Retirement Focus - More Post-Retirement Investing

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
July 15, 2008

Retirement Focus – More Post-Retirement Investing
by Mike Posey

IN THIS ISSUE:

1. A Primer On Variable Annuities

2. Variable Deferred Annuities

3. Disadvantages Of Variable Deferred Annuities

4. Variable Annuities Continue To Improve

5. Retirement Tidbit – Making The Most Of Retirement

Introduction

This week, I am going to continue the series of E-Letters dedicated to investing during retirement. In past Retirement Focus issues, I have covered how to determine how much money is enough at retirement, as well as the various ways of taking retirement income. However, the success of any withdrawal option is going to hinge upon the way your nest egg is invested during retirement.

In my initial discussion about post-retirement investing in the May 27 Retirement Focus, I mentioned that there are a myriad of ways to invest during the payout phase, each with its own set of advantages and disadvantages. For purposes of simplifying our discussion, I categorized these investment strategies into the following broad categories:

1.         Immediate Annuities;
2.         Fixed Income Alternatives;
3.         Variable Annuities;
4.         Asset Allocation Alternatives;
5.         Actively Managed Strategies; and
6.         Other Alternatives.

I covered the first two of these alternatives in the May 27 E-Letter. However, I realize that immediate annuities and fixed income alternatives are considered to be among the most conservative of investment strategies, so they may not be able to provide the level of income needed for retirement. This is especially true in light of Baby Boomers who have not saved enough for retirement, as well as the prospect of ever-increasing life expectancies.

This week, I’ll delve deeper into alternative #3, variable annuities, which have the potential for higher gains and the prospect of higher withdrawals during retirement. However, as we move up the list of post-retirement investment alternatives, it is also important to note that we also increase the risk of investment loss.

I’m also going to revive the “Retirement Tidbit” concept that I discussed when I first started writing these Retirement Focus E-Letters. These tidbits are ideas or resources related to retirement that probably wouldn’t fill up an entire e-letter, but are still important to mention. This week, our tidbit is even more interesting in that it involves a publication written by a Forecasts & Trends E-Letter reader. I think you’ll enjoy what he has to say.

I want to remind you that any investment information provided in this E-Letter is general in nature, and should not be construed as investment or insurance advice. You should always evaluate insurance and investment options in light of your personal financial situation, retirement goals and any special circumstances you may have. Ideally, you should consult a qualified insurance and/or investment professional who can take the time to review your situation and tailor an investment approach to meet your needs.

Variable Annuity Investments

Variable annuities have been around for a long time, and are experiencing a new growth trend as the Baby Boom generation is beginning to take retirement a little more seriously. As I mentioned in the May 27 Retirement Focus issue, a variable annuity is often defined as being a “mutual fund in an insurance wrapper,” but not everyone knows what that means.

In this article, I’ll seek to better explain the variable annuity concept as well as discuss when these contracts may be the best alternatives for part of your post-retirement investing. Note, however, that a discussion about all of the characteristics of variable annuities is far beyond the scope of this brief E-Letter. Since the theme of this series of E-Letters is how to invest during retirement, I’ll keep most of my comments focused on the features of variable annuities that may make them suitable for that phase of your investing life.

Basically, a variable annuity is a type of deferred annuity contract where returns are dependent upon the market performance of a selected group of investments. Thus, variable annuities differ from fixed annuities in that returns are tied to the market and not a pre-determined fixed rate of return set by the insurance company. They also differ in that market action can result in losses as well as gains in a variable contract.

To access market-rate returns, each variable annuity offers a group of equity and/or bond “sub-accounts,” which are essentially mutual funds within the annuity. While various types of insurance provisions can guarantee the original principal and sometimes even certain gains upon the death of the annuitant, there are usually no guarantees as to a variable annuity’s annual performance as there are in fixed annuities. There are, however, certain “living benefit” riders that I will discuss later on that can provide some measure of performance guarantee – for a fee.

As a practical matter, the management of the sub-accounts available in variable annuities is usually a matter of using asset allocation and/or active management investment strategies, both of which are alternative post-retirement investment strategies that will be covered in later Retirement Focus issues. Some companies also have pre-set portfolios from which to choose, but these are usually based on an asset allocation strategy tailored to various risk tolerance categories.

