(Forbes) -- Buy low; sell high. This concept serves as a foundation of sound investment advice, but few have the emotional control to act upon it when necessary.
The stock market has seen prolonged gains for the past eight years, but we all know this trend can’t last forever. How and when it will end is yet to be seen.
While annuities can provide some protection from market volatility, there is one annuity that can expose contract owners to market losses — variable annuities. Now may be a great time to buy low and sell high if you own one.
Investors may actually improve long-term retirement outcomes by transferring out of variable annuities into something that provides stable growth while removing market risk. While variable annuities have done well lately, contract owners can get hurt if the markets experience significant, prolonged losses.
To clarify this timely opportunity to lock in variable annuity gains while removing market risk, we need to understand a few key components of annuity contracts: account value, withdrawal base, and crediting method.
It’s important to note that this strategy needs to be done before a significant market correction; otherwise, the contract owner may find themselves stuck in a situation where the account value is much less than the withdrawal base. In this situation, moving out of the variable annuity may hurt more than help.
Account Value
The account value is simply the amount of money in the annuity.
If someone puts $250,000 into a variable annuity, the account value is $250,000, and this money is placed into sub-accounts that invest directly into the stock market. Once invested, the account value will move up and down based on market activity, directly exposing the sub-accounts to market losses and market volatility.
The account value also represents the funds the contract owner can access in the event of a withdrawal.
Withdrawal Base
A withdrawal base functions as a virtual high-water mark to calculate future guaranteed income: It moves up when the account value experiences gains but doesn’t move down with losses.
For example, if the investor puts $250,000 into a variable annuity, and the account value grows to $300,000, the withdrawal base will lock in these gains at annual intervals. If the account value then drops to $200,000 due to market losses, the withdrawal base remains at $300,000, locking in a “high-water mark.”
In a variable annuity, the withdrawal base will not increase again until the account value recovers from market losses and grows to exceed the previously established $300,000 withdrawal base. If the account value never grows to exceed the $300,000 “high-water mark,” the withdrawal base will not grow.
It’s important to note that the withdrawal base isn’t real money and doesn’t represent funds for withdrawal.
Crediting Method
This method relates back to sub-accounts within a variable annuity used to invest the account value directly in the markets.
If the sub-account investments do well, the account value can participate in market gains. However, if these investments experience market losses, the account value isn’t protected. In the event of significant market corrections, the contract owner may find themselves waiting months or years for the withdrawal base to start growing again. The account value has to recover from losses and hit new account highs before the withdrawal base can continue to grow.
From 2000 to 2010, nicknamed the “lost decade,” many investors ended up net-negative or net-neutral on their investment returns. Many investors are still not fully recovered from losses experienced in the 2008 correction, even with recent market gains. Based on the important role the withdrawal base plays in calculating annuity income, prolonged stagnation of the withdrawal base while waiting for variable annuity account values to recover can potentially impact the quality of life for retirees.
Moving out of a variable annuity when the account value is less than the withdrawal base could sacrifice the high-water mark, potentially having a negative impact on future income. Only when the account value is equal to or greater than the withdrawal base does it make sense to consider the “buy low; sell high” strategy.
Based on recent market activity, many variable annuity owners are in a favorable situation. This climate presents an opportunity to lock in gains by transferring into a different kind of annuity that provides modest gains but also protects the account value from market losses. There are a few to choose from, but, based on current conditions, retirees and pre-retirees may want to consider a fixed index annuity (FIA).
The key differences between a variable annuity and a fixed index annuity are where the account value lives and how the crediting methods work. However, the account value of an FIA isn’t directly invested in the stock market, shielding the account value from market losses.
Often, the account value will have a floor of 0%, meaning that in down markets, the account value remains flat. When the markets go up, the fixed index annuity grows through partial participation in market gains by mirroring various market indexes.
Remember: There are many important factors to consider before transferring out of a variable annuity. Details of the existing contract must be compared to potential replacements, ensuring the transfer will improve retirement outcomes. Most importantly, contract owners must understand their surrender charges, an early withdrawal penalty schedule that decreases with time and varies among different contracts.
Working closely with a trusted professional when considering such a transfer can make all the difference. For many pre-retirees and retirees, locking in gains while also removing market risk from their retirement portfolio can offer added peace of mind and a smarter way to manage their retirement income.
