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CHAPTER NINE
THE PROTECTED INVESTOR SMARTER, SAFER WAYS TO INVEST

TOOLS FOR TRANSFERRING RISK

IF THE TRADITIONAL methods for dealing with risk are inadequate, and the investor has placed a higher priority on preservation of capital than on trying to beat the market, what is the solution? We know there is an inherent risk when investing in the market, but what about the lost opportunity of missing out on the sometimes spectacular gains that can occur? What is a prudent, conservative investor to do?

There are money management tools that can virtually eliminate the risk of being in the market while still allowing for participation in any upside. Many of these tools have been significantly enhanced over the last ten years, while some have been around for hundreds of years. Some of these tools can become overly complicated for the nonmathematically inclined, but fortunately you don’t have to understand all the intricacies of the ingredients to follow a recipe for dealing with risk.

HEDGING

Risk management tools are commonly referred to as derivatives in financial literature. They come in two flavors: futures (contracts for future delivery at specified prices) and options 140(contracts that give one side the opportunity to buy from or sell to the other side at a prearranged price). Futures are only used in the commodities market. Options contracts, on the other hand, are commonly used to hedge stock market-related risks.

Customized options contracts are frequently created by institutions and are traded among these large organizations. In 1973 the Chicago Board of Options Exchange (CBOE) was founded. The CBOE created standardized listed contracts that can be purchased and sold on a number of different stocks and indexes. The CBOE accounts for approximately 51 percent of all U.S. options trading and 91 percent of all index trading. The CBOE lists options on over 1,200 widely traded stocks.

An option can be fashioned on any financial instrument that fluctuates in price. In 1983 the CBOE began to trade options in the S&P 100 index. Today, options are available on just about any index, including sector indexes. Investors can effectively place insurance on their equities by using options strategies. A detailed description of how to use options as equity insurance is included in Appendix A and is highly recommended for anyone who absolutely insists on owning individual equities.

Options are an important ingredient in the development of products that allow the protected investor to participate in the market without risking principal.

MARKET-LINKED INVESTMENTS

The price of an option is based on a number of factors. The theoretical value of an option is a function of the current stock price, expected dividends, the options strike price, expected interest rates, time to expiration, and expected stock volatility. In 1973 Fischer Black, a Wall Street consultant, and Myron Scholes, assistant professor at MIT’s Sloan School of Management, published their landmark article, “The Pricing of 141Options and Corporate Liabilities.” Today, a formula aptly called “Black-Scholes” incorporates all of these factors in the calculation. The ultimate price of an option is based on supply and demand just like a stock, but it is very likely to be close to the theoretical value.¹

Black and Scholes came up with a way to avoid losing money in the financial markets by purchasing a mix of securities that cancel out risk. If market conditions are right, a combination of index options and bonds can be structured to give the investor the same return as the index if the market is up, but no losses if the market is down.²

The easiest way to illustrate how this works is with a simple example. Let’s say you have $100,000 and access to a very safe investment that will generate a little over 7 percent interest. In order to assure that you have $100,000 one year from now, you would invest approximately $93,000 in the safe investment, leaving $7,000. You take the $7,000 and invest in a call option on the S&P 500 index that expires a year from now. If the market goes down by any amount, even to zero, your safe investment will still grow from $93,000 to $100,000 because of the interest. If the market increases, the option would increase in value to give you a total return in excess of $100,000. The amount in excess of $100,000 depends on the return from the option.

The higher the interest rate on the safe investment, the more money that can go into the option. The less volatile the stock market, the more option you get for the money. In a period of relatively high interest rates and stable markets, you could actually have the guarantee against loss and get over 100 percent of a positive market return. So let’s say the market is up 10 percent during the period. Your return might be 12 percent, even with the guarantee against loss.

If interest rates are low, less money is allocated to the option purchase. If markets are volatile, it’s a double whammy because you’re getting less option for the money. Generally, higher 142volatility increases the cost of the option. In this case you still have the guarantee against loss, but if the market goes up, you may receive less than 100 percent of the market increase. Even though the investor may participate in only a portion of a market advance, the market-linked investment is still attractive compared to other safe alternatives.

The financial engineers who work for banks, insurance companies, and brokerage firms manufacture “market-linked” investments that provide guarantees against loss. These institutions have the ability to purchase customized options at less cost than the individual investor and therefore can provide attractive alternative investments.

As an investor, understand that when an institution offers a market-linked investment, the institution intends to be completely hedged for any market outcome. A depository bank traditionally operates by taking money in via deposits and paying a lower rate relative to the money it lends out. This difference is called a spread. The institution really doesn’t benefit if the market heads one way or another. The institution is factoring in the spread so that it can provide stated guarantees and an attractive instrument for the investor while allowing a reasonable profit to the institution.

For risk-averse investors, market-linked investments are attractive alternatives to traditional equity and mutual fund investments. Market-linked investments that are offered by institutions fall into four main categories: certificates of deposit, corporate notes, insurance annuities, and life insurance. Even certain mutual funds now provide principal protection by building a portfolio of zero coupon bonds and individual stocks.

Market-Linked Certificates of Deposit

The market-linked certificate of deposit (MCD) is not a new invention. Big banks have offered them to large and institutional depositors for years and continue to do so. Individuals143began to have access to this type of investment in 1987, although many investors still have never heard of them. The cover of a brochure for market-linked CDs has this descriptive catch phrase: “The power of money in the market. The comfort of money in the bank.” This describes in a nutshell the major benefit of these investments.

The MCD is like a traditional bank CD in that it has a specific maturity date and the principal is FDIC insured. The difference is how the interest is calculated and when it is paid. Unlike traditional CDs that pay a fixed rate of interest, the MCD pays interest that is tied to the performance of a participating stock market index. If the index goes up, your investment does too. Yet, regardless of what the market does, you are still guaranteed the return of your original investment at maturity.

