Upside, No Downside?

February 22, 2023
Upside, No Downside?
           You've likely heard the phrase "market participation without downside risk". This is usually in reference to an investment or contract that tracks a certain index, like the S&P 500, and performs based on that index. Since you are not buying the index, only tracking it, you don't participate in the downside (depending on your contract). These products often include “indexed” or “equity-linked” in their title and can come in the form of annuities, life insurance, even FDIC Insured CDs. So how do they do it? Tradeoffs.
           Tradeoffs, in this case, are what you give up for protection from downside risk. For some people these tradeoffs help their financial plan. For others, they are not worth giving up.
Liquidity: Surrender penalties and lock-up periods decrease liquidity. Certain products/ investments have penalty-free amounts available but rarely is your full account balance available until the end of the contract. There is generally a “free-look” period at the start of the contract when you can get you’re full premium/investment back but after that it becomes very difficult.
Growth: The limit on upside can come from four places.
Caps - If you're capped at 30% and the index goes up 65%, you receive 30%. Missing out on 35%.
Participation Rate (Par Rate) - If the participation rate is 80% and the index goes up 10%, you receive 8%.
Spreads/Asset Fees - This amount gets deducted from the performance of the index before it’s credited to your account.
Rider Fees - The more "perks" you add to an investment or contract, the more it costs, which lowers your returns. If you have an income rider on a policy but guaranteed income isn’t a concern, the rider fee isn’t worth it.
Opportunity Cost: What could have been! By taking risk off and lowering liquidity, you’re now in a position where you could miss out on returns in riskier assets. You may be at a stage in life where less risk is more important than potential returns. That’s great as long as you are making the decision based on a well executed financial plan.
           If you are strictly looking for downside protection with upside potential, keep it simple. Remember, the more you add to a product, the more expensive it becomes which is why indexed annuities and life insurance struggle to compete on a pure return basis. If you don't have a need for them, things like insurance, income riders, and healthcare doublers can really dampen your returns. Not to mention the high commission costs the company pays to agents.
           Similar to every decision we make, every investment has tradeoffs. No investment or insurance product is inherently “good” or “bad”. They become “good” or “bad” based on how they’re used. If you are considering investing in a product that offers downside protection (or doesn't), make sure you fully understand the risks and tradeoffs. Our team at Rock Martin Wealth can help guide you through the process of understanding.