Moment on Money

Letter to Clients: 3rd Quarter 2012

Dear Clients and Friends,

Last quarter I highlighted two services available to you at no charge, shredding and notary public. This quarter I am excited to introduce a new service which I believe can make a significant impact on your financial health.

In the last week of June we launched new software with tremendous functionality. As a client, one of the best features is that it acts as a data aggregator. We create a private, secure website for you. When you log in the first time all of the accounts we manage for you will be there and are updated continuously. You can add in other accounts we do not manage for you; bank accounts, credit cards, mortgages. Basically, you can add about anything you have online access to.

This allows you to have a clear understanding of your current financial situation and it provides me with a complete set of data to integrate into your financial plan. After a plan is developed, the system will alert both of us if we stray off too far from the plan. The system even provides budgeting features, can track your awards programs such as credit card points or frequent flyer miles, and provides a safe place to store and share digital documents.

Yet to come this month is an entirely new website, www.dvfin.com, built around the new system. For the time being, the new website is live but only has a short two minute movie showcasing the system and place for clients to login. Please visit the site and watch the movie. We would love to hear your feedback. Let me know if you would like to start using the new system and we will get you started.

Stocks or Bonds: The lesser of two evils?

The first half of 2012 was a tale of two quarters. The first quarter represented the strongest start for the U.S. stock market since 1998, the second quarter gave back some of those gains. Many investors feel as if they are facing a range of unattractive choices. Stocks appear dangerous and bonds yields are unattractive.

The second quarter saw volatility well above historical norms. Holding stocks has always been risky if your time frame is short, but geopolitical uncertainty and market swings make owning stocks feel especially dangerous today.

There is considerable debate about whether stocks are expensive, cheap, or fairly valued. Some observers express doubts about the sustainability of today's record corporate profit margins and the enduring impact of debt problems and slow growth around the world. U.S. stocks also show up on the pricey side using models such as the valuation approach advocated by Yale's Robert Shiller, comparing stock prices to average earnings over the past 10 years, adjusted for inflation.

On the other side, a fair number of reputable analysts view stocks as historically cheap, pointing to attractive ratios of stock prices to book values and measures like multiples of earnings and cash flows. Indeed, using Shiller's multiple of average 10-year earnings, Europe is inexpensive by historical standards.

Bonds pose different risks. Interest rates are historically low as central banks around the world keep interest rates down to spur economic growth. Given current inflation, in normal times we would expect to see interest rates about 2% higher than today, but of course these are not normal times.

Holding cash to eliminate risk from stocks and bonds virtually guarantees depreciation of purchasing power, and for many investors, cash gives them no chance of earning the returns they need to achieve their long-term goals.

Dan Fuss: Replace market risk with company risk

Dan Fuss is vice chairman of Boston-based Loomis, Sayles & Co. With over 50 years of fixed income experience, he is one of the most highly regarded bond managers of all time. Still actively running money in his mid-70s, Fuss manages a bond portfolio with over $20 billion in assets that over the past 20 years has been a top performer in its category.

In an April interview with Investment News, Fuss made an unusual recommendation for a bond manager: to sell bonds and buy stocks. The reason relates to the risk of rising interest rates. "We're in the foothills of a gradual rise in interest rates," he said. "Once they start to rise, you're probably looking at a 20- or 30-year secular trend of rising interest rates."

He went on to say that when the unemployment rate falls to between 6% and 7%, it's likely that Ben Bernanke and the Federal Reserve Board will alter the policy that has been keeping the interest rate on the 10-year Treasury bill artificially low. "Once that happens, you need to get out of the market risk that's in fixed income and into the company-specific risk you can find in stocks," Fuss said.

Bob Farrell: Market rules to remember

In the 1950s, Bob Farrell attended the same Masters program at Columbia as Warren Buffett studying under Benjamin Graham, the father of value investing. In 1957, Farrell joined Merrill Lynch as an analyst and retired as their Chief Investment Strategist in 1992, although he continues to provide his perspectives through articles and media interviews.

In 1992, Farrell penned 10 rules on investing. Of course there are no hard-and-fast investment rules which can predict what the market will do in the near-term or long-term, but two of those 10 rules are particularly pertinent today and give me encouragement about stock returns in the mid- and long-term period ahead.