In the early 1990s, some MCDs were paying in excess of 100 percent of the change in the index. Due to historically low interest rates, it was common to pay a rate that was less than the change in the index during the early 2000s. When investing in an MCD, consider these factors: the index, the term, the minimum interest rate, the participation rate, averaging calculations, call provisions, existence of caps, redemption provisions, and any other special terms outlined in the MCD.

THE INDEX

Most MCDs are tied to major indexes such as the S&P 500 and Dow Jones Industrial Average. The MCD can be tied to any index as long as the bank can purchase an option to adequately hedge the equity-linked interest payment. This includes international indexes. And as we have seen, institutions have access to custom-made options that individuals can’t duplicate.

Some MCDs are based on a blend of different indexes. For example, a number of MCDs have been issued based on a composite of the Nikkei 225 (Japan), Eurostox 50 (European Union), and S&P 500.

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When the MCD is issued, a date is determined for the initial index set. This is usually at the close of the offering period or the date of issue shortly thereafter. This initial index level is utilized as the base rate for determining any gain in the future. This level does not change over the life of the MCD unless the terms include a reset provision.

THE TERM

The principal and interest are paid at the maturity date. MCDs are usually issued with terms of three to ten years.

THE MINIMUM INTEREST RATE

Some MCDs guarantee a minimum interest rate at maturity regardless of how the index performs. Others have a guarantee of only the return of principal. In any event, the interest is not paid until maturity.

By including provisions that limit interest, banks can reduce the cost of their hedge and provide a product that would otherwise be impossible to issue. These provisions include the participation rate, averaging, calls, and caps.

THE PARTICIPATION RATE

This is expressed as a percentage and is multiplied by the actual percentage gain in the index to determine the percentage of gain credited to the MCD. For example, if the index is up 50 percent and the participation rate is 90 percent, a gain of 45 percent will be credited to the MCD at maturity. This rate is established when the MCD is issued and remains fixed over the life of the MCD. The rate may be higher or lower than 100 percent depending on market conditions.

AVERAGING CALCULATIONS

Sometimes the bank will average the final index over some part of the term of the MCD. The actual method of averaging varies widely between MCDs.

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Some MCDs calculate the final index figure by taking an average of the index on the last day of the month three to six months prior to maturity. I have seen some MCDs calculate the final index value by taking a yearly average of the index over the life of the MCD. In periods of low interest rates, some MCDs use a quarterly average beginning right after issue.

Averaging can work to an investor’s advantage or disadvantage depending on how the market behaves.

CALL PROVISIONS

A call provision in a market-linked CD gives the bank the option of cashing in your MCD before the maturity date. The bank can do this on specific dates each year at a specified rate of return known as a “call premium.” For example, a five-year CD may have a yearly call provision as follows:

See Table

This means that the bank can return your investment at four specified dates that are outlined in the particular MCD issue along with the stated call premium. If the bank called the above MCD after two years of issue, the investor would receive $14,000 on a $10,000 initial investment. If the bank does not call the MCD in the first four years, the MCD will mature at the fifth-year anniversary. The principal will be paid in addition to any interest that may be due.

Of course, the bank will not call an MCD unless the actual index has performed better than the stated call premium. It is the bank’s decision whether or not to exercise the call provision, regardless of where the index stands on the call dates.

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Some MCDs issued during the Internet craze were based on an Internet-related benchmark, such as the CBOE Internet Index. The volatility of this index was so lofty that the cost of the option component of the MCD was also very high. These MCDs were typically issued with call provisions. Without a way to reduce the cost of the hedge, the MCD would have been cost prohibitive from the bank’s point of view.

Call provisions are not standard. You should ask the bank representative or broker/adviser to review all the relevant terms of the MCD with you, including call features.

CAPS

A cap provides a maximum interest return to the investor. For example, a 60 percent cap means that the most a $10,000 investment will return at maturity is $16,000.

Caps are another mechanism used by the bank to reduce the cost of the hedge. Caps are not standard provisions in an MCD contract. Ask the broker or bank employee about the existence of a maximum interest return.

REDEMPTION PROVISIONS

Market-linked CDs are marketed as a “buy and hold” investment by the banks. Early redemption values differ by issuer. MCDs obtained directly from a bank may not provide for early redemptions. Many MCDs available through brokerage firms provide for early redemptions on a periodic basis (quarterly or annually) as described in the offering document. Early redemption values may be more or less than the original investment.

The actual redemption price depends on the current level of interest rates and the present value of the option that the bank has purchased. If interest rates drop, the bond component is worth more. If rates increase, this element of the MCD is worth less. The value of the option component depends on the current level and relative volatility of the index. Generally, an increasing index level and/or high volatility increases the value of the 147option. The option is worth less when volatility is low and/or the index is down. As the MCD approaches maturity the penalty for early redemption becomes less material. In any event, if held to maturity, investors receive at least 100 percent of their original investment.

OTHER TERMS AND PROVISIONS

There is no end to the various MCD structures that can be invented by financial engineers. Review all the terms and conditions of a market-linked CD so that you understand its benefits as well as limitations.

If an MCD has call provisions, caps, or wide averaging windows, these don’t necessarily make it a poor investment. They usually come into play when interest rates are low and/or volatility is high. For example, in an up market a five-year MCD with a 50 percent cap will provide a much greater return than a traditional CD or other interest-bearing investment, along with safety of principal. The upside may not be as high as an index fund, but with the MCD you have the possibility of an above-average return without risk to your original investment.

