Annuity IQ

While the sub-prime crisis is very real it is widely overblown. Yes, firm are writing off billions in “bad Loans” and, by all news accounts, the sky is falling. What is not being made clear to many investors is the fact that these loans are really only affecting large institutions who, largely, leveraged these investments as much as 32 times. That means for every dollar they had in these investments they leveraged it to borrow $32. Only when there was a run on the bank did we see firms really start to get hurt, i.e. Bear Stearns and several hedge funds.

If these institutions did not leverage the investment so much then everything would be ok. Of course they did leverage their exposure and when foreclosures went up, about 11% right now, then this increase devastated the investment and their ability to borrow against them. However, not all of these loans are bad and that is the other issue that we are looking at.

While there are billions in bad loans, to unqualified borrowers, what we are seeing is institutions including most loans, AAA rated with sub-prime borrowers. The institution then writes off most of there loan portfolio that has some exposure, but not total exposure, to sub-prime borrowers. This is why we see billions being written off by large institutions, they are writing off everything.

Here is why they are doing it. They take the big hit, whether it is real or not, then they are getting a tax deduction for it. What they are not telling you is that such a small percentage, generally speaking, is exposed to sub-prime that many of the write offs they are taking will reappear on their books in a few years. The current tax code allows these banks to write off their loans and then, if they become profitable again, add them back to the books at a later date.

Therefore, a bank can take a $10 billion dollar write off today and lets say that only 10% of those loans are actually “bad”, or in default, take their write off today and then when this is all sorted out and $9 billion turn out to be good loans they can add them on to the books later. They are keeping all of the cash flow that these loans produce and can add them back in as an asset later, its a pretty good deal for them, kind of.

The point is that many of these loans are good cash producing investments with higher rates of return than one might think. It is similar to the limited partnership deals that went south in the 1980’s, many people got hurt, but those who held on ended up ok and the “vultures” who bought up large sums of the partnerships bought high cash flow products and made a killing. Will this happen again with these sub-prime investments?

Who knows, but we think it may be time to start looking at these investments with your play money and take a little risk. This can be done either through individual equities with high exposure to this risk, but you would be better off looking at some funds that have these investments. Again, this would be for the people who can afford to loose money if they do not pan out and one should seek the council of a qualified financial advisor before making any investment. One also must remember that the crisis is not over and there may be better buying opportunities ahead.

While we are somewhat critical of immediate annuities and, more to the point, their restrictions we do see value for the product. When these products are used in conjunction with an asset allocated portfolio they can and do significantly reduce risk.

Immediate annuities have a reputation about them as being very inflexible and lack the ability to keep up with inflation. While that is true of older products newer products offer some flexibility. Many immediate annuities have inflation protection riders now, where the payments can increase by 3 or 5% a year, and many newer products have cash refunds to the beneficiaries so the insurance carrier will not keep all of the money when the owner passes away. These new features have increased interest in the old immediate annuity and sales have been very strong over the previous 12 months.

As the Baby Boomer generation retires we expect to see an increase in annual sales for the next few years. The problem with most of the products sold is that investors do not shop around for the most competitive immediate annuity rate. There are several websites dedicated to find the best rate for you, like Immediate Annuity Solutions, but few investors are using these valuable sites. Instead they settle for whatever their financial advisor or insurance agent recommends.

Because of this we highly recommend that you shop for an immediate annuity before just settling. After all these are a lifetime commitment so use the resources that we have available. We like ImmediateAnnuitySolutions.com, but will add more sites as we find them.

Monday June 16, 6:00 am ET

RESTON, Va.–(BUSINESS WIRE)–NAVA, the Association for Insured Retirement Solutions, announced today first quarter results for the variable annuity industry. The combined net assets of U.S. variable annuities decreased 6.0% to $1.40 trillion at the end of the first quarter, as compared with the end of the fourth quarter of 2007. Net assets increased by 0.5% relative to the first quarter one year ago.