Rule 1: Markets return to the mean over time

"Returning to the mean" is another way of saying that over time, performance on stocks will revert to historical averages. The long-term annual return in the U.S. stock market going back to 1926 is 9.8% before inflation and 6.6% after inflation, also known as the real return. Whenever you have an extended period in which returns exceed the long-term average, chances are a period of underperformance will follow. The opposite applies as well; a long period of underperformance will be followed by a period of above-average returns.

The 1990s saw average real returns of 14.9% annually, the best decade on record. Then reversion to the mean kicked in, and the following 10 years saw an average annual loss after inflation of 3.4%. Add the two decades together and you get a real return that's 1% below the long-term average. In essence, it's taken the last decade to rectify the valuation excesses of the previous 10 years—but with that behind us, history (and Bob Farrell's rule on reversion) suggest that long-term real returns going forward should be closer to the 6.5% average.

Rule 5: The public buys the most at the top and the least at the bottom

Since the financial crisis, total assets in U.S. fixed-income funds have more than doubled to over $2 trillion, up from $1 trillion at the start of 2008. At the same time, we've seen record outflows from U.S. equity funds. To me, this is further indication that, provided you have a time frame of five-plus years and can tolerate the kind of volatility we've seen of late, investing in a well selected stock portfolio is likely to serve you well.

Your portfolio

Benjamin Graham, the Columbia professor mentioned earlier under whom Bob Farrell and Warren Buffett studied, gave this advice in 1963:

"In my nearly 50 years of experience on Wall Street, I've found that I know less and less about what the stock market is going to do, but I know more and more about what investors ought to do…. My suggestion is that the minimum amount [of the investor's] portfolio held in common stocks be 25% and that the maximum be 75%. Consequently the maximum amount held in bonds would be 75% and the minimum 25%…any variations should be clearly based on value considerations."

Today I would add a third asset category to the mix, alternative investments. I believe the Benjamin Graham's message from 1963 is not so much about the allocation percentages, but more about diversification. He taught us to neither commit fully nor to abandon any asset class, but instead to remain flexible and constantly seek value.

Given stock valuations and the risk in bonds, for some clients we have recently increased equity weights to the upper end of their range. Of course, market reversals from current levels are always possible; however, taking a long-term view, at current levels there is a strong case for stocks over bonds.

In an uncertain environment for immediate economic growth and equity returns, we continue to place priority on the cash yield from investments. While not suitable for all investors, the returns on some REITs, master limited partnerships, investment-grade corporate bonds, the better-rated high-yield bonds and dividend stocks in selective sectors continue to make these attractive relative to the available alternatives.

As always, thank you for your trust and confidence. Whenever you have questions, I am happy to take your call or meet with your personally. Be sure to let me know what you think of the new system, and in the meantime you can follow us on facebook.com/dvfin for more information.

Best regards,

Art Dinkin, CFP®

Happy Independence Day!

I find it a bit odd when the 4^th of July falls on a Wednesday, the middle of the week. Instead of the traditional long weekend celebration we have two very short work weeks sandwiched around one day of grills, parades, fireworks, and the 2012 special – blistering heat.

My favorite Independence Day quote comes from the man who made it all possible, King George III. On July 4, 1776 he wrote in his diary "Nothing important happened today." So if you wish, sit back and relax. Celebrate our American Independence and the freedom for which so many have given so much.

But just in case you want to work on a little financial independence, I thought I would share something I rediscovered while working on the upcoming quarterly client letter.

Bob Farrell's 10 Market Rules to Remember

Bob Farrell joined Merrill Lynch in 1957 after studying under Benjamin Graham at Columbia University. In 1967 he assumed the role of Chief Market Strategist, a post that he held for 25 years; for 16 of the 17 years prior to that, he was the top ranked Wall Street analyst in predicting the overall direction of the stock market. Farrell continued to write and make public appearances after stepping down as Chief Investment Strategist. He is best known for his 10 Market Rules to Remember, published in 1992.

1. Markets tend to return to the mean over time.
2. Excesses in one direction will lead to an opposite excess in the other direction.
3. There are no new eras -- excesses are never permanent.
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
5. The public buys the most at the top and the least at the bottom.
6. Fear and greed are stronger than long-term resolve.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
8. Bear markets have three stages -- sharp down, reflexive rebound and a drawn-out fundamental downtrend.
9. When all the experts and forecasts agree -- something else is going to happen.
10. Bull markets are more fun than bear markets

Photo Fireworks by bayasaa

Variable Annuity Prospectus: Clarity or Confusion?