Disadvantages and Advantages of MCDs

The market-linked CD has a few disadvantages. The gains are based upon indexes without considering any dividends. An index fund would include reinvested dividends. Dividend yields on most indexes are currently pretty low, so this isn’t a big factor.

The MCD does not have the same liquidity as an index or other type of mutual fund. There is a decreasing penalty imposed by the bank for cashing out early. It should be viewed as an investment that you are willing to buy and hold until maturity.

The MCD will usually pay interest based on the increase in an index, but certain factors can reduce the rate, including a participation rate below 100 percent, averaging, caps, and call 148provisions. MCDs purchased outside of a retirement plan are subject to income taxes. The MCDs are taxed as if they are paying income each year, even though the earnings are not realized until maturity or redemption.

The whole tax issue can be avoided by purchasing the MCD in a retirement account such as an IRA. I’ve seen and heard of many imprudent investment decisions being made for the purpose of reducing or even eliminating taxes. I feel that the principal protection offered by the MCD in a down market offsets the income tax implications.

In spite of some disadvantages with these investments, the many positive features of the MCD, including the protection of principal, make it a suitable investment for part of a protected investor’s portfolio. Financial professionals can guide the investor in the process of choosing specific market-linked certificates of deposit.

As an independent agency of the federal government, the Federal Deposit Insurance Corporation (FDIC) guarantees the safety of deposits, including market-linked CDs, up to $100,000 per depositor per depository institution. The FDIC insures the principal of the market-linked CD but not the “contingent” interest paid at maturity. This could be a factor if the financial integrity of the issuing bank is in question. In the late 1980s hundreds of savings and loans went out of business, costing taxpayers over $100 billion. Banks periodically get into trouble by lending too aggressively and taking unhedged bets on the direction of interest rates. It could happen again. Make sure your MCDs do not exceed $100,000 per account, and don’t be afraid to cash in and lock in gains when appropriate.

The fact that the MCDs are designed to be held to maturity is a positive in that it discourages the in-and-out trading that is so easy to do with index funds. Remember that it has been proven that frequent trading actually serves to reduce returns over time.

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Banks have had a challenging time training their staff to appropriately offer and explain market-linked certificates of deposit. Brokerage firms have had the most success in distributing these investments, even though the investment community hasn’t fully embraced the concept. Smaller banks view MCDs as suitable for “sophisticated” investors, but few customers these days look to their bank for investment advice. In addition, it takes a long time (thirty-five to forty-five minutes) to explain all the details, according to John Soffronoff, president and CEO of the $350 million Premier Bank in Doylestown, Pennsylvania.³

It is likely that future distribution of these MCDs will be primarily through securities dealers. One big advantage of this is that MCDs held in a brokerage account are readily transferable and easily purchased. MCDs that are purchased directly from small to midsize banks can’t be held in a brokerage account, are not transferable, and many have restrictive redemption policies prior to maturity.

Example MCD

Every MCD has its own unique terms and structures. Here is an example of an actual MCD from issue to maturity:

• PRUDENTIAL SAVINGS BANK—ISSUER
  
  
• Five-year term
• S&P 500 is underlying index
• 100% index participation factor
• Minimum deposit—$5,000
• Minimum interest—Zero
• FDIC insurance—$100,000 per depositor
• Issue date—June 2, 1997, S&P 500 at 846.36 on issue
• Maturity date—June 3, 2002

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Payment at maturity is measured by the percentage increase of the S&P 500 index from the starting index value of 846.36 at issue to the closing index value. The closing index value is the arithmetic average of the six pricing dates outlined in the CD terms. These dates are January 1, 2002, February 1, 2002, March 1, 2002, April 1, 2002, May 1, 2002, and May 29, 2002. If the calculation results in a decrease, the original investment will be returned with no interest.

The actual closing index on each pricing date was as follows:

See Table

The arithmetic average of indexes on these dates is 1118.22 (6709.31 divided by 6). The interest calculation is based on the percentage increase in the S&P 500 from the initial index at issue of 846.36 compared to the closing index value of 1118.22. This equals 32.21 percent [(1118.22 - 846.36) / 846.36]. An initial investment of $10,000 generated $13,212 at maturity.

Some banks provide early redemption dates that allow the CDs to be cashed in before maturity, at a market value designated by the bank at the time of redemption. The price can be more or less than the original investment, depending upon the movement of interest rates and the index that the MCD is tied to.

My own personal strategy with market-linked CDs is to redeem when the price has gone substantially up in value over the original issue cost. The $10,000 market-linked CD principal is protected at $10,000. If the redemption value increases to $16,000, the $6,000 increase is an unrealized speculative gain and is uninsured by the FDIC. This gain could evaporate 151all the way back to the $10,000 base level. My strategy is to take the gain, which may be less than the appreciation of the index, and reinvest the proceeds in other secure investments where my new protected principal totals $16,000. I want my gains locked in as often as possible.

On June 1, 2000, Prudential Bank offered to redeem the CD in this example for $16,500 on an original $10,000 investment. The spot appreciation (current S&P 500 index divided by initial index set) of the index was 71.1813 percent, with the S&P 500 index at 1448.81 at that point in time. The market value of $16,500 at redemption was calculated by the bank and was based on the value of the zero coupon bond used to protect the investor’s principal, plus the value of the instruments used to provide the index return. The difference between the spot appreciation of the index and the market value paid at redemption, if any, can be viewed as a penalty for early withdrawal. In retrospect, it was certainly a good time to redeem and lock in the gain.

