by Kennon Grose 

       What is sold using fear tactics and pays the maximum benefit upon death?  

      
       The VARIABLE ANNUITY – a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you.  There is no other investment description on the Securities and Exchange Commission website (http://www.sec.gov/investor/pubs/varannty.htm) that has a highlighted warning label.


 Caution!

-  "Other investment vehicles, such as IRAs and employer-sponsored 401(k) plans, also may provide you with tax-deferred growth and other tax advantages.  For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity.

In addition, if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA), you will get no additional tax advantage from the variable annuity."

        Scott has written a number of very good articles about the variable annuity and normally, I would not feel the need to add one.  (http://assetbuilder.com/blogs/scott_burns/archive/2005/07/12/Answering-the-Variable-Annuity-Industry.aspx)  However, in conducting our many portfolio assessments, we are encountering a lot of investment holdings with variable annuities.  The story is always the same; the weary investor was sold through misleading sales techniques and inadequate disclosure. 

        Therefore, we have chosen to take a closer look at the variable annuity as an investment.  One of the big selling points used to entice our client was the quality of the underlying mutual funds.  (NOTE: it might be helpful to read the article, “The Ingredients of the Portfolio Assessment”, to understand definitions. http://assetbuilder.com/blogs/capital_gains/archive/2007/10/29/the-ingredients-of-the-portfolio-assessment.aspx)

Variable Annuity

The Director Plus – The Hartford
Current Value - $433,557.46
Surrender Charges

Year 1 2 3 4 5 6 7 8 9
Charge 8% 8% 8% 8% 7% 6% 5% 4% 0%

Annual Insurance Charge – 1.60%
Front-end Load (Commission) – 5% to 7%

The Assessment
The following funds are the underlying investment for The Director Plus.

Description 12b-1 Fee Gross Exp Ratio Allocation Value   Morningstar Overall
Star Rating
Hartford Intl Opportunities - IB 0.25% 0.98% 21.01% 91,090.41 Foreign Large Blend 4
Hartford Capital Appreciation - IB 0.25% 0.88% 19.71% 85,457.33 Large Blend 5
Hartford Stock - IB 0.25% 0.72% 13.02% 56,440.05 Large Blend 3
Hartford Value Opportunity - IB 0.25% 0.89% 4.34% 18,832.81 Large Value 5
Hartford Growth Opportunity - IB 0.25% 0.88% 5.58% 24,185.31 Mid-Cap Growth 5
Hartford MidCap Value - IB 0.25% 1.02% 16.87% 73,145.39 Mid-Cap Value 4
Hartford Small Company - IB 0.25% 0.95% 19.47% 84,406.16 Small Growth 5
Total   0.92% 100.00% 433,557.46    

Observations:

  1. The front end load – sales commission – five to seven percent.  This represents a pretty good pay day for the Broker ($20,000 – $28,000) assuming $400,000 initial investment.

  2. The 12b-1 fee will be used to further compensate all of the “servicing” agents.

  3. Per the representation of the Broker, these funds have good Morningstar Overall Star Ratings.

  4. The estimated portfolio gross operating expense is below the average and therefore is a plus for this portfolio.

 

The comparative AssetBuilder Building Block Portfolio 13.
Description 12b-1 Fee Gross Exp Ratio Allocation Value
DFA 1 yr Fixed Income 0.0% 0.18% 3.00% 13,006.72
DFA 2 Yr Global Fixed Income 0.0% 0.19% 10.00% 43,355.75
DFA US Large Co 0.0% 0.19% 8.00% 34,684.60
DFA US Lg Cap Value 0.0% 0.28% 9.00% 39,020.17
DFA US Sm Cap Value 0.0% 0.53% 8.00% 34,684.60
DFA US Micro Cap 0.0% 0.53% 6.00% 26,013.45
DFA Real Estate 0.0% 0.33% 16.00% 69,369.19
DFA Intl Lg Cap Value 0.0% 0.44% 10.00% 43,355.75
DFA Intl Sm Cap Value 0.0% 0.70% 10.00% 43,355.75
DFA Emerg Mrkts Value 0.0% 0.63% 10.00% 43,355.75
DFA Emerg Mrkts Small Cap 0.0% 0.81% 10.00% 43,355.75
Total   0.45% 100.00% 433,557.46