A recent article in Investment News caught my attention. I didn't believe the headline, fewer investors read through a VA prospectus in 2012. How do you get fewer than none?

The article cites a poll conducted by the Insurance Retirement Institute and Cogent Research LLC. Participants had at least $100,000 in investable assets exclusive of real estate. According to the study:

• 14% claim to read the prospectus "most of the time"
• 3% say they "always" read the prospectus
• Participants who claim to do the reading, report that they actually read only 7% - 16% of the document

The variable annuity prospectus, in my opinion, is a perfect example of good intended regulation which hurts more than it helps.

The prospectus is supposed to provide an overview of the actual annuity contract so that prospective purchasers can make an informed decision before they buy. The document explains the details of the contract, the costs and fees, as well as the benefits. In variable annuities the prospectus also provides information about the various investment options known as sub-accounts.

A typical variable annuity contract may be 15 to 50 pages. It is a legal document. For those of us who are not attorneys, the prospectus is supposed to help us understand the contract.

But a typical variable annuity prospectus has ten times as many pages as the contract itself. It is not the legal contract, but it is still written by lawyers and not easily followed by a typical layman. Yet the law requires that every variable annuity purchaser first receive a copy of the prospectus. We are always compliant with the law, but many times I have had investors ask if I would just throw it away for them. Even more tell me that when the big heavy envelope comes in the mail, it gets tossed before it gets opened. The problem is so widespread that some advisors have written articles for their clients on which parts of the prospectus to read and which parts to skip.

Variable annuities can be complex investment vehicles. To fully understand them you need to understand the product as an insurance product, investment vehicle, and the potential tax implications. The intent of the rules and regulations are to provide that comprehensive information in one resource. But if the resource is no less complicated than the contract, are the regulations successful in protecting the consumer or the issuing company?

I am in favor of educating and protecting the consumer. To do that, I think variable annuity issuers should provide simple plain language summaries of their product; something an investor would actually read. Apparently I am not alone in my opinion. It is reported that as a result of this recent study the SEC is considering simplifying the VA prospectus.

Let's hope they do.

Photo Confusion by travel2write4u

Unnecessary Dread

Earlier this week I had a meeting with one of my corporate clients. They are a non-profit organization and I help them manage their investment portfolio. I love the organization, their mission, and the people but I was still dreading the meeting. I knew it wasn't going to be pretty; their investment results have been less than expected. When you are asked to sit down with the finance committee to discuss their account… well, you just know they aren't throwing you a party.

While cordial, there was no beating around the bush. The chairperson started the meeting with "Art, our account is down. Why don't you tell us where we are, how we got here, and what you think we should do." I reviewed their account, the strategy we were using, and was quite frank about where things had gone astray. They asked questions about different scenarios going forward.

No one was happy about the situation, but I expected to feel some wrath about the results. I didn't.

Instead the organization saw this as an opportunity to visit their investment policy and goals. I was surprised to learn they recently discovered an investment criteria section in their fiscal policies manual which was mostly copied from a template a consultant gave them. There was never really much thought put into it originally and it was never updated as the financial world around them changed.

The ensuing discussion was invigorating and liberating. A healthy discussion among various members of the committee was started to update what the organization should do with their money; how much risk they were willing to take; and establish socially responsible boundaries.

I had been dreading the meeting but I wish I had not fretted about it so much. All I can do is tell the truth, and as in the cliché I was set free. The organization will be better after the discussions which started today, and I will be better positioned to serve them well.

A New Web Resource

I have not been publishing as much as I would like and there is a reason. I have been busy writing for another website.

The Moment on Money blog is now 5 years old and has also served as our firm's website. But as the firm has grown so has our team and the services we offer. The time has come for us to launch a new website focused on the entire firm; www.dvfin.com. One of the features we are most proud of is the new client portal.

With this online system, clients have a personalized, secure website where we can help consolidate all of their financial data. It is a collaborative system where we can share and exchange information. Financial reports are available on demand with a few simple clicks. We can even share some of the data with other professionals such as accountants or attorneys.

