On annuities -- When I reflect on the terrible products sold to my father and father-in-law, I am only able to conclude that annuities exist only for their sellers to make money off of the assets of the ignorant or feeble minded elderly.

Which of the following investments-CDs or Variable Annuities- provides the greatest protection of Principle?

I am planning to invest $5,000 for 1 or 2 years towards the purchase of a new car. Currently have $13,000 in CDs, but am looking to improve the "return" if possible (current Return at 4.5%). Your comments would be much appreciated.

Bob

From Scott Burns:

You don't want to invest in a variable annuity if you will need the money in two years--- the early redemption fees will absorb your return. Variable annuities, if they have any use at all, are only good for long term investments.

Your alternative is to find another kind of annuity, one that is structured like a CD and allows your interest income to accumulate tax deferred until maturity. Here's the link to a website that provide yield information on these products: http://www.annuityadvantage.com/annuitydata.htm

Note that it lists terms starting at 3 years and that the yields are in the area of 4 percent. That's probably less than you are looking for.

Scott,

I read your column today on annuities and know from past articles you do not like variable annuities and I don't really blame you. You explain the life choice of the immediate annuity but I have never seen you address the split fixed annuity, period certain, which I think is a safe investment for seniors who can withdraw from an annuity without the additional 10% charge. Of course a large, well rated company must be used. e.g. A person with $1 million could get $50,000/year from a 5% CD, all of which is interest for tax purposes, and maintain the principal. If they take the same amount and invest $200,000 in a 5-year period certain immediate annuity, then step the remaining in 5 year and 10 year fixed instruments at 5%, they could maintain the same amount or more of spendable income while hedging the interested rate changes. Right now the $200K immediate for 5 years would only produce about $45K/year income,depending on the Insurance company used, but only $5K of that would be interest income for taxes, the rest being return of principal. This can be beneficial, especially to widows. I know one right now who, between social security, some veterans benefits and annuity income, lives comfortably and pays no income tax at all.

J

From Scott Burns:

I have written about split annuities, but not for many many years. It's a good tax cutting strategy if your life is pretty simple. Unfortunately, many who use the strategy don't consider the fact that they are rolling a tax liability forward. They could pay less in taxes today at the expense of being in a higher tax bracket for taxes they pay tomorrow.

Long ago, few retirees would have this problem. But that was before the taxation of Social Security benefits. Today, using this vehicle could easily raise a retirees future tax rate because future money would be tax deferred interest whose use would trigger taxation of BOTH itself and Social Security benefits.

I need help for my mother who is the benificiary of a 401k and life insurance from my brother who died very suddenly. She lives on social security and the $600.00 a month my brother gave her. Now he is gone and need help with what he left to her. Would she be able to put money into a roth ira and draw money as she would need it. I do not want her to lose her social security. Her home is paid for. My Mother will be 76 in March. Any advice will be greatly appreciated.

  

From Scott Burns:

A Roth IRA wouldn't be appropriate for your mother. If her Social Security income is 100 percent Social Security she will not lose it. If a portion of her benefits are "Supplemental Security Income" then income as a 401k beneficiary would reduce her SSI. But NOT her Social Security.

The 401k money should probably be rolled into an IRA account that could be invested in a low risk mutual fund. Exactly how it is invested would depend on the amount to be invested.

It is also possible that your mother would benefit from having a portion of the 401(k) account money turned into a life annuity. It would increase her monthly income and simplify taking care of the money.

But I see interesting statistics out there every day about Mutual fund investors NOT getting that magical average of the S&P 500 because they get scared, and move out of the markets everytime there is a downturn and jump in only after the markets have been up substantially. As a matter of fact, I saw the exact example on your website for a "grandma that messed up". If an investor is in a VA with an income guarantee (and I don't know where you get your information, but they are not that punative or complicated) of a NET 5% of what they put in, they stay invested through the ups and downs. So a VA with an income guarantee cost about 2% more per year than the same, naked mutual funds. How much growth did granny miss out on by going to money market in July?

I agree completely with you concerning Equity Indexed Annuities. They are terrible for the most part. Some have 14 year surrender charges and they can be as high as 25%.

