.2.25 to 2.5 percent.

Murdoch says FIA investors today should seriously consider waiving the purchase of a lifetime income rider, which usually costs about 1 percent annually. This way, you keep more of your FIA’s gains. It also makes sense to do what you can to maximize the FIA’s earnings potential because FIAs pay only a percentage of the rise in an index.

There is a note of caution. If you think you want to buy a FIA, you have to take the time to understand the substantial differences in so-called crediting methods – the formulas that insurance companies use to calculate how much of the increase in the investment index you pocket. The range is huge.

Some FIAs pay an index “participation rate” of only 15 percent. This means if the market rises 10 percent, the FIA owner receives only 1.5 percent. FIAs like this must be avoided – period. By contrast, a few good FIAs pay a 100 percent participation rate on a low volatility index. Another pays a relatively generous participation rate of 45 percent on the S&P 500. These are the kinds of FIAs you want to buy because they’re positioned to perform well in a respectable market environment.

While a good stripped-down FIA is probably the best option for most investors in today’s investment climate, Annuity FYI understands that people still want alternatives. So what follows is an update on other credible options that could be pursued. In general, annuities are best for conservative investors because they pay higher interest rates than other interest-bearing investments.

Fixed Annuity Ladder

A ladder of Multi-Year Guaranteed Annuities (MYGAs) offer a partial hedge against the risk or rising (or falling) rates, as well as a still-respectable income stream. Avoiding the three-year MYGA, which pays too little, you could create a ladder of five, seven and 10-year MYGAs paying annual interest of as much as 3 to 3.25 percent, including the option to withdraw up to 10 percent of your principal annually without penalty.

The different maturities in the ladder spread the risk inherent in the uncertain timing of rate movements. It rates rise, you’ll be able to buy higher-yielding MYGAs or lifetime income annuities down the road. The ladder also protects you if rates keep falling because your rates are locked in for years.

Immediate Annuities

Immediate annuities provide income payments for the rest of your life – and payments that are higher than other annuities because they include principal, as well as interest. (Investors do have to sacrifice their principal up-front). Immediate annuities are also tax-advantaged because no taxes are paid on your principal. To come out ahead, however, these make sense only for people likely to live into their 90s.

Deferred Income Annuities

DIAs are a type of immediate annuity that delays payments until an investor elects to take them. Most buyers are still working and intend to continue doing so for years. DIAs can offer the biggest bang for your buck – they are relatively inexpensive because the insurance company isn’t on the hook to make payments for as many years. As a type of immediate annuity, DIA payments are also tax-advantaged.

Variable Annuities

It’s debatable, but this may be a decent time to buy a VA, especially if you have a long-term investment horizon.

A VA is an annuity that allows investors to choose from a basket of sub-accounts (mutual funds), and, unlike FIAs, pays 100 percent of what stock markets do. Yes, the stock market is very pricey, but it may still climb because the key propellant – many think there is no other good place today to invest — remains in place. Even if the market tumbles, as it inevitably will at some point, there is no reason to doubt that it will still be the best financial investment for most people over time if they are buy-and-hold investors.

Bear in mind that VAs do charge the highest fees because of their additional sub-account management fees. VA lifetime income rider withdrawal rates also tend to be about a half percentage lower than those paid by FIAs.

Unlike the case with FIAs, it would be foolish to buy a VA without a lifetime income rider because that would make a VA too much like a stock mutual fund, which has much lower fees. But for those who want guaranteed lifetime income, as well as significant stock market exposure, a VA is the only game in town today.

Yet More Options for Those Want to Avoid Annuities

Looking hard at places to invest your money today but just don’t like annuities? They are relatively illiquid and so not for everybody.

Here are additional options worth considering:

Certificates of Deposit

There is a way around the paltry rates most CDs pay today: Check out good deals online at regional banks and credit unions, some of which pay up to 2.25 percent annually on a five-year CD. This is materially better than the 1.6 percent rate offered today by 10-year U.S. Treasury notes. Another option is to buy a ladder of mostly shorter-term CDs. This pays less but offers far more flexibility.

What is good about CDs is their relative liquidity. The penalty for early withdrawal is usually only six months of interest, far less than an annuity surrender fee.

Bond Mutual Funds or Ladders

These offer diversity, plus a rate that may rival the 10-year Treasury note.
Corporate bonds with a five-year maturity today pay about 1.75 percent annually. A five-year high-yield bond – a riskier corporate bond – pays about 1 percentage point more. Tax-free municipal bonds pay less than both but usually make sense for people in higher income brackets.

Bond funds offer greater diversification but more interest rate risk in a rising rate environment. High yield funds offer higher yields but assume more principal risk. Some high yield bond funds, however, can move into cash to limit risk.

Those concerned about interest rate risk should avoid bond funds and buy a ladder of individual bonds. You won’t lose money if you hold them until maturity.

Couple a Bond Fund with a Stock Fund

If you can handle some risk, consider investing 20 percent of funds otherwise allocated to bonds in a diversified stock index fund. Couple this with a much larger investment in a bond fund. Over time, studies show this is actually less risky and generates a higher return. Rebalance annually the allocation to each fund.

— Steve Kaufman

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