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Return To Bonds Article Archive   Financial Planning and Retirement - A New High Yield Savings is in Town By David Lewis Traditionally, there has only been one way to earn interest on your savings (as opposed to investing in the stock market or some other type of variable financial contract): find the highest fixed interest rate you can find, put your money into that account, and hope for the best. It could be a savings account, a bank CD, or a fixed annuity or life insurance. But, this also meant that if you were to buy into any of these you had to accept that fixed rate and no more. If the stock market started doing well, you would have to draw some (or all) of your money out of one of these accounts and place it into a higher risk account. Today, no such need exists. Some life insurance companies and banks are providing an innovative saving option to their contracts called "equity indexing". This concept makes it very easy to reap the upside of the stock market without any of the downside risks - all without investing in the stock market. If the stock market gains 10%, so can you. If the stock market loses 10%, not only do you not lose money, you actually make a guaranteed fixed rate of return. How could anyone possibly offer something like this, and more importantly why? How do companies offer you the upside of the stock market without any of the risks of investing? The first point that should be stressed is that by using a contract which promises an equity indexing feature, you are not investing in the stock market in any way, shape, or form. You are giving your money to a bank, brokerage house, or an insurance company and in return they are acting as a financial intermediary. In return for buying into such a contract, they are willing to pay you handsomely if the stock market gains value. The "index" part of "equity indexed" represents a number used to measure the general behavior of stock prices by measuring the current price behavior of a representative group of stocks in relation to a base value. The Dow Jones, for example, measures 30 of the largest and most established companies in America; often referred to as "blue chip" companies. It consists of companies like Walt Disney, Wal-Mart, and Microsoft. The S&P 500, on the other hand, measures 500 large cap companies, most of which are American. To make an equity indexed contract work, there needs to be two components: bonds (or bond-like instruments) and index call options. A bond is a loan made by the Government or a corporation to another party, usually an institution like a bank or a life insurance company. These pay a fixed rate of return. If the bond is going to pay (i.e. if the debtor - the Government or the corporation - does not default on the bond) it will pay the stated interest rate. There is no variance. Government bonds are widely used and deemed to be "good as gold". Highly rated Corporate bonds, or "investment grade" bonds, carry very little risk of default. An index call option is a stock option. A stock option is the right - but not the obligation - to buy or sell stock for a preset price (which is set when the option is purchased). There are two types of options: call options and put options. A put option is the right to sell stock at a preset price, and a call option is the right to buy stock at a preset price. So, for example, if you thought that a company's stock was set to gain value, but you weren't 100% sure that it would, you could buy a call option for much much less than buying the actual stock. Essentially, you are able to control a large amount of stock with very little money up front. You don't actually own the stock and you don't ever have to buy the stock, which is what gives you protection if the stock doesn't do as well as you expected. However, there is an expiration for every option. And...the longer the expiration date, the more expensive the option will cost (i.e. a 3 month call option may cost $500, but a 1 year call option may cost $750). An index call option is a call option on a stock index - usually the S&P500 stock index. Banks and insurance companies are able to use a very precise mix of bonds (to guarantee the contract owner's principal plus a small amount of appreciation) and index call options (to capture the upside potential of the stock market) to produce a new type of contract that gives the contract owner the upside potential of the stock market, without any of the downside risks associated with a direct investment in the stock market. Equity indexed contracts do provide a guaranteed minimum, but the guarantee is usually weaker than in traditional 'declared rate' contracts, like bank CDs, and this is because the focus is on the upside potential of the contract. If fixed rates are higher or comparable to indexed returns and you would like to take advantage of fixed rates, some contracts provide the option to switch to fixed rate returns that mirror current bank CDs or annuity contracts. Insurance companies and banks are willing offer indexed returns because they are obviously making money with this approach. They can afford to credit you with the interest gains, because just like every other financial product, these contracts also have their own expense and administrative charges. Are these contracts right for me? Equity indexed contracts traditionally offer higher returns than fixed interest contracts, but often do not provide the same kinds of returns that some stocks can provide in a rising stock market. In addition, because the equity indexing feature is tracking an index, there are no dividends that will be credited to the contract as there may be in a direct investment in the stock market. An equity indexing strategy serves as a more aggressive approach to savings by providing potentially higher interest rate returns than a fixed interest contract. David C Lewis, FMM, RFA specializes in financial planning and retirement His website provides free information about pre retirement planning and other related financial topics. keywords: equity indexing | savings | rate of return | guaranteed rate of return | high yield | high yield savings Commodity Investing

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