Table 1. variable annuity Net Assets

(Dollars in Millions) 3/31/08 12/31/07 3/31/07

Total Net Assets $1,396,576 $1,485,202 $1,389,880

Source: Morningstar, Inc.

variable annuity total sales, also known as premium flows, for the first quarter was $41.6 billion, a 1.7% increase from the first quarter of 2007. First quarter net sales, also known as net flows, of $7.2 billion showed an increase of 12.3% from first quarter 2007 net sales of $6.4 billion. The mix in premiums for the first quarter showed that 64.2% of the total sales were in qualified plans and 35.8% in non-qualified plans.

Table 2. variable annuity Total Sales1

Quarter Ended

(Dollars in Millions) 3/31/08 3/31/07

Total Net Asset $41,644.0 $40,949.8

Net Sales $7,215.5 $6,425.5

Source: Morningstar, Inc.

Table 3. Quarterly variable annuity Total Sales & Net Sales

Quarter Ended

($ Millions) 3/31/08 12/31/07 9/30/07 6/30/07 3/31/07
Total Sales $41,644.9 $47,828.5 $46,215.8 $47,253.6 $40,949.8
Net Sales $7,215.5 $8,912.3 $9,375.0 $8,669.8 $6,425.5

Net Sales as % of total sales 17.3% 18.6% 20.3% 18.3% 15.7%

Source: Morningstar, Inc.

The mix of net assets by investment objective showed that $783.5 billion, or 56.1% of $1,396.6 billion total assets, was held in equity accounts. This is a decrease of 6.1% as compared with the first quarter of 2007 when $834.0 billion, or 60.0%, was held in equity accounts. The mix also shows that $262.9 billion, or 18.8% of assets, was held in fixed accounts.

Table 4. variable annuity Assets by Asset Class

(As a percent of total assets) 3/31/08 3/31/07

Equity 56.1 % 60.0 %
Fixed Accounts 18.8 18.6
Balanced 12.1 10.6
Bonds 9.6 8.2
Money Market 3.4 2.6

Source: Morningstar, Inc.

About annuities — With the decline in availability of employer sponsored pension plans and proposed changes to Social Security, an annuity is an integral component of a retirement plan. It is a long-term retirement investment vehicle offering a combination of insurance benefits, guaranteed lifetime income payments and tax-deferred savings. variable annuities allow individuals to invest in a variety of underlying fixed and equity funds, and provide returns based on the performance of these funds. Only annuities protect retirement assets against market volatility and guarantee retirement income that cannot be outlived.

About NAVA — NAVA, the Association for Insured Retirement Solutions, is a non-profit trade association located in suburban Washington D.C. NAVA provides a variety of services to the industry including educational forums, research, and conferences aimed at furthering the development and understanding of fixed and variable annuities, income annuities and variable life insurance.

1 Total Sales (also called total premium flows) represents the sum of new sales (all first-time buyers of a contract, including inter- and intra-company exchanges) and additional premiums from existing contract owners. Net Sales (also called net flows) represents Total Sales minus surrenders, withdrawals, inter- and intra-company exchanges, and benefit payments.

While there are some good fee-based planners in the world we find it rather odd that everyone just assumes that they are the best choice for everyone. The selling point of the fee-based planner is the fact that they do not collect commissions from product sales and therefore they must be unbiased. While this seems reasonable enough to the average person are these advisors really the way to go?

The idea that a person can be unbiased just because they do not collect a commission from product sales, but collect a fee no matter what you buy, is ridiculous. Every time you read an article and the author was asked a question they tend to always recommend that you speak to a fee-based planner before you make that investment. Now, here is the problem, fee-based advisors are still earning commissions, sorry, I mean fee, for the amount of money that is invested, or my favorite, they get paid $200 an hour for their time.

By the time the average person gets done with a fee-based planner they end up paying way more than any sales load or CDSC on a regular broker sold mutual fund.

Here’s an example:

A client wishes to invest $100,000 and a commissioned broker recommends an A share mutual fund with a load of 4.25%, or $4,250 in commissions. That is all the client pays, besides annual expenses, in commissions. Now if the same client went to a fee-based planner they would recommend index funds and then slap on a 1.5% annual fee for their services. Assuming the investor holds the mutual fund for 5 years, not an unreasonable assumption, then the fee based planner would have made $7,500 in fees as compared to the $4,250 the commissioned broker would have made. What is worse is the fact that the planner probably did recommend index funds and they still have the stones to charge a fee, seriously, a trained monkey can pick an index fund. Based on this assumption, which is very fair and reasonable, it is pretty clear that at the end of the day everyone gets paid.

