Market Recovery Program
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Chapter 8
GETTING PART WAY THERE: THE INDEXED STRATEGY
What is this “third way” which combines the best of both the market-based and fixed strategies?
It’s called the indexed strategy.
You have the best of fixed investments because all the money you put into it -- your principal -- is guaranteed; so the safety factor is there.
But you also have the opportunity to participate in the stock market when it goes up. All interest earned is linked to what the S&P 500 stock index does, which for the past 80 years -- at least until the recent downturn -- has averaged more than a 10% return each year.[1]
You’ve mentioned the S&P 500 Index several times. What is it?
The S&P 500 stock index comprises 500 of the most widely held companies in the U.S. representing a variety of industries, such as technology, health care, utilities, etc.
How does the strategy work?
When the S&P 500 index goes up, you participate in that growth. It’s measured one year at a time; from the anniversary date of the beginning of your contract until that date the following year, and so forth each subsequent year.
When the market goes up, your account is credited with interest. Depending upon how the calculation is done you‘ll receive either a percentage of the gain; a cap on the total gain experienced that year; or a monthly average. These are the most popular crediting methods although there are a few others.
What happens in those years when the market goes down?
When the market goes down not only do you not lose any of your principal but you don’t lose any of the gains you’ve already made in previous years. You don’t make any money in those years when the market goes down but you don’t lose anything either.
Can you give me an example of how it works?
Let’s say that a few years back you contributed $10,000 to the indexed strategy, and let’s say the S&P 500 did 10% the first year, bringing the fund to $11,000 ($10,000 plus $1,000 which is 10% of the $10,000). However, your $10,000 grows to just $10,700 because although the market went up 10%, you’re in the indexed strategy and your participation means you getting only a portion of that gain which we’ll assume for illustration purposes is 7%. See Figure 7.
Figure 7
Let’s say in the second year the S&P 500 did 10% again, bringing its total to $12,100. Let‘s also say your indexed strategy is capped at 7.0%. So your account has grown by $749 the second year (which is 7.0% of $10,700) to $11, 449. See Figure 8.
Figure 8
In the third year, the market drops 20%. The S&P fund drops accordingly to $9,680.
However, because your money is in the indexed strategy, instead of losing 20% and having your account reduced, your account value stays at the $11,449 level. You didn’t make any money that third year but you didn’t lose anything either. See Figure 9.
Figure 9
Gosh, this sounds great…but this is all still very hypothetical. Can you show me any concrete results of an actual Indexed strategy and how it has actually performed in reality?
Appendix B -- Indexed Annuity 8 year results presents the actual results of an indexed strategy over an 8 year period. $100,000 turned into almost $160,000. According to the Compound Interest Rate chart, that works out to approximately a 6% annual return (see Appendix A -- Compound interest on $100,000).[2]
We seem to be getting closer to our goal. It seems we’ve obtained a 6% return which, according to the compound interest rate chart, will get Joe $320,714 in 20 years on his $100,000. At 4%, it would have resulted in $219,112. That’s an additional $101,602 his $100,000 generated in the same time frame by obtaining a mere 2% more!
But 6% is still not enough. Yes, it is pretty good, certainly. And if we’re 50 years old and want to retire at 70, turning $100,00 today into $320,714 in 20 years is nothing to sneeze at.
Then what’s the problem?
The 6% is not guaranteed. Getting this truly great 6% is not written in stone.
And, besides, Joe still hasn’t got his funds back to his goal which is $400,000.
What if we could get an even higher return, say 8%? Would that be enough to get Joe back to where he was? What will the compound interest rate chart tell us regarding 8% instead of 6%?
Why don’t we do take a look.
At 8% your money doubles every 9 years. In 18 years it doubles again. See Figure 10.
Figure 10
From a glance at the chart, it looks like Joe gets his $400,000 back in 18 years at 8% per year. [3] And, amazingly, it would all come from the same $100,000 we were using before.
Same $100,000, same time period: again, the only difference is the interest rate….yet there is an additional $246, 984 for Joe in Year 20 when his $100,000 accumulates at 8% ($466,096) compared to 4% ($219,112).
So, 8% does indeed do the trick.
But this is all just speculation if nothing is guaranteed. The 6% the indexed strategy is capable of producing looks pretty promising because that’s what it’s done in the past. Unfortunately, past performance is no guarantee of future earnings.
I suppose the best possible scenario would be not only if the 8% was available but guaranteed as well. But I can’t imagine that such a thing exists in this day and age of low interest rates…
Let’s take a look…
[1] From the period of October 1927 until October 2007, the S&P 500 Index produced an annual average “Index Rate of Return with Full Dividend Reinvestment” of 10.12%. See: http://politicalcalculations.blogspot.com/2006/12/sp-500-at-your-fingertips.html
[2]The website indexannuity.org is an excellent source of information on indexed annuities. At the following page under “returns” one can examine an extensive articles and studies on the history of indexed annuity returns: http://indexannuity.org/library.htm
[3] The exact figure is $399,602.
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