Variable annuities are only "Bad' if the rep does not disclose the pro and the cons. The commissions on VA's are in line with that of any loaded mutual fund. I know reps who hate them, say they are a rip off, then put all of their clients into managed money or wrap fee accounts. And proceed to charge the client 1-2% to manage that money. The money goes into mutual funds for the most part. So the cost is the same for the VA and managed money, yet managed money cannot add an insurance rider that may or may not ever be used. BUT the rider does give the investor piece of mind to stay invested instead of having a knee-jerk reaction and bail out of the markets (i.e. this past june when the markets dipped and Israel and Lebanon were warring).

Ted

  

From Scott Burns:

My response to variable annuities is about the numbers. It's not about hating or loving, it's about what serves investors best. One of the interesting things about variable annuities is that the people who are enthusiastic about them are the people who sell them. You'll find very few members of NAPFA (the fee only financial planner group) who have any use for Vas because commissions have not influenced how or what they think.

Many issues with Vas are iatrogenic in nature, meaning that the treatment (a VA) is what causes the problem. Fees on Vas are so high that the vast majority of the money is in equity funds because that's the only place where it makes any sense at all. That, in turn, increases the appeal of the guarantees that add still more costs to the burden.

The better alternative is broad diversification in unmanaged index funds. Balanced funds did well during the 2000-2002 crash and people with broad diversification (e.g. international, REITs, value, and small cap) have done very well. Over the last 5 years, for instance, a simple five or six part portfolio of index funds returned 13 to 14 percent, after expenses averaging about 33 basis points. The five year period included the worst of the three year meltdown for most investors, 2002.

An investment advisor (not a salesman) can do this for a fee. Even a full 1 percent annually would be a smaller burden than the fees built into most VA products.

It's about the math. It's not about what I feel.

  

I agree, it is about the math.   Perhaps you should look at the research John Huggard did on VA's vs. Mutual Funds.   He was commissioned by the mutual fund industry to do a study showing the advantages of MFs over VA's.   His conclusion is that the advantages go to the VA.   One of the reasons is that not all of that 1099 income from MF's is long term capital gains.   Perhaps on an index fund it would be, but go to Putnam's website and look at their release on cap gains for 2006.   For many of their funds, about 1/3 of all the gains pushed to investors is short-term.   That will be taxed as ordinary income.   Trading costs and expenses are higher in traditional MFs that the sub-accounts in VA's.   Of course a client should use equity funds in a VA.   To buy fixed or bond based funds is foolish.     The income guarantees allow the investor to increase equity exposure, to try for greater gains, because they know what the safety net offers.   No such thing is available in stand alone funds nor with a money manager.   Without income guarantees, a VA's M&E costs will be very similar to   the NAPFA fees.   I wonder what you think the commission structure is on VA's?  

As for NAPFA, please show me the advisor that 1% is on the high end for their clients.   Perhaps for the clients with over $1 million.   But what about the "average Joe" that you are trying to help?   1.5%?   2%?   Of course the way to keep cost low, the average investor should open an "e" account and buy ETF's and manage that themselves.   Although many get scared when any volatility creeps in.   Then they want an advisor to take over the reigns so they can blame someone else for difficult markets.

I just don't think the math is as bad as you think.   Again, I would encourage you to look at the work John Huggard has done

   From Scott Burns:

If it's about the math, it's good to start with someone who can do it accurately. That isn't John Huggard. His work is riddled with errors that run from simple math to conceptual. When I read his book I got so angry at his sloppiness I had to stop reading. His publisher should be ashamed at publishing a book with such a lack of basic accuracy.

If you think I'm being a crank, check with Bill Reichenstein at Baylor. When I called him to ask if he was familiar with Huggard he said he had testified as an expert witness about Huggard's errors.

As to the 1099 income, the original NAVA sponsored study from a major accounting firm was a farce of assumptions that tilted the results. And that's without considering the index fund cure.

I agree with you about general fee levels, NAPFA or not, but I think that's a problem the industry will have to deal with--- the financial services business model, with its 200 basis points goal, is inherently damaging to clients. My expectation is that the broad level of fees will continue to come down over the next decade--- it will come down fast if we have a period of below average returns.

Scott,

Thanks again for another great article last week. I made copies and passed it around at work. We (at my company) don't always appreciate the value of our pension plan because it is so "hidden" (they can't see it on their W-2's and can't spend it now). We only recently began receiving yearly statements that show us how much we are entitled to once we retire (that happened after I wrote a letter to our General Manager asking for such a statement). I've been reminding some of the folks at work here over the years, what a great benefit our pension plan is. I have now been asked, "If one did buy an annuity would you be taxed on the steady steam of income that you would receive?" This is a logical question relating to your article last week. We want to make sure we are comparing "apples" to "apples". We know we have to pay tax on our pension plan income, but if you bought the annuity with after tax dollars, one would think at least some of the annuity income would not be taxed.