The system automatically measures where you are and constantly compares it to where your financial plan thinks you should be. We can show you what would happen in any "what if" situation you could imagine, and we can model how likely it is for the plan to work.

Very recently, the client login feature went live. The rest of the new website is under development but should be released before the end of the quarter. More information about the client login system is already up on the site. Check it out. See why DV Financial is one of Greater Des Moines premier firms for financial planning, investments, and insurance.

Marble, Golf Ball, Baseball, or Beach Ball?

Which would you rather carry around in your pocket; a marble, golf ball, baseball, or beach ball?

Put a marble in your pocket and you may never feel it. Occasionally, when you reach into your pocket for change, you will see it and remember it is there but most of the time it will be out of sight and out of mind.

A golf ball is a bit bigger. Put it in your pocket and you will feel it at first. But soon you will become accustomed to it and you will be able to walk around normally. Of course it is pretty hard to ignore when you reach your hand into your pocket.

You can't ignore a baseball in your pocket. It will fit by itself, but you probably could not put anything else in your pocket. You will also notice it every time you stand, sit, or take a step. It may not be a hindrance but it certainly isn't comfortable.

The beach ball simply won't fit into your pocket, no matter how hard you try to stuff it in.

Saving for retirement can be analogous to what you carry in your pocket.

Start early enough and you just need to carry around the marble. A small consistent investment into your retirement plan, given enough time, should be enough to comfortably reach your retirement goals. Occasionally you will notice the deduction from your pay stub or bank account, but the contributions should be small enough that it is not making an impact on your lifestyle.

If you are slow to start retirement saving you can make up for your lost time by making bigger contributions. It would be similar to carrying a golf ball in your pocket. At first you will definitely feel the effect on your lifestyle but it won't take long for you to adjust. When you look at your budget it would be hard to ignore your retirement contribution, but it should not feel painful.

Some people end up waiting until it is almost too late. Having less time to save means they need to contribute more. Like putting a baseball in their pocket, it will still fit in the budget but it probably also prevents them from adding other expenses (or toys) they may want. The amount they have to save is large enough that it is difficult to overlook and is never far from their mind.

If you wait too long, you simply cannot catch up. Your retirement plans will need to change.

The sooner you start, the more comfortable your retirement savings. Don't delay; start today.

Photo credits: Marbles… by kevinjay; golf ball, at Ruth Lake Country Club by WebWideJosh; Baseball by acordova; model with beach ball by planetc1

Speeding Up the Plow Horse

Economics is not an exact science. If it were, forecasters could predict the markets much like meteorologists can predict the weather. That is why I follow several economists on a regular basis but Brian Westbury from First Trust is probably my favorite. I have been following Brian since 2007. There were times during the financial crisis when Brian would expound about a V shaped recovery and I thought he had lost it. But sure enough, almost every economic chart shows the economy rebounded nearly as fast as it fell; a perfectly shaped V.

The markets of the last five weeks have been tough. After a great start to the year almost all of the gains have been erased. Confidence is low and nerves are high. In his weekly Monday Morning Outlook, I think Brian Westbury wrote a practical, insightful, and accurate analysis of our current economy. Rather than reinvent the wheel I'd rather just share Brian's work with you (with permission from First Trust):

Speeding Up the Plow Horse, by Brian Westbury, Chief Economist, First Trust

We call it a Plow Horse Economy…it ain't gonna win the Belmont, but it ain't gonna keel over and die, either. And there is nothing in the latest data or market action that changes our mind; the economy is not in recession and we highly doubt it will fall into one anytime soon.

The Pouting Pundits of Pessimism are hyperventilating over the weaker-than-expected 69,000 increase in May payrolls, a downward revision in first quarter real GDP growth to 1.9%, a 10-year Treasury yield of 1.5%, and a stock market that has given up its gains for the year.

Back in the winter months, when the payroll numbers were relatively robust, the pessimists complained about a declining labor force. But now they ignore that the labor force rose by 642,000, while the participation rate rose to 63.8% from 63.6% in April. Not very consistent of them, eh?

That wasn't the only area of the jobs report that defied the pessimists. The household survey (which captures small businesses) reported 422,000 new jobs. This was not enough to overcome the huge gain in the labor force, so the unemployment rate ticked up to 8.2%. But the acceleration in the household number suggests the job market is not as bad as it was made out to be.

