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Posts Tagged ‘FDIC’

It’s natural for investors who are still skittish after a decade-long roller coaster ride with the stock market and plummeting real estate values to be risk averse and seek out investment alternatives for protecting their nest eggs for retirement, college funding or simply their emergency cash.

And where there is demand, there will be supply.  So naturally, financial firms will design products geared toward satisfying this demand.

One such product that’s getting more attention recently are Market Linked Certificates of Deposit (CDs).

These are in essence a savings product designed to provide a minimum guaranteed interest rate plus the opportunity to increase the return by linking to the return of a specific market index or in some cases an index for inflation.

Such products are part of the larger class of “structured products” produced by investment banks that can come in many flavors and various strategies:  reverse-convertibles, principal-protected notes, Exchange Traded Notes.  They essentially are debt bundled with a derivative and marketed as a way to bet on stocks and interest rates as a way to manage certain risks. All offer in one package strategies using some sort of derivative and may offer a combination of principal protection, risk reduction and/or enhanced returns.

Recent surveys of more than 17 brokerage firms and more than 38 million investors show that most of these products are used by those with under $500,000 in investable assets.  For those with assets between $250,000 and $500,000, about 1.5% of their assets are placed in such products which is slightly higher than the 1.33% of assets for those with under $250,000 to invest.  (Investment News, 11/15/2010, page 52).

More than $70 billion of such products are held by investors with more than $42 billion bought in 2010 according to Bloomberg data.  And given continued uncertainty about the markets, the demand looks like it will not be abating any time soon especially as financial marketing organizations use investor fears as a selling point. Brokers and banks often receive higher fees and commissions for selling such products.

Keith Styrcula of the Structured Products Association said in a recent interview “these kinds of investments have become so attractive because people can no longer trust stock market indexes to go up.” He added that “there’s a lot of fear in the market right now, and a lot of investors don’t just want one-way exposure anymore.”  (Investment News, 11/15/2010, page 51).

But even though these products are marketed as a way to reduce risk they are not risk free.  There is no free lunch and this is no exception. Such products are subject to liquidity risk, market risk, credit risk and opportunity costs.

Market-Linked CDs are a form of principal-protected note offered by an investment bank.  These are not your Grandmother’s bank CDs.  First, such notes are offered as debt of the sponsoring institution so there is always the potential of credit risk.  Think of Lehman Brothers which was a large producer of such notes.  If the issuing firm fails, as Lehman did, the investment is at risk. While there is FDIC-protection on the principal, that may be small comfort when dealing with the time frame to get access to your money through a FDIC claim process.

They may involve a complex strategy which may be buried in the details of the offering’s prospectus.  For market-linked CDs, for instance, the issuer offers the downside protection by managing a portfolio of Treasury bonds (like zero coupon bonds to meet the projected maturity date of the CD).  The upside potential that is offered comes from investing in the bond yield through various strategies.

In such a low interest rate environment, these notes work only if provided sufficient time for the issuer to implement its strategies.  This is one reason that such CDs typically have long lock up periods that can be five years or more.

An issuer may guarantee a minimum interest amount but this is typically not FDIC-insured.  And this is really an obligation of the issuer so that’s where the credit risk comes into play. And you should note that the minimum guarantee usually only applies when the investment is held to maturity.  An investor will lose this guarantee by redeeming before the contract maturity date. And because of the nature of these products, there really is no secondary market around to allow someone else to buy you out early.

The upside potential is calculated based on the performance of the index chosen.  The CD investor does not own the index or the stocks in the index.  The issuer uses its money to invest and potentially reap the dividends issued as well as the appreciation.

What the issuer offers to the CD investor is a certain percentage of the upside gain of the index (called a participation rate) but limited by a ceiling (called a cap).  This calculation of the gain can be convoluted for an investor to understand. While it’s pretty simple to understand a typical CD (put $1000 in at an annual interest rate of 3% means you have $1,030 at end of the period), the same is not true for market linked CDs.

Your gain may be based on an average (so now the question is how are they calculating that average: monthly,  semi-annually, annually, term of the CD) or a Point-to-Point calculation. (Example: If the market index is 1000 when the account opened, went up to 2000 after one year but drops to 1050 by the maturity date, then the point-to-point is from 1000 to 1050 or 5% in this case).

In many ways these are similar to other structured products like market linked annuities (sometimes referred to as index annuities or equity-indexed annuities).

I addressed many of the same issues about calculating returns and possible risks in a post on the subject a while back.

Bottom Line:

Whether or not such products make sense for your personal portfolio really requires a good, long chat with a qualified financial professional. Like any other investment, the potential risks and opportunity costs need to be weighed against your personal goals, time frame, liquidity needs and the potential offered by other alternative options.

So if you are considering such products, just be aware of all the risks and look beyond the marketing brochure at the local bank.

Resources:

SEC Investor Education on Market-Linked CDs

MoneyLinkPro Blog Post on Market Index Annuities

Wikipedia Definition

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Like the mythical siren’s call, the pitch is enticing – a seemingly perfect investment.

Investors can buy into a contract offering a minimum return with the potential to capture the upside of increases in the stock market while avoiding portfolio value declines if – and when – the market goes down.

This blend of promises can be found in ‘equity-indexed annuities” or EIAs offered by insurance companies.

And these offerings have become popular given the steep declines in the stock market.  According to a report in the WSJ (9/02/09), sales of EIAs during the first half of 2009 rose 20% compared to a year ago to $15.2 billion.

As compelling as these products may sound, they are anything but simple.  There are many complicated moving parts to each EIA contract. So buyer beware!

