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Flat Fee Variable Annuity… What is there to like?

12/8/2006

By: Scott DeMonte

Over the past few months, I have seen an increased amount of advertising for a flat fee variable annuity. On the surface, these contracts seem appealing, as they only charge $20 per month M&E, or $240 per year total. They also offer 140+ investment selections to choose from, but what is the catch?

Well, there really is not a catch, more like what’s the big deal? This contract is a bare bones variable annuity contract that offers no death benefit, no living benefit or any other bell or whistle. When these products first rolled out, we were very curious about them and although we did not rate it, we did take a 30,000 foot look at it…we were not impressed.

Our first concern was what is there to like about a ‘B’ rated company? Absolutely nothing. Even though the investment is made in separate accounts and there are no guarantees the insurance carrier has to reserve for, (meaning the fees they collect are 100% profit), you should steer clear of any non-investment grade insurance carrier.

The performance is dependent upon market returns-- not the financial security of the issuing insurance company, but what happens if they do go out of business? Anyone who has been a policy owner or who knows someone who was a policy owner of a company that has gone defunct knows it is not a picnic to deal with that type of situation. As a matter of fact, it can take years to get your money out of a defunct insurance carrier.

We are not suggesting that the issuing company of this product is in jeopardy of going under, but when you have been down graded to a ‘B’ rating (the B rating was issued by A.M. Best and Fitch issued a BB rating) with a negative outlook, why would you want to take the risk? Especially since their only hope of a higher rating was to sell a portion of their business units, and that was completed earlier this year. The best you could hope for would be an upgrade to a ‘B+’ rating. It does not strike us as a secure investment.

With that being said, how about the product? It is interesting, and being in the business, we were interested in any product that can deliver good results at a lower cost. Like so many other ‘cheaper’ variable annuities, we were not very excited after we examined the product.

Since there are no guarantees at all, we think it is only appropriate for a very small segment of variable annuity investors. Also, this product is geared to appeal to a certain type of financial representative, usually the registered investment advisors who are fee-based planners. This means if you buy this product from a registered investment advisor, you will be paying a management fee to the advisor on top of the $20 a month charge and fund expenses.

This in itself is no big deal, as everyone deserves the right to earn a living however they choose and we have no problem with fee based advisors, but paying an advisor an annual fee can negate the proposed cost savings of this flat fee annuity product. When I spoke to a company representative she indicated that the average advisor is charging on the range of 1% to 2% a year fee on top of the other charges.

When you add up all the costs you are not saving anymore money than if you purchased a traditional variable annuity product. If the average sub-account is charging .80% and you add the advisors fee to it you will be paying 1.80% to 2.80% plus the $20 per month and under certain circumstances the fee that is paid to the advisor from the account can be taxable as well.

Considering you can purchase a no-surrender or shortened surrender contract for roughly the same amount of money per year there is no advantage to this type of variable annuity. When we look at a traditional 7 year surrender variable annuity product there is virtually no cost savings at all.

Keep in mind with traditional variable annuities the advisor can choose a trail commission option, meaning they will receive an ongoing fee for as long as you own the contract and they are the advisor. If the trail option is chosen by the advisor than a traditional variable annuity product can pay the advisor very similar to how a fee based planner gets paid without adding anymore cost to you or the contract, it is all built into the M&E charges.

As a matter of fact the consumer may be paying more for the ‘cheaper’ contract than the traditional commissioned variable annuity product with the cost of the fund expenses, the $20 a month charge and the additional 1% or 2% additional fee charged by the advisor. On that note, the advisor may also be making much more money over the long term if they collect that 1% or 2% fee from the account, which negates the second argument of ‘no sales commissions paid’.

If we average the fee from what we were told was the average consumer was being charged the average fee would be 1.50%. If we assume no growth, because the fee is against account value and in this case it would be a level charge over the time period, over 7 years the advisor would have made 10.5% in fees with the fee only product. The difference is that the advisor gets paid over time with this type of contract versus getting a 6.5% upfront commission from a traditional variable annuity sale.

Although we applaud the effort of this type of product, we do not see it being right for the average variable annuity client. We also see other registered investment advisor products that offer better features with very reasonable fees. American Skandia/Prudential for example offers an extremely competitive registered investment advisor product with all types of bells and whistles at a very low internal cost with much higher financial ratings.