Minimum Interest Plans

In periods when interest rates are low, you may find other curious MCD terms and structures that allow the bank to hedge its guarantee but give the investor the possibility of an above-average return. For example, on March 28, 2002, HSBC Bank issued a four-year MCD that provides a minimum guaranteed return of 11 percent (2.75% simple interest, 2.64% annualized) if held to maturity. In addition, the investor had the possibility of getting as high as 112 percent (28% simple interest, 20.67 annualized) by adding the sixteen quarterly percentage changes in the NASDAQ 100 index subject to a cap each quarter of 7 percent. In this case the minimum interest assures the investor a positive return if held to maturity but gives the possibility of an even greater return.

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I believe that the MCD’s primary advantage—providing market-linked returns with a guarantee against loss—more than offsets any shortcomings. For the protected investor the return of the investment is of primary importance. Next comes the return on the investment. In an up market, the investment returns on an MCD may be less than on a mutual fund or individual stocks. The protected investor accepts this as a cost of the guarantee on the principal. Also, keep in mind that most investors do significantly worse than the overall market. As a result, the return on the MCD is likely to be superior to individual stocks and mutual funds managed by the investor. Market-linked investments allow the protected investor to comfortably tie money to the stock market.

EQUITY-LINKED NOTES

An equity-linked note is similar in structure to a market-linked CD, but the note is guaranteed by a corporation and is not backed by the FDIC. Evaluation of a potential note investment should include enhanced due diligence on the credit-worthiness of the institution that issues the note. Brokerage firms that have good credit ratings issue most of these investments. Technically, the notes are liabilities of the issuing firm, which makes the investor a general creditor of the firm.

The easiest way to evaluate the credit and default risk of investing in a market-linked note is to review the credit rating assigned to the debt securities by the two most popular bond rating companies: Standard & Poor’s and Moody’s. Both provide a grading system that is useful in determining whether the note is of the highest quality. It doesn’t do any good to purchase a security with a guarantee against loss if the firm providing the guarantee goes out of business. More on credit ratings can be found in Appendix B. If credit risk is of great concern to the investor, it’s preferable to use other market-linked investments that have a guarantee from a highly rated 153insurance company or FDIC-insured bank. However, notes can sometimes provide a greater selection of index choices and better opportunities for liquidity.

Equity-linked notes are referred to by many different names. They are sometimes referred to as hybrid products and structured products. In addition, the brokerage firms create their own odd-sounding acronyms like MITTS, SUNS, TARGETS, and TIERS.

In 1999 Stephen Bodurtha, vice president of customized investments with Merrill Lynch, testified before the House Budget Committee Task Force on social security. He stated, “Potential downside risk keeps many people from investing in stocks, even when long-term growth is the objective. To help with this problem, Merrill Lynch has pioneered Protected Growth investing, which combines participation in the long-term appreciation potential of growth assets, such as stocks, with protection of principal. The purpose is simple: to allow the pursuit of growth with limited risk.”⁴

Merrill Lynch refers to the bulk of its equity-linked notes as MITTS. This stands for Market Index Target Term Security. Merrill typically will offer a MITTS security at $10 per unit. Once issued the securities are listed and traded on the New York Stock Exchange, the American Stock Exchange, the Chicago Board of Options Exchange (CBOE), or NASDAQ. PaineWebber and Lehman have issued notes priced and traded like bonds ($1,000 denominations). Trading is usually thin, which contributes to inefficiency and periods of overvaluation as well as undervaluation.

Salomon Smith Barney has referred to their version of equity-linked notes as “Safety First” investments. They have been issued in the form of principal-protected equity-linked certificates. The more recent versions are AAA rated by Standard & Poor’s and Moody’s because the principal is backed by AMBAC, the same insurance company that provides private insurance on municipal bonds.

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The various index notes traded on the American Stock Exchange are listed on the web site, www.amex.com. In some cases the specifications of the notes are available, including the beginning index set. Click on the tab labeled “structured products,” and then click on “index notes.” Equity-linked notes that trade on the Chicago Board of Options Exchange are available at www.cboe.com. Click on the “products” tab and then click on “structured products.”

Although the concept of an equity-linked note is simple, you will find that every single note has its own unique characteristics, and it is best to get some advice to determine whether any of them will help meet your own financial goals and objectives.

Equity-linked notes are not unique to the United States. They can be constructed in any country and any currency as long as the issuing company can obtain the financial instruments to adequately hedge the guarantees they are providing to the investor. In Great Britain, Merrill Lynch HSBC is offering what they call “PIP” investments, which stands for Protected Investment Product. CIBC World Markets is the dominant Canadian purveyor of equity-linked notes.⁵

According to the ABA Banking Journal, today’s wealthy investors are more knowledgeable about investment alternatives, and financial institutions seeking to attract or retain these customers would do well to offer alternatives, including hedging strategies for individual stocks and principal-protected notes. In effect, hedging strategies mitigate risk by locking in a range of stock prices based on floor and cap levels (through exercise of put and call options). Principal-protected notes, in contrast, offer the safety of bonds. They protect the principal at maturity, while providing the upside potential of equity markets, with returns linked to the performance of equity indices.⁶

Equity-linked notes have their share of critics. Financial advisers generally have negative to neutral things to say. “They really should be pushing these in a bull market, not after a bear 155market,” expresses Carl Carpenter, portfolio manager with Tar-box Equity. John Markese, president of the American Association of Individual Investors says, “It’s hard to find ten-year time horizons where stocks have lost money. Even over seven-year stretches, the S&P has lost money only four times going back to January 1926.” Even industry critic John Bogle states, “If you are skittish about the stock market, perhaps you are better off staying out of stocks altogether.”⁷ Market-linked CDs have been the subject of similar criticism.