Projecting performance of this Broker recommended variable annuity back in time to 12/2003 provides the following historical results

12/2003 - 9/2007 N Periods Geometric Mean (%) Arithmetic Mean (%) Standard Deviation (%)
Hartford Director Plus 2 Intl Opportunities IB 46 20.80 21.48 13.02
Hartford Director Plus 2 Capital Appreciation IB 46 18.32 18.99 12.77
Hartford Director Plus 2 Stock IB 46 10.14 10.49 8.94
Hartford Director Plus 2 Value Opportunities IB 46 13.38 13.88 10.81
Hartford Director Plus 2 Growth Opportunities IB 46 17.53 18.35 14.07
Hartford Director Plus 2 MidCap Value IB 46 14.32 14.96 12.23
Hartford Director Plus 2 Small Company IB 46 14.84 15.86 15.52
Hartford Director Plus 46 16.23 16.81 11.71

 

 

Definitions:

Geometric mean – represents the real growth of your dollar. For example, if a stock fell 50 percent in the first year, and rose 50 percent in the second year, then it would be incorrect to report its “average” increase per year over this two year period as the arithmetic mean (-50% + 50%)/2 = 0%. According to this measure, you would still have your dollar. The correct calculation is the geometric mean which yields an average loss per year of 13.4 percent. Correctly reflecting the true value of your dollar at 75 cents.

Standard deviation – is a measure used to determine how much something fluctuates. The S&P 500 Index has a standard deviation of 19.6 percent. This means that it will provide its long-term average return, about 10 percent, in any year plus or minus 19.6 percent. It will do this two-thirds of the time. So it will return somewhere between 30.6 percent and minus 9.6 percent (10% +/- 19.6%) in most years. The return will be greater, or smaller, the remaining one third of the time. The greater the standard deviation of an asset, the greater our risk.

N Periods – number of months we can go back in time to review historical returns and standard deviation. From 1/1999 to 9/2007 is 105 months.

 

The comparative AssetBuilder Building Block 13.
12/2003 - 9/2007 N Periods Geometric Mean (%) Arithmetic Mean (%) Standard Deviation (%)
DFA One-Year Fixed-Income 46 3.19 3.19 0.73
DFA Two-Year Global Fixed-Income 46 2.97 2.97 1.01
DFA Intermediate Government Fixed-Income 46 4.02 4.11 4.30
DFA Five-Year Government 46 3.27 3.31 2.68
DFA Five-Year Global Fixed-Income 46 3.45 3.48 2.68
DFA U.S. Large Company 46 11.96 12.27 8.45
DFA U.S. Large Cap Value 46 15.20 15.72 11.08
DFA U.S. Small Cap Value 46 14.74 15.78 15.78
DFA U.S. Micro Cap 46 11.56 12.55 15.19
DFA Real Estate Securities 46 19.49 21.25 20.70
DFA Intl Value 46 26.34 26.96 12.76
DFA Intl Small Cap Value 46 27.30 28.02 13.76
DFA Emerging Markets Value 46 43.56 45.63 24.76
DFA Emerging Markets Small Cap 46 37.34 39.08 22.15
AB BB 06 46 9.15 9.24 4.42
AB BB 07 46 11.08 11.21 5.55
AB BB 08 46 12.73 12.91 6.58
AB BB 09 46 14.64 14.90 7.80
AB BB 10 46 16.02 16.33 8.53
AB BB 11 46 17.73 18.11 9.54
AB BB 12 46 19.37 19.83 10.61
AB BB 13 46 20.77 21.30 11.42
AB BB 14 46 22.05 22.64 12.23

The historical result is AssetBuilder Building Block 13 delivers 4.54 percent per year additional return with less risk. Adding the annual insurance premium further reduces the investor’s return.

Even with “good” funds, the high costs of the compensation schemes, fees and expenses make the variable annuity a “poor” investment choice.