An Annuity Can Fund Looming College Tuition

This is a financial paradox: Can we aggressively position assets today that have the potential for strong growth in the next 24 months, without exposing those assets to market risk? As one who is a natural cynic and thinks free lunches are a sucker’s bet, I have been conditioned to expect that the only way to greater financial reward is to take incremental risk. But as I’ve written about in other forums, this is a unique time to get more reward than would otherwise seem possible, and to do so without not only more capital risk, but with absolutely no exposure to market losses.

The solution for my wife and me was to purchase a fixed-indexed annuity (FIA) with a five-year surrender charge schedule and no additional fees. This means charges of 8%, 8%, 7%, 6%, 5% are applicable for amounts we withdraw in the first five years, with no charges after the end of the 5th year. The exception to those charges, which we will exercise to help with tuition, is the 10% free withdrawal amount. This means we can withdraw up to 10% of our contract value once per year with no surrender charge. We allocated our entire purchase amount to two indexed accounts that use volatility-controlled indexes.

Volatility-controlled indexes were developed by money center banks over the last decade and offered to insurance companies as indexed-account choices within FIA contracts. It came at a time during which the Federal Reserve was pursuing easy money policy which left insurance companies' FIA options budgets very lean. These lean options budgets in turn resulted in very low indexed interest caps on traditional FIA indexes like the S&P 500, translating into very little upside potential, 3%-4% in many cases. The lower volatility of these new volatility-controlled indexes as compared to the S&P 500 meant that a skinny options budget would “buy” more upside potential, even if the absolute performance of these indexes was lower than that of the S&P 500. But now with the Fed raising rates at a historically rapid rate, the participation rates for new money on these indexes have skyrocketed, in some cases having tripled in the last year.

Regarding our own annuity, while the initial participation rates associated with these accounts are not guaranteed for the life of the contract, we did split our allocation evenly between accounts that credit every year and those that credit every two years. The two-year accounts sport initial participation rates of 220% and 360%, respectively, while the one-year versions of those same indexes have initial participation rates ranging from 140% to 255%. Those participation rates are then applied to the performance of the indexes after the one- or two-year terms, resulting in either interest being credited, or no interest (but no losses).

When we write the first tuition check for our son in about two years, our annuity will have had six opportunities to credit interest; the one-year indexed accounts will have four chances to credit interest, while the two-year versions will each have one chance to produce results.

We will want to exercise our 10% surrender charge penalty free withdrawals by the time we write that first tuition check, , which we are hoping will be exercised on a contract value that is significantly larger than the amount that we paid for the annuity. And given our age, we won’t have to deal with any 10% tax penalties, since we will be over age 59.5.

A low bar to outperform and the potential to do much better

We could have kept things simpler and more predictable and gone with a sure thing like a five year fixed annuity with a guaranteed annual interest rate of 5.25%. Doing so would have ensured that two years from now, total interest accumulated would have been 10.776% of the premium value. But let’s do some math and you’ll see why we chose to take a calculated risk on interest crediting.

Half of our annuity allocation is in two volatility-controlled indexes that will each have the potential to credit interest in two years. The other half is in these same indexes but will have an opportunity to credit annually. One of these indexes has a higher volatility target (12%) and thus has lower one- and two-year participation rates (140% and 220%, respectively) than the other index, which sports 255% and 360% participation rates and a 5% volatility target. The tradeoff? The index with the lower participation rates and higher volatility target is less diversified and has more growth potential, while the lower volatility index trades some growth potential due to greater diversification in exchange for higher participation rates.

What performance will be required of these two indexes over 24 months such that their value individually exceeds the sure thing of 5.25% a year that we have chosen to forgo? The answer will require some truly simple math to divine, as we determine how each of the four indexed accounts will need to perform over the next two years to each beat the benchmark bogey of 10.776% that a fixed annuity with a 5.25% rate would produce at that time::

• 2 Year Indexed Account, 360% participation rate:
  • 776/3.6 = 2.99%, or about 1.50%/yr for 2 years
• 2 Year Indexed Account, 220% participation rate:
  • 776/2.2 = 4.9%, or about 2.42%/yr for 2 years
• 1 Year Indexed Account, 255% participation rate:
  • 25%/2.55 = 2.05%/yr for 2 years
• 1 Year Indexed Account: 140% participation rate:
  • 25%/1.40 = 3.75%/yr for 2 years

Now that we’ve done the math, the next question seems obvious, all due to caveats to past performance not being indicative of future results. How often have these indexes produced annual performance greater than the above – either actual or hypothetical- such that when applied to those participation rates, the result after two years would exceed that from the fixed annuity? A quick glance at both indexes shows that the one with the higher participation rates for one- and two-year crediting terms has produced more than enough performance in 20 years of its combined actual and back-tested history (actual 2016-2022, hypothetical 2003-2015) to exceed the two-year result from a 5.25% fixed annuity. Only two of the 20 years were negative, and the average of all 20 years, including the two negative years, was about 5%.