It’s interesting how the perspective can change as the market changes. In May 1998, in the midst of a bull market, Money magazine mentions the Merrill Lynch “Protected Growth” equity-linked notes in an article entitled “Is this Kind of Insurance Worth the Cost?” The “cost” referred to by the article was the fact that dividends (1.4% for the S&P 500) were not included in the calculation of index gains. In addition, there is mention that some of the notes do not offer 100 percent of the participation of the index.⁸

A little over three years later, in August 2001, Money did an article entitled “A Walk on the Safe Side… Securities with Downside Protection Are Looking Pretty Good These Days.” The article mentions finance professor Zvi Bodie, a believer in equity-linked notes, who has been quoted as saying, “There is no mix of stocks and bonds and cash that will give you what you can get by investing in equity-linked notes.” This positive article, by a different author than the 1998 piece about equity-linked notes, questions why we haven’t heard more about them since they’ve been around for over six years. Quoting from the article: “Perhaps investors weren’t interested in downside protection because they didn’t believe the markets could go down. How times change.”⁹

Equity-linked notes and market-linked certificates of deposit both offer participation in a particular market index with 156downside protection. Both have very similar structures and are underwritten by banks and brokerage firms.

Other institutions that offer returns tied to the market with downside protection are insurance companies. The equity-index annuity is configured differently than notes and MCDs and offers another kind of investment vehicle that works well for long-term commitments.

INSURANCE COMPANIES—EXPERTS IN EVALUATING RISK

An insurance company can cover just about any kind of risk as long as it isn’t a speculative risk. Trained in the intricate nuances of statistics and probability, insurance actuaries can calculate a premium that allows the company to cover its claims and make a reasonable profit on its capital. State insurance departments closely monitor all aspects of insurance company operations, including ongoing financial health, the reasonableness of premiums, and claims processing.

Annuities

An annuity is an investment whereby you receive an income either for life or a specified number of years. There are two types of annuities: immediate and deferred. An immediate annuity is funded with a single, lump-sum payment, and the income starts soon after the investment is made, usually within twelve months after purchase. A deferred annuity is funded with a single lump-sum payment or a series of flexible payments. Distribution begins at some undetermined time in the future, typically at retirement.

Immediate annuities have very little flexibility. The investor gives up rights to the principal in return for the guaranteed payment. These are used to provide a steady fixed payment, usually for life. Deferred annuities are the more flexible and appropriate choice for most people. Many investors never actually157 take the guaranteed income (annuitize) their investment offers but instead take withdrawals during the distribution phase of their contract.

Annuities have favorable tax treatment when purchased outside of a qualified retirement plan. Payments into an annuity are not tax deductible, but the earnings are not subject to current taxes. Any earnings on the annuity are tax deferred until they are drawn out in the future. The IRS considers that earnings are withdrawn first and principal last for tax purposes. If a withdrawal is made before age 59-1/2, it may also be subject to a 10 percent federal tax penalty. For this reason annuities are considered as appropriate investments for retirement accumulation and as a supplementary savings mechanism for retirees.

Deferred annuities may also be subject to surrender charges by the insurance company. These charges are in addition to the 10 percent penalty that the IRS dings you for early withdrawals, which makes annuities suitable only for long-term objectives.

Annuity payments are invested in either fixed or variable accounts. Variable annuities offer a combination of mutual funds and guaranteed accounts as investment options. The insurance company does not make any warranties as to the safety of principal on the underlying investments in a variable annuity unless they are specifically identified as guaranteed investments. Because the money is placed into unprotected mutual funds, most variable annuities are not suitable for the risk-averse investor. However, if the guaranteed accounts are attractive, the protected investor can consider these options within the variable annuity.

Fixed annuities offer a solid guarantee of principal by the insurer and are appropriate for the protected investor. When you purchase a fixed annuity, the issuer guarantees you a return of principal along with a stated minimum interest rate during the accumulation phase. 158

Equity-Index Annuities

Another type of fixed annuity is the equity-index annuity. The returns on the equity-index annuity are tied to market indexes instead of a fixed interest rate. As a result, the equity-index annuity has greater upside potential relative to a fixed interest annuity, even though both types guarantee principal.

The financial engineers who work for insurance companies have been improving the equity-index annuity design, even as the financial markets (interest rates and volatility) have made it a more challenging environment. I expect that we will continue to see creative innovations that protect principal while providing for market-linked returns.

The more often an annuity resets and the gain is locked in, the better for the investor, especially when the market is volatile and has both up and down years. Excellent equity-linked annuities are available today that have an annual reset provision. This means that any gains are locked in yearly. With the annual reset, the worst case is that the annuity doesn’t return anything for the year. This practice makes it easier to envision the protected investment process as a series of steps from year to year. Some years it’s a level step where no money has been made, but no money has been lost either. Other years it’s a step up as the investment grows in value. The size of this step will vary with the market. There is never a step down! The new investment base is always protected.

The modern equity-index annuity allows for the compounding of any gains on an annual basis. In addition, the annuity will offer a variety of indexes as well as a fixed interest account that returns can be linked to. For example, one of the most popular equity-index annuities allows investors to allocate funds among the S&P 500, S&P 400, Dow Jones Industrial Average, Russell 2000, and a fixed account with competitive interest. Within thirty days after each anniversary date the investor can reallocate funds among these five choices. Since the funds are in an annuity this is a tax-free transaction.

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Equity-index annuities do not currently give 100 percent of the increase in a particular index without some sort of modification or cap. Modifications may include calculating the gain based on an average rather than on the point-to-point method. Under the point-to-point method a “margin” may be deducted from the calculated gain or any gain may be reduced by a participation rate of less than 100 percent. The cap would put a maximum on the amount of the gain in a particular period. These factors change as the financial markets change.