To sum it all up, if there is no cost savings, if the product does not offer any guarantees, the fees will be about the same as a traditional variable annuity and if the company is not in a strong financial position then why would you consider this type of product? It makes very little sense, especially since the average person is buying the annuity contract for the protection they now offer. The protection is living benefits and, to a lesser degree, death benefits which some studies show 65%+ of all new variable annuity sales have attached to them.

These flat fee or low cost variable annuity products are benefiting from the misinformation you are getting from the mainstream media, who themselves do not understand variable annuities and how they work. You must do your own research from an unbiased source, such as www.annuityiq.com, and not take what you see or read at face value. You need to get the facts about how annuities work from a professional, not from people who try to feed on your fears and ignore the obvious to point out the irrelevant.





Capital Gains, a Taxing Problem

October 31st, 2006

By: Scott DeMonte

In 2006, mutual fund investors are looking at the third largest capital gains distribution ever. Capital gains are estimated to top $200 billion dollars, of which an estimated $20 billion will have to be paid to the government. These numbers are considered conservative by many experts.

$200 billion in capital gains and dividend distributions is a huge number, and is only topped by 1999 and 2000 capital gains and dividend distributions, which were $238 billion and $326 billion, respectively. Now, many people will tell you that with the capital gains rate and dividend tax being low, this is not that big of a deal when, in fact, they are wrong.

Let’s put this in perspective: $200 billion (estimated capital gains distributions) at 15% (current capital gains rate) equals $30 billion dollars in taxes due to the IRS. If you add short term distributions into that equation, the numbers could be much higher, (short term capital gains are taxed at ordinary income). Unfortunately, even if you reinvest your dividends and capital gains, you will still have to pay taxes on them.

All those taxes are due on a so-so year in the markets. Even though the Dow is hitting record highs, the rest of the market averages are not very spell binding. The NASDAQ has relatively underwhelming performance, and the S&P is doing better as compared to the last few years, but it is by no means having a stellar year. Yet capital gains distributions are having the third highest amounts in recent history.

This illustrates the point that turnover in mutual fund portfolios is very high. Turnover is the amount of times the mutual fund will trade its total portfolio. For example, if a mutual fund has a turnover rate of 70% that means they will sell 7 out of 10 stocks in their portfolio by the end of the year.

That creates capital gains distributions to the mutual fund owner. These distributions could be long term or short term distributions, depending on the length of time the mutual owned the stock. If the mutual fund held the stock for less than one year, it is short term capital gains. If they owned the stock for more than one year, it is long term capital gains. Long term gains are taxed at 15% and short term gains are taxed at your ordinary income tax rate.

In other words, you are going to pay taxes whether you like it or not. So, what can you do about this? Your options are limited, but very effective. You could examine tax-efficient mutual funds, which try to hold stocks longer and trade stocks less often. This keeps the turnover rate low and therefore will generate far less in capital gains distributions. You could also look at using a tax deferred investment such as a variable annuity.

Tax managed mutual funds got their start in the public arena with Eaton Vance’s Tax Managed Fund in the early 1990’s, but have been available to high net worth and institutional investors for much longer. These funds try to hold stocks longer and trade them less often. They also try to offset any gain with a loss they might have in their portfolio. All of this is geared to keep your taxable distributions low, and they have been fairly successful with this strategy. There are now many tax managed funds to choose from in the mutual fund world with many different asset classes to offer.

The other option is using a variable annuity, which is tax deferred. This investment allows you to invest in mutual fund- like investments called sub-accounts. All earnings in the annuity will build tax deferred and you will not owe any taxes until you actually take a withdrawal. Withdrawals before age 59 ½ will result in an IRS penalty of 10% plus ordinary income taxes on any gains, but these investments were designed for long term investors and should not be used as a short term solution.

The bottom line is if you want to keep more of your money, then you need to take a serious look at deferring taxes. The average mutual fund investor loses between 2.5 and 5% of their total return due to taxes being paid on their investments. That is a substantial sum of money to pay to the government every year. This is also an area that most investors ignore, but the fact of the matter is that the more investment dollars you keep, the better off you will be over the long term.

Examine both of these options and consider using one or both of them to plan for a stronger, more tax efficient retirement. Working with a financial advisor can accomplish amazing things when you take an open honest view of the choices laid out before you.

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