There are two basic types of variable annuities – variable immediate annuities and variable deferred annuities. The variable immediate annuity is much like the fixed immediate annuities I wrote about last time, in that they are designed to make periodic (usually monthly) distributions to an annuitant during retirement. The variable immediate annuity differs from the fixed version in that the amount of the periodic payment can change over time based on investment returns, while fixed immediate annuity payments are usually the same amount for life.

The potential for payments from a variable immediate annuity to increase over time can be a welcome feature for annuitants who are concerned about maintaining their purchasing power throughout retirement. As life expectancies continue to grow longer, the variable immediate annuity provides the potential for keeping up with the ravages of inflation. However, investment gains are obviously not guaranteed in a variable immediate annuity. If repeated losses occur, the payment from a variable immediate annuity could end up being far less than what would have been available from a fixed annuity.

To help counteract this disadvantage, some variable immediate annuity sponsors have come up with a “floor” payment, usually consisting of 80% or 85% of the amount of monthly payment at the beginning of the contract. With this feature, even if the sub-accounts incur investment losses, the monthly benefit will never fall below this floor. However, this added insurance comes at the cost of higher fees which, in turn, reduce the investment return of the sub-accounts.

The use of variable immediate annuities is growing, especially as Baby Boomers start hitting early retirement age. For some, the potential for monthly income payments to grow over time may help to offset the fact that they saved too little over their working lifetimes. For others, however, the possibility of receiving lower payments over time due to investment losses makes variable immediate annuities less attractive than the fixed immediate annuity. As a compromise, some investors include both fixed and variable immediate annuities in their retirement portfolios to provide a combination of stability and the potential for future gains.

Variable Deferred Annuities

The second type of variable annuity is the variable deferred annuity. Much like the fixed deferred annuity I discussed in my May 27 E-Letter, the variable deferred annuity is designed to be a way to accumulate savings on a tax-deferred basis over an investor’s working lifetime. Ideally (at least for the insurance company), the variable annuity investor will convert the accumulated value at retirement into a variable immediate annuity income stream. However, according to most reports, very few deferred annuity contracts are ever “annuitized.”

While variable deferred annuities are typically an investment vehicle used during the accumulation phase of an investor’s working lifetime, they are now being marketed to retirees in ever-increasing numbers. Part of the reason is that investors do not usually like putting all of their money into an immediate annuity where it is usually locked up for the rest of their lives with little or no liquidity. Another reason for this increased popularity among retirees is that insurance companies have become very creative in offering new riders for variable annuities that make them more attractive as a post-retirement option.

Even though variable deferred annuities might be suitable for both pre- and post-retirement investors, the focus of this E-Letter is investment alternatives during retirement. Thus, I’ll focus most of my comments on features of variable deferred annuities that retirees find beneficial. I hope to do a separate, more general E-Letter on pre-retirement uses of variable deferred annuities sometime in the future.

That being said, the primary benefit of a variable deferred annuity in both pre-and post-retirement investment scenarios is tax-deferral. Gains within the contract are generally not taxed until withdrawn upon annuitization or surrender of the contract. This feature can be especially attractive when using active management strategies that produce short-term gains and losses.

In the past, variable deferred annuities were not viewed to be optimum post-retirement investments since periodic withdrawals were not encouraged, and sometimes even penalized. This restriction was generally the result of the long-term nature of the contract, as well as large up-front selling commissions that made it necessary for the insurance company to encourage keeping the contract in force, even if it meant subjecting the investor to significant surrender charges upon early termination.

However, as fewer workers are being covered by pension plans with guaranteed monthly benefits, the variable deferred annuity has evolved to be more “withdrawal friendly” for those in retirement. While many contracts still pay significant up-front commissions to the insurance agent and have surrender charges for early termination, they also provide for certain amounts of annual distributions that are not subject to an early withdrawal charge. Some have even gone so far as to provide for guaranteed levels of withdrawals even if the investment experience is negative.