By the way, even if the commissioned broker sold the investor an annuity they would have only made a 6.5% commission or $6,500 from the investment which is still far less than the fees the planner charged. It is really odd that all of these magazines talk about high commissioned annuities and mutual funds while the fee-based planners get a free ride because they do not collect a commission, but charge a fee. The average fee-based planner client is paying the same amount of money per year as the variable annuity client, roughly, with no guarantees or tax deferral.

Just because someone charges a fee instead of a commission it does not make them smarter or any less human. Well, may be they are smarter as they know by chargeing fees they will make more money over the long-term, but none the less they are still sales people. We do not care how people choose to make a living, but just be honest about it and the media should be ashamed of themselves for not recognizing the obvious.

One last note, I recently read an article by Humberto Cruz who quoted a fee-based planner who said that any variable annuity that guarantees the client their money back sounds “fishy” to him. This is the other problem with both the media and the fee-based planners, they have no idea how variable annuities work and what the living benefits ultimately do. If that planner who Mr. Cruz quoted did not understand what a guaranteed minimum accumulation benefit was then he should not have even commented on it.

These guys are relentless with their misinformation, especially on annuities. It is a miracle that they are still in business, especially with all of the bad advice they give. In their recent article titled “Are Annuities Ever Not Stupid?” they really show their stupidity.

First, they say: “An annuity is a contract between you and (usually) an insurance company”, emphasis added. The last time we checked all annuities were issued by an insurance company. We know we are going out on a limb here, but since all we do is annuity work, we are pretty sure that statement is just plain wrong. The thing is they mention Fidelity and Vanguard as Annuity options at the end of the article, are they suggesting that their annuities are not issued by insurance companies? They are by the way.

Second, they recommend all equity stocks as a reasonable alternative to an annuity. Talk about comparing apples-to-oranges stocks and annuities should NEVER be compared as a similar investment. variable annuities do offer equity investments, but they are mutual funds, generally speaking, and diversified while stocks are not unless you buy many different stocks.

Third, they say equity indexed annuities are ugly, well we kind of agree with them, but the facts are still a bit dubious in their statement as they lay into fees on indexed annuities. Generally, there are no fees, perhaps an asset charge or a spread, but most offer straight participation rates.

Fourth, variable annuities are bad! There is a shocking statement for you. Here is what I find interesting, before they said that they had this blurb: “You’d think investors would avoid these products. Yet no less an eminence than retirement whiz John Greaney, a regular Fool contributor and former engineer who successfully retired at age 38, has said repeatedly that under some circumstances, one type of annuity can be a useful component of your overall retirement strategy. Writing in the March 2005 issue of the Fool’s Rule Your Retirement newsletter, Greaney showed how adding a lifetime income Annuity to your retirement portfolio can help ensure that you don’t outlive your retirement savings.”

Now, first off the day we listen to an engineer about retirement is the day we should all start letting our pets drive us to work, come on that is just plain stupid. If we were building a bridge then I may consult with John, but not when we are investing our money. Second, right in this statement they illustrate a variable annuity. An equity investment with a lifetime income component, what do you think living benefits are with equity sub-accounts? Thats right an equity portfolio with a lifetime income component.

Finally, lifetime income annuities sometimes make sense, i.e. immediate annuities. While immediate annuities do make sense for many investors, they do have significant drawbacks which the author so blatantly glossed over. He then recommends Fidelity and Vanguard, not that they are bad annuities, but what is the deal, did T. Rowe Price not buy enough advertising to get mentioned by the Fool? For a website that says to always shop around they certainly do make the same annuity recommendations rather frequently, therefore their recommendations have to be dismissed as they are hypocritical.

If you are going to bash a product at least know something about them, do not use sound bites from a decade ago. Worst of all they described a variable annuity in one portion, a more risky version individual equities and and immediate annuity, and then said they stink in the next. If you do not understand what or how a product works then do not talk about it. Otherwise you simply sound, well, foolish.