Approximately one half of all annuity assets are in qualified plans.¹⁰ If you place an annuity in a qualified plan such as an IRA, you are taking advantage of unique investment guarantees that the annuity can provide, which are not available with other investments. Even market-linked CDs and equity-linked notes don’t have features like an annual reset provision and automatic compounding. By their very nature, equity-index annuities are long-term investments that are very suitable for retirement plans such as IRAs, SEPs, Keoghs, and 401(K)s.

The modern equity-index annuity does not have an up-front sales charge, so 100 percent of the money that is placed in the annuity goes to work for the investor. The insurance companies usually have a decreasing surrender charge or penalty for early withdrawals. The surrender charge period generally varies from five to fifteen years. The policies with the longer surrender periods should provide relatively better benefits. Be sure to compare policy terms and stated benefits to determine who is offering the best plan. A professional who specializes in protected investments should be able to do this for you. Most policies allow the owner to draw out up to 10 percent each year without a company-imposed penalty. If you are under 59-1/2, there will be the 10 percent IRS penalty to contend with.

Before investing in any insurance company product, make sure the company is financially strong. A. M. Best and Weiss Ratings assign grades to insurance companies based on financial 160strength and ability to meet obligations to policyholders. In addition, Standard & Poor’s and Moody’s assign ratings on insurance company debt. See Appendix B for rating information.

I read an article on equity-index annuities that made an interesting analogy. Here is an excerpt:

I’d like to add that when you win on the equity-index table, your winnings could be compounded without any risk of losing what you have already made.

Upside without the Downside

In the early 1990s National Home Life (now called Peoples Benefit Life) issued an equity-index annuity with the return based on the five-year performance of the S&P 500 index. The policy provided for the higher of 100 percent of the increase in the index or a minimum return of 3 percent per year over five years. There was a cost of 5.75 percent to buy the policy and a five-year minimum commitment.

A $10,000 investment in the policy on the first of April 1994 resulted in a net investment of $9,425 after the sales charge. Therefore, the minimum value of the contract five years later was $10,926 ($9,425 compounded at 3% per year). The S&P 500 index on the first business day in April 1994 was 438.92. Five years later on April 1, 1999, the index was at 1335.18. The index more than tripled over the five-year period. As a result, 161on April 1, 1999, the value of the account grew to $28,652 using this point-to-point methodology.

At this stage the investor could cash out, transfer to another account, or commit to another five years under the same terms without paying a sales charge. This value was now locked in and couldn’t decrease regardless of what happened to the market subsequent to this reset date. Therefore the minimum guaranteed value in April 2004 is $33,215 regardless of where the index closes at that time.

I gave a talk in front of a group of investment brokers in late 1993 that was suitably entitled “Stocks Suck.” I reasoned that it made no sense to be in stocks or mutual funds when there were alternative investments available that provided the possibility of the upside of the market, a guarantee against loss, and even a small minimum guaranteed return. Why mess with the stock market when this is available?

The feedback was less than enthusiastic. Here are sample comments: What about the dividends on the index? Isn’t 5.75 percent too high a cost to get in? When has there been a five-year period when the market wasn’t up? Wouldn’t a mutual fund give a higher return? There was very little worry about the possible downside of the market but lots of concern about not doing as well as the market. I argued that these kinds of investments remove the gambling aspect of stock market investing for very little cost. Most felt that this wasn’t a troubling factor because historically the market has always increased if given enough time.

Unfortunately, this particular annuity is no longer offered. Of course, whenever a return is tied to the market, remember that past performance is not necessarily indicative of future results.

Averaging Is Not Always a Bad Thing

Using a daily average to calculate an investor’s possible gain does not always reduce the return. It depends on how the market behaves in the period of averaging.

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Unforeseen events such as the tragic day of September 11, when terrorists struck america can have a dramatic affect on the market. The stock markets closed and then reopened on september 17. The market dropped sharply in this first week following the attack. After this week of big losses the market began to rebound sharply, but by September 2002, the market was lower than the lows of a year earlier.

A contrast between some of the major indexes on September 25 of these two years is as follows:

See Table

An annuity with a point-to-point method of calculating the gain with an annual reset would provide no return to the investor during this period because there was no gain to share in. That’s the bad news. But the good news is that the investor wouldn’t have to share in any of the losses either. So for this one-year period the point-to-point annuity investor had a return of zero.

For annuities using daily averaging a dramatically different picture results. The beginning index set is the same, but the daily averaging actually served to benefit the investor in this case. Take a look at these figures:

See Table

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An annuity with a daily averaging methodology of calculating the gain actually generated a gain to the investor during this period when the market was down significantly on a point-to-point basis. Depending on the insurance company and the original issue date of the policy, this gain was reduced slightly by a participation rate or index margin. For example, Midland National Life policies issued on September 25, 2000, indicated a 100 percent participation rate and a 1 percent index margin on the Russell 2000 index for daily averaging policies for the one-year period ending September 25, 2002. As a result, the investor in the Russell 2000 index received a 14.4 percent (15.4% - 1%) return for this year. This gain was locked in regardless of future index performance. The investor actually had a nice positive return in a year that the Russell 2000 index was down 9.4 percent!

Most policies allow the investor to change the allocation of money between indexes if so desired for the next yearly period, including a fixed interest option that is not tied to the market. I always like to have a small portion in the fixed account so that there is at least some increase from the previous year.

Depending on how the numbers fall, one calculation method may provide far superior results to another. Averaging would have reduced the return significantly in the point-to-point example for the five years ending in 1999 because the market pretty consistently increased during this period. But the point-to-point method contains the risk of giving up prior gains during the calculation period.

Another popular interest crediting method is called the high-water mark look-back. Account values are locked at their highest level as determined by a policy anniversary measurement. However, before future earnings may be added, the market must totally recover from any downturn. Therefore, if the index immediately drops, it must fully recover from the 164loss during the calculation period before getting into positive territory.