In the insurance industry, such benefits are called “living benefits,” in that they are guarantees paid during the lifetime of an annuitant rather than to beneficiaries upon death. Living benefits can come in a variety of forms, with some being more important before retirement, and others afterwards. The living benefits most applicable to post-retirement investing are as follows:

Guaranteed minimum income benefits provide for a monthly income based on a stated annual growth rate, usually 5% to 7%, even if the actual investment results in the sub-accounts is less (or even negative). Note, however, that this benefit is generally only available if you take periodic income from the contract, but not if you want to surrender the contract for a lump sum.
Guaranteed minimum withdrawal benefits that allow an annuitant to withdraw a fixed percentage of the annuity premiums (usually 5% to 7%) for a specified period of time. Such withdrawals can continue until the end of the specified time, or until all premiums have been withdrawn. This feature guarantees return of all premiums, even if investment losses result in the loss of some of the original principal. However, investment gains can increase allowed withdrawals over time.
Guaranteed minimum withdrawals for life allow an annuitant to withdraw a smaller percentage, usually 4% to 5%, of the original premium for life, without regard to investment performance. Thus, these payments continue even after they reach the amount of original premium paid, and even if poor investment performance erodes principal. As above, good investment performance can increase future withdrawals.

These guaranteed income features are what really separates variable deferred annuities from mutual fund investment portfolios. Sure, it’s possible to set up an investment portfolio to pay a certain level of income, and have that income vary with the performance of the underlying investments. It may even be possible to guarantee principal over a certain period of time using zero coupon bonds. However, mutual fund companies and brokerage firms are not going to guarantee all or part of that payment for the life of the investor. Insurance companies, on the other hand, specialize in such guarantees.

A final benefit of a variable deferred annuity may be asset protection. In some states, money held in annuity contracts may be protected from creditors. In such cases, physicians and others in occupations with a high economic risk may find that asset protection may offset any negatives associated with these contracts. However, asset protection is not available in all states, so it’s important to contact your state insurance regulator to determine whether or not this benefit is available where you live.

That’s the good news. The bad news is that all of the favorable features discussed above come at a cost, and sometimes this cost can be considerable. Plus, the cost is sometimes not measured in dollars, but rather in lost flexibility or access to your principal. Therefore, along with the various advantages discussed above, it’s also important to review some possible disadvantages of variable deferred annuities as a post-retirement investment.

Drawbacks Of Variable Deferred Annuities

In the investment industry, the variable deferred annuity is either one of the most valued or most maligned investments, depending upon your perspective. As I discussed above, variable deferred annuity contracts offer the ability to participate in market gains and losses on a tax-deferred basis, as well as provide some level of insurance benefit to heirs. Some also offer living benefits that offset some of the criticisms of earlier generation variable annuity contracts.

Outside of the insurance industry, however, variable deferred annuities generally get a cold reception. Liz Pulliam Weston has an article about variable deferred annuities on the MSN Money website entitled, “The Worst Retirement Investment You Can Make.” Just the title gives you some idea of how many Investment Advisors view variable annuities. This and many other similar articles I have reviewed discuss that the benefits offered by variable deferred annuities are more than offset by negative features of these contracts. These disadvantages include, but are not limited to, the following:

Tax deferral or tax trap? As noted above, one of the most frequently cited advantages of variable deferred annuities is the deferral of taxation on investment gains. However, what’s not always said is that a variable deferred annuity converts all types of gains to ordinary income. Thus, there are no long-term capital gains or dividend tax treatment, just ordinary income subject to the standard tax rates. Tax rules also dictate how much of each distribution is taxable income and how much is return of principal, which can reduce tax planning flexibility.