If that index earned that same average of 5% annually for the next two years, the annuity crediting performance after two years for the half of my annuity allocated to that index over one- and two-year crediting periods (assuming the one-year term is renewed at the same 255% participation rate), would be about 32%, or almost three times the guaranteed alternative of 5.25% per year in a fixed annuity.

The other index follows a similar story, albeit with lower participation rates and much higher index performance. But let’s add a timely twist. Since 2022 saw negative performance in just about every volatility-controlled index (since most index constituents lost value last year, except for energy), how might the annuity indexed accounts have performed after a negative year, if we had the benefit of today’s high participation rates in the past?

Other than 2022, 2018 was the only negative year out of 20 years in the index with the higher participation rates and more constituent diversification, while the index with the lower participation rates experienced six negative years out of the 17 years of its performance history. That is no surprise since it is based on a single index, the Nasdaq 100.

Hypothetical Two-Year Annuity Performance AFTER a negative year

• Indexed Account w/360% participation rate for 2 years, 255% for 1-year crediting.
  • Actual History begins 1/25/16
  • Last and only negative year other than 2022: 2018
    • Index Performance 2019: 13%; 2020: 3.28%, Compounded: 16.7%
    • 2-year crediting end of 2020 = 16.7% x 3.6 = 60.1%
    • 1 year crediting end of 2019 = 13% x 2.55 = 33.15%
    • 1 year crediting end of 2020 = 3.28% x 2.55 = 8.36%

Total Average Crediting % at end of 2020 for 1- and 2-year terms: 52.2%

• Indexed Account w/220% participation rate for 2 years, 140% for 1-year crediting.
  • Actual History begins 1/29/20
  • Most recent Negative year other than 2022: 2018*
    • Index Performance 2019: 24.95%, 2020: 19.43%, Compounded: 49.23%
    • 2 Year crediting end of 2020 = 49.23% x 2.2 = 108.3%
    • 1 Year crediting end of 2019 = 24.95% x 1.4 = 34.93%
    • 1 Year crediting end of 2020 = 19.43% x 1.4 = 27.20%

Total Hypothetical Average Crediting % at end of 2020 for 1- and 2-year terms: 89.97%

Total Hypothetical Average Crediting % between all four indexed accounts at end of 2020: 71%

The window of high-participation rates is now open, and nobody knows how long it will last. If the Federal Reserve finishes its inflation-fighting efforts sooner rather than later and markets stabilize, index performance should improve, but there is no guarantee that participation rates for new money will remain as attractive as they are today. Waiting for inflation and rates and the dollar to all come down will surely help index performance but will likely reduce participation rates for new money. If the two ingredients for great results are high participation rates and decent index performance, one of those two is available now and the other may develop during the ownership experience. Waiting for the skies to clear may mean that one of the ingredients – historically high participation rates – is no longer available.

That is precisely why we moved with alacrity to buy this type of annuity now, with these indexes split between one- and two-year strategies and locked in high initial participation rates. While we don't expect the index performance two years from now to mirror what I’ve shared here, what if we were fortunate enough to earn half that amount, say 35% total interest? That would surely achieve our goals of accelerating our tuition readiness and with zero market risk. By mixing one- and two-year crediting strategies, the two-year strategies help offset renewal risk on the annual crediting versions, while the annual crediting versions offset the risk of a bad year wiping out a biennial crediting opportunity.

Lastly, if this annuity performs beyond our expectations, it is likely that the capital markets have also done well. That should give us some pleasant choices at that point, meaning perhaps we can fund college from existing growth assets in two years that grew better than anticipated. That means we can keep our annuity earnings safely in reserve, since prior earnings can’t be forfeited, for a future rainy day when perhaps the capital markets are not doing well. Nothing happens in a vacuum, which is why it was so appealing to me to have one asset that is positioned to take advantage of good capital markets patterns but while also being immune from capital markets losses.

As the theme song from Smokey and the Bandit goes, “We’ve got a long way to go, but a short time to get there.” I can’t think of a better way to try and get there safely than with a FIA.

*negative years from 2006-2022: 2006, 2008, 2011, 2015, 2018, 2022

John Rafferty has spent much of his 30-year career building annuity marketing departments at MassMutual, AIG/American General, and Symetra. He holds a B.A. in economics from Colby College and an M.A. in public policy from Trinity College, and currently operates an annuity sales and marketing consultancy, RaffertyAnnuityFraming.com.

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