In times of tremendous volatility averaging may be the better way to go. In any event, the more often the gain gets “locked in” and the index reset, the better in a volatile market. We want to participate in the gain in the up periods and avoid the pain in the down periods. The equity-index annuity allows us to do this.

If there is enough money involved, multiple equity-index annuities with diversified issue dates may make sense. Gains are usually calculated on a policy year basis. So the issue date determines the annual reset date and the beginning index for determining the following year’s performance. September and October are historically considered the “danger” months for being in the market. If this trend continues, these are good months to include in your time frame for purchasing an equity-index annuity that uses averaging.

It also makes sense to consider annuity policies with different methods of calculating the gain (point-to-point versus averaging) for diversification. One may provide far better results compared to the other in different market environments.

Equity-Index Life Insurance

If you own any life insurance that has a cash value, you may want to consider converting the policy to equity-index life insurance instead. I believe that, strictly speaking, life insurance should be purchased primarily for death protection. Term insurance, which generates no cash value, provides a death benefit at the lowest possible cost. Policies with cash values include whole life, universal life, variable life, and equity-index life insurance. If a policy that has a cash value is purchased, it is an investment in addition to providing the death benefit.

For short-term needs, cash value life insurance is a terrible investment. Returns can actually be negative if the policy isn’t held for a certain period of time. However, if life insurance is 165needed to meet long-term objectives and you are saving for distant needs such as retirement, guaranteed cash value life insurance can be viewed as a reasonable low-risk investment. This applies especially to individuals with high tax rates who have a need for the insurance. Current tax laws permit tax-free accumulation of earnings inside a life insurance policy.

Cash value life insurance has been a popular investment mechanism with many people over the years. But in 1979 the Federal Trade Commission announced results of a multiyear study that showed returns on whole life policies held for twenty years or more were averaging only 2 percent to 4.5 percent per year. This came out when interest rates had soared as inflation skyrocketed.

Around 1980, the concept of comprehensive financial planning and having a trained financial planner recommend a course of action in line with an individual’s goals and objectives was becoming popular. Planners were recommending that people borrow large amounts from their policies or even cancel their policies to invest in other areas, including money markets that were paying over 10 percent at that time. Insurance companies have been scrambling ever since to offer more competitive policies in an attempt to regain the confidence of the consumer.

In 1967, according to the Bureau of Labor Statistics, about 44 percent of households used a personal life insurance agent. In 1988 this figure had dropped to 32 percent. The United States had 252,000 agents in 1973 and only 190,000 in 1998. Aside from a brief surge in the 1980s caused by the introduction of universal life policies, the number of insurance policies sold has fallen annually over the past twenty years. Obviously the industry and its agents have yet to regain the full trust and confidence of the consumer, even though the products now offered by the industry are superior to those issued in the past.

The universal life policy offers tremendous flexibility as compared to the old whole life policies. The policy owner, 166within certain guidelines, can alter the premium payment and the death benefit in response to changing needs and circumstances. The insurance company can change the mortality (probability of death) charge as trends change. This is good for the consumer if people are living longer because this cost would decrease. The company can also change the interest that is credited based on changes in interest rates, usually with a guaranteed minimum.

Variable universal life allows the policy owner to invest the cash value in separate subaccounts that are not guaranteed by the insurance company. These separate accounts include mutual funds, and there is no guaranteed minimum return. The investment risk falls on the shoulders of the policy owner.

Equity-index life is actually a form of universal life. Policies provide for a guaranteed minimum interest rate, a current interest rate, and a bonus rate linked to the performance of the S&P 500 index. The guaranteed minimum rate is usually in the 2 percent to 3 percent area. The current interest rate is either the same as the minimum or a higher rate declared by the company. The bonus rate is calculated by a formula based on the one-year performance of the S&P 500. This number is multiplied by an index factor, which can change yearly.

If there is no bonus interest, the policyholder is still getting a return that is only slightly less than would be received in a traditional universal life policy. Over the long run the equity-index policy is likely to provide above-average returns in some periods and credit only the guaranteed minimum return in others. The concept appeals to me. Each year the value is increasing regardless of how the market performs.

The notion of partially participating in an up market and locking in the gain while having a guaranteed minimum rate of return is appealing to risk-averse investors. They are happy to participate partially in the up side as long as there is absolutely no participation in down markets. In periods of extreme volatility the market may drop dramatically in one 167period and increase impressively in another. It’s nice to completely avoid the free falls but benefit when times are good.

I want to emphasize that equity-index insurance works best when there is a need for the death benefit and the owner is in a high tax bracket. Some people buy cash value life insurance as a means of forced savings. Life insurance cash values should be viewed only as a supplement to an investment plan. I’ve seen situations where a person is overinsured because of placing too much trust in the advice of an aggressive insurance agent.

BE WARY OF SOME PRINCIPAL-PROTECTED INVESTMENTS

The horrendous losses suffered by investors in the early 2000s have created opportunities for financial marketers to create many products that protect principal and come in all shapes and sizes. Beware of products that advertise principal protection but include contingencies on receiving the protection. I’ve seen products that advertise protection, but only in the event of your death or disability. Other products will have an attractive minimum guaranteed rate, but require that you take out a limited amount of principal over time at a very low rate in order to receive the protection.

Variable annuities with a guaranteed income rider are often misunderstood or misrepresented. They will guarantee a high rate such as 6 percent. You pay an extra fee for this rider each year. The problem is that in order to cash in on the guarantee you have to annuitize the contract over many years at a very low interest rate. The risk-averse investor should avoid variable annuities. They have relatively high fees and are most suitable for risk-tolerant mutual fund investors seeking tax deferral. The rider gives the purchaser of the annuity a false sense of security.

