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“So what do you think of annuities?” I typically hear that question about three or four times a year, but in the past two years, with the market volatility and the fear that goes with it, this question has cropped up more and more. The reason is: fear sells. And when annuity salespeople are rampant in the market touting these products and promising that they offer “guarantees” and “higher rates of return,” people start to take notice because financial planning is so important. Hmmm … where do I sign up?
Types of Annuities
There are various types of annuities, each with different benefits, depending upon where the assets are invested and when payments begin. A “fixed” annuity, for example, provides a specified rate of interest for a period of time, while a “variable” annuity offers greater opportunity for growth but also comes with higher risks. Other types include “indexed” annuities, “deferred” annuities, “single premium” annuities and “flexible premium” annuities. Keep in mind that the cost of these products often is directly proportional to their complexity – the more complex, the more money someone will pay for the product and, typically, as happens with complex products, the less a customer will understand what he or she is buying.
I’m not generally a big fan of annuities, mainly because they are expensive, have potential negative tax consequences, and are complex and confusing. For clients who come to us already owing an annuity, I’ve often asked them general questions about it, and they looked at me with glassy eyes and said they hoped I’d tell them. Without getting into to all the details and nuances of the different types of annuities, the following are some of the pros and cons of owning them in your portfolio.
Pros to owning annuities:
- An immediate lifetime annuity contract can guarantee periodic payments for life (main risks are inflation and the credit-worthiness of the company)
- Provide an option – compared to CDs – for those who are risk-averse and don’t want to risk losing part of the savings (fixed annuities still have credit and inflation risk)
- Provide a steady source of income
- Allow investments to grow tax-deferred (qualified and non-qualified annuities)
- No restrictions on who can invest (anyone can purchase a nonqualified annuity)
- Can be customized to fit your needs
- The sum value of some annuities are guaranteed to be at par or greater than the value of the amount invested (variable annuities – this benefit usually comes at a very high cost)
- Are backed (in some cases) by state guarantee funds, so if the company cannot pay, investments may not be lost (vary by state)
Cons to owning annuities:
- They are very expensive! I haven’t found one client who wasn’t completely shocked when we pointed out the fact they were paying (in most cases) between 2.5% and3.5% per year for their product
- Offer (mediocre) insurance coverage (one of the biggest selling points)
- Investment options are restrictive to mutual fund subaccounts that are often very expensive on their own (variable annuities)
- A big selling point is the tax-deferred savings, yet I find other retirement plans (especially employer-sponsored 401(k) plans) a much more attractive, less costly, less complex, simpler means of funding for retirement
- Lack of liquidity – funds are often tied up for six to eight years and are subject to a sizeable “surrender charge” if withdrawn early
For retirees, an annuity offers an assurance of a stream of income for life or for a specified period of time. For those who fear the potential loss of their money due to poor investment choices, that “guarantee” can be attractive. Keep in mind that that while the annuity income can look big, a good portion of the annuity’s income is a return of principal. The problem with buying into this (and paying too much for that guarantee, in my opinion) is that there are numerous other options that are typically more flexible and suitable that should be explored. But in the end, if having an annuity will help someone sleep better at night and bring them peace of mind, then a diversified portfolio manager at FIM Group can help find low-cost/low-load products that do not, for example, charge surrender fees or have very low expense charges. There are a handful of good products on the market, and we can help provide the due diligence before buying.
If you currently own an annuity, or are interested in learning more about these products, please feel free to call one of FIM Group’s advisors. We’d be happy to explore whether or not an annuity may be appropriate for you.
Protecting Your Assets
The majority of FIM Group accounts are held with Charles Schwab and Co., Inc., our main custodian, we feel that now is an appropriate time to remind our clients about the internal protective practices and stringent standards taken by Schwab that are designed to ensure the safety and security of your hardearned assets:
- Keeping Client Securities Separate from Broker-Dealer Securities – Client securities – such as stocks and bonds that are fully paid for or excess margin securities – are segregated from broker-dealer securities, in compliance with the SEC’s customer protection rule. In the unlikely event of insolvency of a broker-dealer, these segregated assets are not available to general creditors and are protected against creditors’ claims. This is a legal requirement for all broker-dealers.
- Account Protection by the SIPC and Lloyd’s of London – Schwab’s asset security measures offer protection for securities and cash by the Securities Investor Protection Corporation (SIPC). All Schwab accounts are insured by SIPC for securities and cash in the event a broker-dealer fails financially.Additional brokerage insurance is provided through underwriters at Lloyd’s of London. This additional protection becomes available in the event that SIPC limits are exhausted and there are no additional funds available from the estate of the failed brokerage firm.
- FDIC Coverage – The Federal Deposit Insurance Corporation (FDIC) is a U.S. federal agency that protects investors against the loss of their deposit accounts (such as checking and savings) in the event of the failure of an FDIC-insured bank. All deposit accounts held at Schwab Bank, including the Schwab Bank High Yield Investor Checking® account and the Schwab Bank High Yield Investor Savings™ account, are FDIC-insured.
- Information Security Measures – In addition to protecting clients’ assets, Schwab is committed to protecting client privacy and safeguarding information. – To learn how Schwab protects client privacy, visit >www.schwab.com/privacy – To learn how Schwab keeps client personal and financial information safe online, visit www.schwab.com/schwabsafe – To learn how Schwab plans to provide continued client service in the event of disruption to normal business operations, please visit www.schwab.com/businesscontinuity.
Invest with a margin of safety
Recently several FIM Group managers presented a webinar in which we discussed the markets, economy, investments and Roth IRAs. One of the topics we touched upon involved giving investments a margin of safety. Great investors are naturally disciplined toward investing with a margin of safety. Investing icons like Sir John Templeton and Warren Buffett, for example, talk about importance of discipline and a process of evaluation to ensure that a significant margin of safety exists for every investment made. For many investors, price is the best safety enhancer. For example, if you buy a dollar bill for 50 cents, you have less risk than if you paid $2.00. What a company is worth, of course, lies in the details and complexities of the “What is it worth?” decision. You need to evaluate if you are paying less than what it’s worth with a degree of safety that compensates you for the risk and possibility of making a poor investment choice.
At FIM Group we use both soft and hard – qualitative and quantitative – techniques when making the “What is it worth?” decision. Since the numbers are the easy part, as they are the known variables, we spend a lot of time on variables such as management, ethics, industry, product and product strategy analyses. All of this bakes into a decision that potentially involves hundreds of decision tree branches.
Based on past participation, the most popular webinar we’ve conducted to-date is titled “What’s in My Portfolio and Why?” FIM Group will continue to host webinars on relevant investment topics. Visit www. fimg.net for the most up-to-date webinar information, and be on the lookout for e-mail alerts announcing upcoming webinars. If you prefer, or if it’s easier than accessing an online webinar, you may contact any FIM Group representative, and he or she will send you a CD that you can review anytime.
What gives an investment a margin of safety?
- Sort through Millions of Opportunities
(50,000+ stocks) - Good Management
(If Steve Jobs Took Over GM) - Good Industries
(Health Care, Food, Energy, Entertainment) - Good Ethical Values
(Transparency is Reality) - Good Companies
(Fad or Needed Goods & Services) - Good Products and/or Services
(Make Great Companies) - Good Balance Sheet
(Little Leverage) - Free Cash Flow/Income
(Cash to Reinvest or Pay Dividends) - Skin in the Game
(Insider/Family Ownership)
KEY
Buy and sell at the right price.
BOTTOM LINE
Prices fluctuate due to the liquidity of the markets, instant emotional responses and crowd behavior.
Volatility is a friend of the wealth-creating investor.