We also heard that 70% of the time an economy slows to below 2% real GDP growth a recession follows. We aren't quite sure what this is supposed to mean. If someone can show us an economy that didn't fall through 2% growth on the way to recession we will give them a million new Drachma. Regardless, recent revisions to construction data suggest real GDP growth gets revised back up above 2% for Q1.

So why do we have a Plow Horse economy and not a Race Horse economy? The answers are simple…they're the same reasons Europe had slow growth and a high unemployment rate for the past three decades: government spending, taxes, and regulation have been a huge burden. Think of a race horse carrying a 250 lb. jockey or a plow horse dragging the plow through stumps and roots in a field. Government is a burden which slows growth and reduces job opportunities. The only way to get a permanent acceleration – in real GDP, incomes, and job growth – is to lighten the load. The good news for the US is that there is a four step plan to make this happen and we're going to face all of them this year.

First is the recall election on Tuesday for Scott Walker as Governor of Wisconsin. Democrats in Massachusetts and Rhode Island – even Rahm Emanuel in Chicago – have also carried out reforms for government workers, but Walker's efforts created a massive political backlash. A Walker victory would set the stage for more reforms in other states.

Second is the late June Supreme Court ruling on Obamacare. Health insurance is an important issue and many reasonable people disagree about inequities in that market, but a government takeover would signal further growth in government spending and regulation, which would dampen the entrepreneurial spirit and increase uncertainty.

Third is the November 7th presidential election, when voters across the country get the chance to signal a desire to roll back the size and scope of government. "Core" government spending – outside of defense, TARP, interest and entitlements – has hit a record high in recent years. A change in leadership would mean a chance to greatly reduce the share of GDP controlled by Washington. Finally, the scheduled tax hike on income, capital gains, and dividends in 2013 has become a wall of uncertainty for business to overcome. If the first three steps happen, this one will too.

These steps will decide whether the US heads toward a European-like future or remains a bastion of free market capitalism. As each step unfolds, the momentum of the decisions will also become more visible. We remain confident America is a "center-right" country that respects its Constitution. If so, look out. The Plow Horse may turn into a thoroughbred.

This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

Photo Horse Plowing by BugMan50

Comparison of 401(k) and IRA

When I teach Personal Finance at DMACC, I love to ask the students "other than contribution limits, what is are differences between an IRA and a 401(k)?"

The similarities are plentiful. Both come in before tax and after tax (Roth) versions and both offer tax deferred growth. The easy difference is the contribution limits. In 2012, you can contribute $17,000 to a 401(k) ($22,500 if you are age 50 or older) versus a maximum contribution of $5000 ($6000 if you are age 50 or older) to an IRA. But there are two primary differences many retirement investors overlook; one is an advantage and the other is a disadvantage.

The advantage of a 401(k) is free money from the employer. 401(k)'s are a form of defined contribution profit sharing plan. Employers offer incentives for employees to participate because the highly compensated employees (that is generally the owners and executives of the company) may be limited in their own involvement unless enough "rank and file" employees participate. It is not unusual to see a matching incentive where the company adds to an employee's contribution. For example suppose the employer offers a match of 50% of the first 6% contributed. If the employee makes $100,000 per year and contributes $6000 to the 401(k), the employer will add an additional $3000 to their contribution. Who wouldn't be happy with a 50% "return" on their investment in the first year? The employer's money may be subject to vesting requirements, but in most situations employees are fully vested after 6 years of eligibility. Once an employee has received the employer's money and has become fully vested, there is no additional advantage to the 401(k) over an IRA.

The advantage of an IRA is an issue of control. Most retirement plan participants do not realize that they do not own their accounts. Retirement plan assets are owned by a trust, for the benefit of the employee. The trustee, who is often also the employer, has a fiduciary responsibility to act on behalf of the employee in the employee's best interest. Precedence has been established that this responsibility includes offering a reasonable selection of investments but limits the participants to only those investments offered inside the 401(k) plan. On the other hand, IRA's are owned and controlled by an individual who is free to invest in any investment which can legally be held in an IRA. Furthermore, since only the account owner can authorize a distribution, it is sometimes a lengthy process to get money out a 401(k).