In retirement, any amount paid in income taxes obviously reduces the amount available to spend for life’s necessities. The current tax rates for dividends and long-term capital gains are very attractive, and can reduce the tax bite on retirement distributions. That being the case, the tax deferral available in a variable deferred annuity may not be worth the difference in tax rates that may apply. Should dividend and capital gains tax rates rise in the future, then this disadvantage may become less of a factor.
Next, opponents of variable deferred annuities cite the penalties for early withdrawal as a major negative. While there is a special penalty tax that applies to distributions prior to age 59½, that is not a consideration for this article as we are talking about post-retirement investments which usually occur after that age. Instead, the issue is being locked into an insurance contract by way of surrender charges that can last 10 years or more, depending upon the contract.
Variable deferred annuities also have a death benefit that guarantees beneficiaries receive no less than the premiums paid, and sometimes even part of the gains earned on the contract. Opponents, however, say that this insurance is often of little value and is overpriced.
Advisors also complain that all of the bells and whistles now available in variable deferred annuity contracts make them far more complex, both for agents to sell and clients to understand. This complexity, or what we like to call “moving parts,” can have a far different effect than what is anticipated by the annuitant.
Some of the insurance companies offering guaranteed living benefits do so on the condition that the premium is invested only in designed portfolios established by the company. This, in turn, reduces investment flexibility for the investor in exchange for guaranteed levels of income or withdrawals.
Fees – Fees – Fees. As in just about any endeavor in life, variable annuity guarantees come at a cost. In some cases, the cost to provide insurance, guaranteed benefits and investment management shaves quite a bit off of the return realized in the sub-accounts. Morningstar reports that the average variable deferred annuity contract charges fees of 2.44%, including fees for managing the sub-accounts, while the average open-ended mutual fund charges 1.32%.
Perhaps the biggest rub comes in the form of surrender penalties for early termination, since these are usually designed to cover the large up-front commissions paid to insurance agents on many variable deferred annuity contracts. It seems that the fee-only Investment Advisor world has a problem with those who sell on commission, and perhaps they always will.

This conflict is at least partially due to the fact that relatively high front-end commissions coupled with restricted exit provisions lend themselves to questionable sales practices. Consequently, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) keep variable annuity sales practices under close regulatory scrutiny. Stories abound of agents who have sold variable annuities to investors who were unsuitable for such investments, primarily for the purpose of maximizing their commissions.

While the above discussion of advantages and disadvantages does not contain every possible pro or con of variable annuities, my primary focus has been to make you aware that they are not the one-stop retirement investments that some free-lunch seminars make them out to be. Where they work, they can be a big advantage. Where they don’t, however, they can be disastrous.

Variable Annuities Continue To Improve

So, how should a retiree approach the issue of buying a variable annuity? The first thing to do is realize that deferred and immediate variable annuity contracts are two of many tools available to retirees to provide income during retirement. However, they are not necessarily the best choice for all retirees. Variable annuities seem to work best for investors who value guarantees and are concerned about outliving their money, but who also want the potential to share in market gains over time.

Since I have worked for a life insurance company in the past, my opinion may be a little different than those of other Investment Advisors. I tend to think that both variable deferred and immediate annuities have a place in some investors’ portfolios, but the situation has to be just right. I also think that the insurance industry is getting close to a more viable combination of guarantees and features at an acceptable level of fees.

For example, several companies have already come out with “longevity insurance,” which is an immediate annuity that is purchased at retirement, say age 65, but starts paying a lifetime monthly income at age 80 or 85. This type of policy allows retirees to take larger withdrawals in early years from other assets, knowing that a safety net will kick in later on.

We have also seen the insurance industry roll out some variable annuity policies aimed at fee-only Investment Advisors instead of commissioned agents, and I expect these offerings will be expanded in the future. A good example of this is a variable annuity policy that we offer to our clients that has no commissions, no surrender penalty and no insurance charges. The only fee is a flat monthly charge to maintain the insurance policy, plus the regular investment management fees charged by our recommended Advisors.

As you can see, the insurance industry is being very proactive in meeting the needs of present and future retirees, and I look for them to continue to provide innovative retirement solutions in the future. With 78 million Baby Boomers approaching retirement, they have every incentive to do so.

Retirement Tidbit – Making The Most Of Retirement

Since I began writing these Retirement Focus issues last year, the primary focus has been on the financial aspects of retirement. Working for an Investment Advisory firm, these issues tend to be our primary focus, especially as we read that members of the Baby Boom generation have not set enough money aside for their eventual retirement. However, the financial aspect of retirement is just one of many things to consider for those who are at or near retirement age.

