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Bob Carlson's - September 2015


Investing when Rates are Low, Poised to Rise

What do you do when interest rates are low but the Federal Reserve makes clear it is going to start raising rates? Now, you earn very little money from cash and safe investments. Bonds and similar investments have higher yields, but they're going to lose value when interest rates rise. In many cases, principal losses from rate increases will more than wipe out the higher yields. Today's historic interest rate situation is a difficult one for investors.

Making decisions even more difficult is that interest rates aren't likely to rise rapidly. The decision would be easier if we were on a fast path to normal interest rates. We could hide in cash for a year or two until rates were much higher, and then consider buying high-yielding investments. But I expect rates will rise slowly over several years, because the Fed can't afford to raise rates too quickly. It might damage the economy.

Investors want to know what to do with the bond or income portions of their portfolios in this environment. They want to be diversified so all their investments aren't in stocks, but they don't want to lock in almost guaranteed losses in bonds as rates rise over the next few years.

Also in a difficult situation are people who are retired or getting ready to retire and looking for guaranteed income. The traditional choice for them is to buy an immediate annuity. But buying an immediate annuity now would lock in today's very low interest rates for the rest of their lives.

There are two vehicles available for investors in these quandaries. Either one will keep your principal safe, is likely to generate a reasonable yield in most circumstances, and the yield is likely to increase if markets rates rise and the economy grows.

One vehicle to consider is the fixed index annuity (FIA), also known as an index annuity. These annuities are very controversial and for good reason. Many of them have fees that are too high, and they're very complicated. Many buyers of FIAs apparently don't really understand what they bought. Those problems, however, shouldn't keep you from considering the really good FIAs available. A good FIA protects your principal while providing the potential for solid yields.

You buy an FIA by making a deposit with the insurer. Your principal is guaranteed not to decline from market changes, though with many FIAs you'll receive less than your principal back if you withdraw it before a minimum time has passed. FIAs used to guarantee a minimum annual return, but under the Fed's zero interest rate policy they now only guarantee you won't lose money.

In addition, your account is credited with interest each year. The interest isn't determined by market rates. Instead, you choose from investment indexes offered by the insurer, and the returns of the index are used to determine the interest credited to your account.

You won't receive the full return of the index. Most annuities first have a participation rate of 50% to 70%. If an FIA has a participation rate of 50%, only half the return of the index is used to determine the interest credited to your account. FIAs also have annual caps, or limits, on returns that usually are 5% to 10%. Your maximum interest credit for the year is the cap, no matter how well your index performs. Many FIAs also have their own ways of calculating an index's returns, such as excluding dividends or using an average of the index's closing values each day of the year.

Because of the calculation method, participation rate, caps, and expenses, when an index returns 12% for the year, some FIAs will be credited with 5%, others will receive 10%, and most will receive something in between.

That's why FIAs shouldn't be compared with stocks or mutual funds. They are to be considered for the safe portion of your portfolio. You should be shooting for returns comparable to the yield on intermediate bonds or a bit higher but with no risk of losing principal (unless the insurer fails). Today, investors who are worried about what happens to bonds when rates rise should consider FIAs.

Here's a specific FIA to consider, the Nationwide New Heights Indexed Annuity 9. First, it's from an insurer you know and that has good financial safety ratings. Second, Nationwide made this annuity simpler than a lot of its complicated competitors. In fact, you have options to avoid participation rates, caps, and a lot of the uncertainty over how much interest your account is likely to be credited with each year. (There are three other versions of the annuity, but they differ in the surrender periods. We're looking at the nine-year surrender period.)

You can choose from three investment options. The first is a balanced index known as the JP Morgan Mozaic Index. It includes stocks, bonds, and commodities. Because of the strategic allocation of this index, it has done well in many market environments and didn't lose money during the stock bear market of 2008.

You have two other investment choices in this annuity, which primarily are for those who want to shoot for higher returns and are optimistic about stocks. You can select the S&P 500 index or the MSCI EAFE (essentially the developed country stock markets outside of North America). These choices are likely to have an additional expense deducted, known as a strategy spread, before interest is credited to your account.

The catch, if you call it that, with this FIA is that your choice of index lasts for three years and the interest isn't locked in to your account until the three years ends. Most FIAs have a one-year crediting period. This shouldn't be an issue if you choose the JP Morgan Mosaic Index option, and the index continues its historic performance of not losing money because of its strong diversification.

Other benefits of this annuity are that you can see the performance of your index each day. With most FIAs, you won't know the interest to be credited to your account until after the year ends.

So, the advantages of the Nationwide New Heights 9 Index Annuity are your account is backed by one of the strongest insurers, this FIA is much simpler than others, you can have a balanced index with an excellent history, and you see the index performance each day. The annuity also pays full current value to the beneficiary when you pass away, unlike many FIAs. There's also an attractive income rider for those who want guaranteed income later.

The second vehicle to consider is the deferred fixed annuity. FIAs aren't very everyone. The DFA is the traditional plain vanilla, CD-type annuity. You basically receive the interest income of a bond without the principal fluctuations or risk. You deposit an amount with an insurer, and the insurer credits interest to your account each year. The interest is determined by the insurer, using its investment experience and expenses. Most insurers reset the interest rate annually, but some use other periods. Generally, you're going to receive an interest rate similar to the yield on intermediate investment-grade bonds.

As interest rates increase, the interest credited to your account should rise with a lag. But your principal will be steady. Your account principal won't fluctuate with interest rates the way the value of a bond will.

There aren't many moving parts to the DFA. It's for people who want safety and a decent yield with this part of their assets. If you're worried about what will happen to bonds or bond mutual funds as rates rise but an FIA isn't for you, take a look at DFAs.

For example, there’s the Midland National Life 5-Year MYGA (Multi-Year Guarantee Annuity). Its guaranteed yield for five years is 2.75% annually for those who deposit $200,000 and 2.50% for those who deposit less. There’s a penalty for withdrawing money before five years. After that, there's no penalty and the yield is set annually by the insurer.

Midland National has been in business since 1906 and has an A+ safety rating from September 2015 ll7 are tax deferred. All income compounds in the annuity free of income taxes. There are no income taxes until you begin taking distributions.

These annuities also should be considered by some current retirees and near-retirees who are considering immediate annuities. I like immediate annuities because they provide guaranteed income for life. In retirement, it can be a good idea to put a portion of your nest egg into immediate annuities to ensure fixed expenses are paid.

The drawback to immediate annuities now is that you lock in today's low interest rates for the rest of your life. I don't expect interest rates to bounce to normal levels soon, so leaving the money in a low-yielding CD or similar investment until yields are higher isn't a good idea. Instead, consider putting the money designated for an immediate annuity into one of these other types of annuities. You're likely to earn a higher yield while we wait for market rates to rise to a level at which you're ready to purchase an immediate annuity. Most FIAs or DFAs allow you to withdraw up to 10% of your account each year without penalty. That allows you to draw some spending money from the annuity while waiting ot purchase an immediate annuity.

For more details about the annuities mentioned here, and other annuities, contact my annuity expert, Todd Phillips of Phillips Financial Services (888-892-1102). He researched the annuities in this discussion. You also can buy Todd's book, The Future of Retirement Savings: How to take advantage of stock market linked growth without the stock market risk. It normally costs $9.95, but my readers can purchase it for $5.95, which is his cost for shipping.

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