Joe

From Scott Burns:

You're dead right on both counts.

Defined benefit pension plans will probably be most appreciated when they are no longer available and everyone has to struggle with the issue of squeezing a lifetime income out of their investments. It costs about 7 percent of payroll to adequately fund a DB pension--- that's more the twice the amount most corporations spend on matching funds for their 401(k) plans. So a major cost has been shifted to workers. Having a DB plan through my employer allowed me to invest more aggressively in our 401(k) plan so I am twice thankful.

Also right about the taxation of DB plan income. Since it was never received as income, it is 100 percent taxable. A life annuity purchased with after-tax funds, however, is apportioned between interest income and return of principal based on your life expectancy. Since part of the monthly income is treated as return of principal, your tax bill can be significantly lower.

Mr Burns

I am a 50yr widow with 2 children under 12 and approx $500,000 to invest for my retirement. My advisor has recommended I invest $300,000 in Accumulator GMIB. Leave it alone for 12 yrs and I will be able to draw $36,000. yrly for life. The cost is 2% yrly! I will also draw about $12,000. yrly from SS. The other $200,000. is to be invested in a diversified equity portfolio with a 1% management fee. According to their analysis I will need $91,000. a yr to live off of with 3% inflation and my current expenses of $67,000. yrly at 62. By 86 I will need $185,000. a yr and be broke, except for the $36,000 yrly annuity which will not even come close to what I will need.

Why is this a good investment strategy? Considering I am just now reentering the work force after a 12 year absence I will probably need to withdraw some of this investment before then. They are counting on me adding to it! When I first met with this group I told them I only wanted a financial plan. Now they are upset with me because I am not jumping on their management fee plan. I feel like I shouldn't be doing this but I don't know where to turn to for advice that will benefit me and not just the broker. (This is a friend of mine.) With this plan she is the only one guaranteed a profit!

What would happen if I just put all of it in your Four Square or Five Fold plan and left it in their for the next 35 yrs??

Please don't laugh! I have $300,000 in a money market fund right now and the rest in investments of stocks and mutual funds which has made about 8% over the last 10 yrs. I am feeling very desperate!

Thank you! BM

From Scott Burns:

Walk away. Don't look back. Most offers of financial plans are "loss leaders" that are done in expectation of "gathering" your assets into products with substantial commissions. That is exactly what has happened here with the advice of putting $300,000 into a GMIB variable annuity. These products lock up your money, kill flexibility, and are very expensive to leave. That's not what you need. As a widow with children you need flexibility. And all of us need to manage our investments at low expense.

There's also a practical side that has been ignored. Currently, you need income for yourself and an additional amount for your children. What you personally need, later, is not a simple projection of what you are spending today because the children won't be an expense in the future.

I think you would do much better with the building block portfolios--- and the more building blocks the better. You'd have diversification, flexibility, low expenses, and a high probability of superior long term returns. A separate and more conservatively invested portion of the assets should be put aside for your children's education.

You've got a lot of decisions ahead of you. I know it may not seem so now but you are the most important element in all this--- how you decide to spend money, when and how you go back to work, what you decide to do about shelter (and when), etc. etc.

We recently asked an advisor to develop a financial plan for an upfront fee. This was done, along with reccommendations for investment, advice on long term care, and wills. My wife and I both are receiving pensions that have COLAs, and I am working part time. Social Security is about 1.5 years away for my wife(62), and 3 years away for me(66).We have about 250k in savings, with about 140k in qualfied plans. He suggested 1% savings, 3-4% emergency fund, 5-6% short term fund, and the rest invested in the market as index funds and an annuity called the "Balance Plus Annuity" by American Investors Life Insurance Company. The amount going to each would be based on our comfort with the market. I asked about variable annuities based on your prior comments. He said this was not a variable annuity, but I'm not sure exactly how it would be described. We are not comfortable with the market and are considering rolling the qualified money to the annuity. Are you familiar with this company and this annuity? Is there a better one that you could suggest? Thanks, S.C.