There are also principal-protected mutual funds that offer a period of time in which the principal is protected. These funds 168generally invest in a combination of zero coupon bonds and a managed portfolio of equities. Be wary of possible high annual expenses (over 2 percent) and sales charges. Relative to market-linked CDs and notes, as well as equity-linked annuities, the principal-protected mutual funds are a poor choice.

You may also run across other investments that sound like they are principal protected but have downside risk. An equity-linked product called a reverse-convertible is marketable to investors in periods of low interest rates. These securities provide double-digit interest returns, but the investor takes on the risk of being delivered the underlying equity or index. This means if the index or security is down significantly, the investor will lose money. Be sure that your investments are principal protected even if the underlying index or equity drops to zero.

WHY HAVEN’T I HEARD OF THESE BEFORE?

In the European Union and Japan individual investor demand for equity-linked investments has soared. If you venture into any of Banque Generale du Luxembourg’s forty branches across the Grand Duchy, you will find posters promoting Protected Sector Notes. “Energize your portfolio!” they urge, with the participation in the gains of an international basket of leading equities while providing the investor with principal protection.

At the counter, leaflets promoting Banque Generale du Luxembourg’s array of protected products are available. Open a copy of the local newspaper, Luxembourg Wort, and you will find advertisements for equity-linked debt products being promoted by most European banks. It’s a pattern being repeated across Europe and Japan.¹²

Interestingly, the first publicly traded index-linked note, issued in 1991, wasn’t offered by a bank or brokerage firm, but 169through the government of Austria as a five-year bond linked to the S&P 500 index.

Market-linked investments have been available in the United States since the early 1990s but relative to the overall investment universe have been nothing more than a niche product. One reason for this is that investors and their advisers did not see the need for a product that provided protection against loss. The average investor underestimated the risk of investing in the stock market until the bear market of the early 2000s shocked everyone into reality.

Another factor inhibiting the growth of market-protected products in the United States has been distribution. Equity-index annuities and insurance are purchased through insurance agents. These are not securities but are considered fixed products. Only licensed insurance agents may sell them. Only one in twenty insurance agents has ever sold an equity-indexed product. There are many variations and features of indexed insurance products, and many agents don’t understand them.

Registered representatives of brokerage firms sell market-linked notes and CDs. These are considered securities. The very premise of guaranteed principal protection is at odds with the traditional teachings of risk management, so many brokers and advisers discredit them as illegitimate investment candidates. In addition, the trend with investment advisers is toward charging fees for advice in lieu of commissions. A fee of 1 percent per year for five years in a managed portfolio is much greater than a one-time commission of 1 percent or 2 percent that a broker makes from the sale of a five-year note or MCD.

You are sure to hear more about protected products as time goes on and investors demand better protection of their hard-earned savings. Insurance agents and registered representatives who want to be of service to the risk-averse investor will have to invest the time to become adequately trained in the nuances of protected investments.

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GETTING THE HELP YOU NEED

Depending upon your situation, you may need the expertise and guidance of others when you are implementing a plan to protect your assets. If you are just starting out and saving for your first house, the simple plan of keeping expenses under control relative to your income is your first priority. Stay away from credit card debt, and get the highest interest rate you can with your cash savings. There are thousands of banks and credit unions in the country. You may be able to double or triple your interest by doing a little comparative shopping.

Financial Professionals

Financial professionals who can help you with the planning and implementation of your protected strategy include the following:

• Certified Public Accountants—Experienced CPAs have a natural tendency to be conservative and are ideally suited to help you construct a plan of protection as well as help you with tax planning issues. Some CPAs are also trained as Personal Financial Specialists. It takes a lot of training and study to become a CPA, indicating a dedication to the profession.
• Financial planners—Anyone can call himself or herself a financial planner. No license is needed. A Certified Financial Planner (CFP) or Chartered Financial Consultant (ChFC) has been trained in all aspects of financial planning and passed a regimen of nationally administered examinations on investments, taxation, estate planning, and risk management.
• Insurance agents and stockbrokers—Many financial planners also have an insurance license and a brokerage license. The examination process is less intensive than the professional designation programs.
• 171Investment advisers—Investment advisers charge a management fee based on the amount in an account, or an hourly fee for giving advice. There is no exam or special training required at the federal level to become a registered investment adviser.

It’s a challenge to find one professional who can assist you with all aspects of a Protected Plan. For example, a CPA may be able to help construct a plan, but generally you’ll need an insurance agent or broker to show you the various protected investments that are available. In this case the CPA can help with the comparison and help analyze and select the best-protected investments for your situation.

If you can find a professional who agrees to help you implement your strategy without trying to sell you on their “unique” mutual funds, stock management program, or other unprotected investments, you may have found a valuable resource. Shop around. Check out their experience, education, and professional background. The adviser should have experience and earned at least one professional designation such as CPA, CFP, or ChFC. Try to avoid the slick sales types and find someone you can freely communicate with who is patient enough to explain how things work.

I would be sure to work these two questions into the discussion with a financial professional:

1. How often do you utilize market-linked certificates of deposit, equity-linked notes and annuities, as well as equity-index life insurance?
2. What kind of planning strategies and investments would you use for a conservative investor concerned about risk of loss, but also concerned about missing out on possible stock market gains?

The answers to these questions should tell you whether you are going to receive real help with your investment plan that 172effectively manages risk, or the same old stale advice. You can get the insurance agents and brokers to research the protected investments their firms offer and put together a plan yourself. They will receive some sort of compensation if you purchase the investment through them, so you shouldn’t have to be concerned about paying an additional fee for the information. In any event the first priority for the risk-averse investor is to make certain that the portfolio is fully safeguarded against loss.