Recent stock market volatility is a reminder for many of us of the financial crisis in 2008. The huge market selloff that started in late 2008 was the catalyst for the Great Recession that followed. Many investors, myself included, lost a ton of value in our 401(k) and investment accounts. Although losses varied depending on your individual investments, most of us lost somewhere between 30% and 50% of the value of our accounts. There’s no doubt that the market has rebounded, with the Dow Jones Industrial Average (DJIA) hitting record highs this year. But, and this important, most of that bull market that we’ve been experiencing since 2009 (almost 5 years) has only helped to bring our accounts back to where they were before the crash of ’08. So why am I pouring salt on the wound by reminding everyone about this harsh reality? It’s called annual reset, and along with the protection of principal guarantee, they are probably the most powerful and unique features of Fixed Index Annuities (FIA).
Annual reset, as it’s referred, is the feature of an FIA that basically “locks in” gains on every policy anniversary, so every year. By locking in the gains on an annual basis, your annuity will never participate in market losses and will never lose the gains from previous years. Those of us who had a Fixed Index Annuity in 2008 did not lose 30%-50% of the value of their annuity when the market crashed. And because of the annual reset feature of their annuity, when the market started to rebound in 2009 they didn’t have to recoup any losses before they started realizing positive gains. There is a tradeoff that I will get into later, but for now, let me try to illustrate this with real numbers to show you how having some of your funds in a FIA is a good way to protect your retirement savings, especially in volatile markets.
In order to keep things simple, let’s look at 2 different hypothetical scenarios with some very round numbers. We’ll call the participants in these two scenarios John and Bob. In 2008, John turns 60 and decides to roll his 401(k) into an Individual Retirement Account (IRA). He uses the $500,000 in his 401(k) to purchase various stocks and mutual funds, diversified properly across many sectors. At the same time, his friend Bob also turns 60 and rolls his 401(k) into an IRA. However, instead of investing in the stock market, Bob chooses a more conservative approach by purchasing a FIA with a premium bonus of 10%. Then a few months later, it happens. The stock market crashes, setting up the worst economic collapse in the U.S. since the Great Depression. By early 2009, John’s IRA has lost 40% of its value and stands at $300,000! Bob’s annuity, however, didn’t lose any value. His $500,000, plus the $50,000 premium bonus, leaves his value in early 2009 at $550,000.
The tradeoff that I mentioned earlier for principal protection and annual reset is that over the next several years, as the market rebounds, Bob will have his upside capped at a certain level. John will not, but look at is starting point. Let’s bring this back to the present day and look at where their accounts stand now. Let’s say that the stock market as a whole has averaged 15% over the past 4 years since the collapse. At a 15% return over 4 years, John’s IRA would have recouped the losses suffered in 2008 and would have a value now of $524,702. Now let’s look at Bob’s IRA. He opted for a more conservative crediting strategy in his Fixed Index Annuity called the annual point-to-point strategy. Let’s assume, for the purposes of this illustration, that his annual cap was 5% each year. HIs value of $550,000 growing at 5% per year for 4 years would give him a present day value of $668,528!
Each of us have different risk tolerances, and no one should have all of their eggs in one basket. But in this hypothetical scenario, I hope I’ve laid out how powerful Fixed Index Annuities can be as part of an overall diversified approach to retirement planning. Oh, and during 2008 and 2009, while John saw his blood pressure rising and had countless nights without sleep, Bob slept peacefully knowing his IRA was protected against market downturns.