So once the free money is fully vested, there is no good reason to maintain a 401(k) over an IRA. I generally recommend a tax free direct transfer from a 401(k) to an IRA whenever someone changes employment or is eligible for an in-service distribution. By doing that, they are better able to control their investment and the timing of their withdrawals.

Photo retirement by 401k

Seeing the Whole Picture

I like to believe that I am fearless. I have jumped out of an airplane several times. I have run all 26.2 miles of a marathon. Yet each of us has our nemesis, and the one fear I cannot seem to conquer is my fear of the dentist. I know it is silly and irrational. Fortunately I have found a dentist's office which is willing to work with me on this. I don't schedule routine visits, they keep track of when I am due and call me when they have a last minute cancellation. They understand that my anxiety would cause sleepless nights if I knew I had a dentist appointment coming up.

My goal is to get in and get out as quickly as I can. I'll sit down, they can do their thing, and then let me pay and leave. I don't want to discuss my teeth. I don't want to know what is coming next. Just do it. I hate when they ask me questions about non-dental issues like which drugs I take for high cholesterol. Quit wasting my time and let me leave!

I know some of our clients see our service similar to the way I see the dentist; necessary, but unpleasant. They want to come in, conduct their business, and leave. I am sure they hate when I ask questions about matters which are seemingly unrelated to matter at hand, but if I understand their entire financial situation I can sometimes offer solutions which save them considerable expense.

That happened recently. A new client came in for our first meeting. They had one issue on their agenda; but I wanted to see a complete picture.

The client is a married couple in their late 30's and early 40's with two children. One child is graduating high school this year, the other is elementary school. They are victims of the economic downturn. First, he lost his job. Later, she lost hers. They decided to start a new business but it has been slow to develop. He has since returned to the workforce, but at a significantly lower salary than he was accustomed. She continues to work on the new business full time and may soon have a deal closed to provide the capital they need to take the business to the next level.

Until financing is secured things are tight. Too tight. After a few unexpected expenses related to home repairs, their emergency reserves are down to a week's expenses. Maybe two. They came to me to get money from his IRA, regardless of the tax and penalties, so their emergency fund can return to a comfortable status … just in case.

As I asked questions I learned that they have three primary financial assets. He has an IRA, she has an old 401(k) with her former employer, and they also have a 529 plan for their oldest child. We discussed what the impact of taking a withdrawal from each account would be.

His IRA was put in a variable annuity with income guarantees about two years ago. While I did not facilitate that transaction, I agree with the choice they made. Since IRA's must ultimately provide an income, VA's with income guarantees are often a good solution. But they are not a good source for early liquidity. In addition to any IRA distribution being fully taxable, and the additional 10% federal excise tax because he is younger than 59 ½, the annuity is still in its surrender charge period. Taking money out of his IRA would cost at least fifty percent of the amount withdrawn. I told them we could do it, but there were cheaper solutions.

Her retirement fund is still with her former employer. The paperwork is a little more complex, but as a former employee she can access all or part of her balance. Any withdrawal payable to her would still be fully taxable and subject to the excise tax, but at least they would not have to pay the surrender charge.

Instead of either of those options, I suggested they consider the 529 plan. Withdrawals from 529 plans are tax free as long as they are spent on qualified educational expenses in the same calendar year as the distribution. Their son has selected a small private college. While they did get a phenomenal financial aid package, they will be spending more on his education this year than they want to withdraw for "just in case". They can take the withdrawal from the 529 plan now and put it in their emergency reserves. If things go well there will be no need for the emergency fund, their business will secure the financing, and when the college bills arrive late this summer the money will be there. If things do not go according to plan, they can spend the money in the emergency fund now and replace it with a taxable withdrawal from a retirement plan when the education bills arrive. It will still be expensive, but at that point it is unavoidable. By delaying the withdrawal from a retirement plan until it is the only option, they may not be paying taxes on money they don't actually need.

The clients really liked the plan and took immediate steps to implement it. I feel great because they have the potential to save thousands of dollars in taxes. There is no guarantee that this strategy will succeed, and the strategies presented are not appropriate for every investor. Individual clients should review with their financial advisor the terms, conditions, and risks involved with specific products or accounts.

The next time my dentist "wastes my time" asking questions, I am going to have to remember this case and realize that the professional probably knows how to take care of me better than I do.