Think of investing as finding the route to your destination (a goal) and matching that with the appropriate mode of transportation (or investment vehicle) to get you there.  You may be traveling from Boston to New York and can choose highways or back roads. You can choose hi-speed rail, a car, a bus, a bike or even a plane.  You can drive or fly yourself or hire someone else to drive. All will get you to where you want to go but it’s a question of what kind of comfort level you want on the ride, how much time you have to get there and at what cost – in fees or simply mental health.

For those who may not have the stomach for the gyrations of the stock market but are looking to be more venturesome, the EIA may be a suitable compromise. It’s sort of like someone hiring a driver for the trip but traveling on main roads while avoiding highways.

First, understand that an annuity is offered by an insurance company and backed by the credit-worthiness and deep pockets of the insurer.  There is no FDIC backing. This is not a bank product (although you may find them sold by brokers with desks in banks).

Next, understand that an index can be any benchmark for any asset class or market.  The most common benchmarks include the Dow Jones Industrial Average (DJIA), the S&P 500 and NASDAQ in the US.  Overseas, indexes include the NIKKEI in Japan for instance.

An equity-indexed annuity (EIA) ties the amount that will be credited to an investor’s account to the performance of a particular index. 

But don’t expect to receive a one-for-one increase in your account value based on the index’s increase.  Instead, these contracts include a “participation rate” that sets a percentage of the index gain that is used.

The index-based interest credit may be further limited by “caps” that set a maximum amount of gain.

For anyone who has ever had an Adjustable Rate Mortgage, the process is very similar to how loan rates are recalculated.

Calculating the interest credit is further complicated by the method of measuring the change in the index value.  For instance, the insurer can determine the index change based on the “Annual Reset” – the difference between the index value at the beginning and end of each contract annual anniversary date.  Or a “point-to-point” method may be chosen that compares the index value at the beginning date with some future date like the fifth anniversary. Or the insurer will use “index averaging” taking multiple index returns and averaging them.

By the way, the index value won’t include changes resulting from dividends. While total return on the S&P 500 averaged 9.5% between 1969 and 2008, more than one-third of the return was attributed to dividends.  So these EIA market participation formulas will be calculated on a lower base when dividends are not considered part of the index return.

Typically but not always, there is a minimum amount of interest that is credited. But be aware that this minimum interest credit may not apply to 100% of the contract value.  It may apply an interest rate of 3% to only 90% of the value.  It may apply 1.5% interest to 85% of the total value.  It all depends on the terms of the contract.

EIA contracts have dual values:  the one based on the index value, participation rate and cap; the other based on the minimum interest credit.  And if you get out of the contract before the full term, you may be forfeiting the index-based account value. The insurer would then pay out the amount based on the minimum guaranteed portion which may be lower than what you expected compared to the index formula.

And how many football fans would be happy if their favorite team was on the 1-yard line and the referees moved the goal post?  Well, most EIA contracts reserve the right to unilaterally change terms reducing the participation rate or using stiffer lower, caps for example.

And most contracts have very steep surrender charges that can start at 10% to 15% of the contract value in the first year and declining from there for up to 10 years.

And be aware of the financial incentives that are part of these contracts.  Some EIAs offer “bonuses” to investors – an extra 5% or 10% added to the initial deposit.  But there is no free lunch.  In exchange for such a bonus, the insurer will likely increase the surrender penalty.  So as much as the bonus is an incentive to open the contract, the penalty is an incentive to not move the money out.

Follow the money, too.  Many EIAs pay out commissions to brokers between 6% and 10% and sometimes more.  An investor should be aware that there may be an incentive by a salesperson to offer this as a catch-all solution whether or not it fits the investor’s particular situation. 

The advantages to an EIA include the opportunity to participate in the upside of a market index as an alternative to investing directly through mutual funds for instance.  When an investor opens up an annual statement, there may be less apparent volatility because the account balances aren’t fluctuating wildly.  So this may help a conservative investor dip a toe in the market and sleep better.  And like most annuity products, investors have free access to a portion of their money without surrender charge (usually 10%). And like any other insurance product, it provides a guaranteed death benefit.  Like other annuities, it offers an income stream that you cannot outlive.

The average return on such EIA contracts has been reported to be in the 5%-6% range.  Given the complexities of these contracts and the average returns, it may be a costly way to limit your market exposure but it may make sense for those looking for a principal-protected CD alternative for the cash portion of their portfolios as well as a source of income to supplement retirement.

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PAYING FOR COLLEGE.

 

 

Do you own a business (full time or part-time)?  Do you own investment real estate or a farm?

 

Would you be interested in learning how to use IRS rules to help you pay for college?

 

If you want to find ways to pay for college without ruining your personal retirement, there is hope (and it’s not just the renames tax credit mentioned below).

 

In this series, we’ll go over the various strategies available to help parents explore the various possibilities to reduce taxes and improve the odds for receiving financial aid, grants or scholarships.  (Consider this: There are more than 110 different strategies.)

 

Food for thought: 

 

  • Encourage your pre-teen to open a Roth IRA with earnings from their paper route or other jobs.
  • Consider hiring your child to work in your business or help with chores related to your investment property.
  • Use a CollegeSure CD issued by an FDIC-insured bank to accumulate savings
  • Think about using a fixed income annuity to hold a portion of money for college to avoid the potential loss in principal that can happen with a 529 plan invested in mutual funds.

Tax Tips:

 

The Hope education credit is renamed the “American Opportunity Tax Credit,” is increased to $2,500, and applies to four years of

college, not just the first two. In addition, 40% of the credit is now refundable. Income limits apply.

 

Another break for those paying higher education expenses: In 2009 and 2010, funds in Section 529 college plans can be used tax-free to pay for

students’ computers, computer technology, and Internet fees.

 

For more information on this topic, continue to check out this blog as well as the weekly Wedesnday night conference call series.

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