Photo Jeff Eitzman – Uber Dentist – Colour (1 of 4) by royblumenthal

Variable Annuity Tax Deferral: Is it worth the additional expense?

I have been in practice long enough now to have seen products change and evolve. Take the annuity for example. In the late 1980's when I was getting started, most annuities were traditional fixed annuities. They offered fixed interest and were backed by the credit worthiness of the issuing insurance company. Fixed annuities offered two primary benefits; tax deferral during accumulation and the ability to create a lifetime stream of income. However, in order to get the lifetime income the annuity owner had to sacrifice their principal and that lack of flexibility often was a major issue so the majority of annuities were used for tax deferral.

As the stock market soared in the 1990's, so did the popularity of the variable annuity. The variable annuity (VA) differs from a fixed annuity in that instead of the issuing insurance company paying interest, the contact value is invested into separate accounts which are similar to mutual funds. As the money was no longer part of the insurance company's general assets, the stability of the annuity was much less dependent on the issuing company. Instead, the VA's performance was directly linked to the performance of the underlying investments. The primary motivation for investing through a VA as opposed to other investment options was that the growth in an annuity is tax deferred until it is distributed.

The first ten years of the 21^st century brought the aftermath of the tech bubble, 9-11, and the great recession. Investors who had enjoyed great returns as the markets soared became more interested in protection and less concerned about sheltering taxes. Again the financial industry innovated and developed riders to provide guarantees for income, without having to forfeit the principal, and annuity sales continued to grow.

I have watched the reasons to purchase an annuity evolve from safety to tax deferral to income guarantees. Now the industry is changing again. With the volatility in the markets over the last few years the majority of annuity companies are either cutting back on the guarantees they are willing to make, or are charging more for the same guarantees.

Recently I attended a continuing education seminar hosted by a variable annuity company. The host addressed the audience and told us about the recent changes to their products but what caught my ear was his comment "as the industry reduces guarantees or increases fees, the annuity marketplace is going to go old school. The attractiveness of VA's is no longer the fancy bells and whistles, but instead we will be selling annuities in a return to the advantage of tax deferral."

Critics of VA's point out that insurance companies charge fees, above the costs of the investments themselves, for variable annuities. While there are many fee structures and each product is different, VA fees are typically 1% to 2% per year. There are also other complicating factors to consider such as surrender charges and an additional 10% excise tax for annuitants less than age 59 ½.

After hearing the comment that VA's should be purchased for their tax advantages, I wondered if the advantages outweighed the costs and complications. I examined nine different scenarios and calculated the advantage a VA would have, considering the expense, over a non-annuity, taxable account with identical investment returns.

	Investment Return	Tax Rate	Annuity Expense
Case 1	8%	35%	1.7%
Case 2	12%	35%	1.7%
Case 3	6%	35%	1.7%
Case 4	8%	50%	1.7%
Case 5	10%	50%	1.7%
Case 6	4%	50%	1.7%
Case 7	8%	35%	1.9%
Case 8	12%	35%	1.9%
Case 9	7%	35%	1.9%

In most cases the VA does offer an advantage, especially with the higher returns or in higher tax environment. However, if the investment returns are lower (cases 3, 6, and 9) the taxable account has the advantage.

This analysis ignores two important issues. The first is difficult to quantify since there is a wide variation in the marketplace, but variable annuities are meant to be long term holdings. The investment portfolio can change but most VA charge a substantial fee, called a surrender charge, for the first 3 to 10 years. Surrender charges typically maximize around 8% and reduce every year. So even in the high return, high tax situations which really make variable annuities excel, an early liquidity event can reduce or eliminate the VA advantage.

The other consideration outside the scope of this analysis is one of tax policy. Under current tax law, all gains distributed from annuities are considered ordinary income and are taxed at ordinary income tax rates. It does not matter how long the investment was held. If it comes from an annuity it is taxed as income. Gains from non-annuity accounts are taxed as capital gains. As long as the investment was held for a year or more, the current maximum long term capital gains rate is 15%. With a tax rate that low, gross returns have to be about 13% if the annuity fee is 1.7% for the annuity to break even. Long term returns in excess of 10% would be extremely unlikely.

The natural conclusion is that until taxes rise dramatically and the market experiences a secular bull market, I do not see the tax deferral of variable annuities as a strong enough benefit by itself.