Recently, I was very pleasantly surprised to receive a package in the mail from one of our readers, Dave Brazier. While Dave praised the work I had done on the financial aspects of retirement, he reminded me that another important aspect for retirees is how best to utilize their time in such a way as to “bring them fulfillment and enjoyment in their retirement years.”

Dave’s comments immediately made me think back to the many individuals I have known and talked to about their retirement. When I was younger, I didn’t think much about time management in retirement, since it seemed to me that retirees had all the time in the world to do anything they wanted. However, as I worked in the retirement field and talked to more people who were actually in retirement, most said that the reality of retirement is very different than what they had planned.

We often joke about retirees spending all of their time traveling or fishing or playing golf, but I learned from my retired friends that there is only so much fishing or golfing you can do before boredom sets in. In other words, these things were great as diversions from a busy workload, but were not as much fun when they became the “only thing to do.”

Fortunately, Dave has a solution for our readers who are retired, or who are nearing that goal. Since his own retirement in May of 2000, Dave has explored ways to successfully move from working full time to a fulfilling retirement. The results have been collected in a book he has entitled, “Have the Time of Your Life in Retirement.” This book offers a wealth of planning and time management advice drawn from Dave’s own retirement experience. However, rather than describing it myself, I’ll put it in Dave’s own words from his letter:

“The enclosed book…describes a simple process to help people transition from the work force into retirement and provides insights to help retirees enrich their retirement living. Almost everyone who reads [my book] will find an activity or some advice that will enhance their retirement experience.”

“The book describes a key process I used to help me in my successful transition to a fulfilling retirement in New Hampshire. This tool helped me broaden my activities to include trout fishing, keeping a journal, cooking, hunting wild mushrooms, making maple sugar, doing crossword puzzles, making apple cider, etc. [makes you wonder how he found the time to write a book, doesn’t it? JMP] It has been a process that has continued to guide me over the last eight years. Retirement should be an exciting phase of people’s lives and this book can help retirees achieve this objective.”

“[My book] is ideal for the person who is considering or in the process of retiring. Often people do not adequately prepare for life after working and boredom sets in after the initial retirement euphoria begins to fade. This book can help prevent this phenomenon. It is also ideal for those who have retired and have not achieved the excitement or fulfillment they expected. This book can help them explore the available alternatives. In addition, it can also serve as a valuable resource for those who are in retirement and having a great time. I know I am always looking for new ideas or activities to add to my ‘potential to do’ list. This book was written to aid people in finding new passions in life.”

I think the thing that struck me the most about Dave’s letter and his book is his use of the words “excitement” and “fulfillment.” I have to admit that when I think of retirement, “rest” is the first word that comes to mind. However, Dave seems to realize that “rest” can lead to “rust,” and I’ve always heard that it’s better to wear out than rust out.

I found Dave’s book to be concise and easy to read. It’s only 90 pages, including Appendices, so it’s easy to read in one sitting. However, if you employ all of his suggestions and checklists, it will keep you busy much longer, possibly for the rest of your retirement years. It has the ring of a book by someone who has not only mastered his own retirement strategy, but who earnestly wants to help others to find the same level of fulfillment.

Dave’s book is available from Amazon.Com, Barnes and Noble, www.tatepublishing.com or www.retiretothegoodlife.com, and is distributed by Ingram/Spring Arbor, a major book supplier. The price on Amazon is only $9.99, a small investment to make for an enjoyable retirement. Neither ProFutures Investments nor Halbert Wealth Management will receive any compensation should you decide to purchase Dave’s book.

I highly recommend this book to anyone who is at or near retirement, and I think it’s a great “how-to” book for just about anyone contemplating how they will spend their retirement years. Even if you have been retired for a number of years, Dave’s book may be able to help you find additional activities that can lead to greater fulfillment.

There are also a number of other resources available to retirees that can also help add enjoyment to their retirement years. One that I came across years ago is an Internet-based organization with the address of www.2young2retire.com. This website has a number of activities and resources to consider, and also has a periodic e-mail update available by subscription. Of course, you can also obtain information about retirement activities from the AARP website (www.aarp.org), if you can make it past all of the political stuff.

Conclusion

As we have seen, variable deferred and immediate annuities are among the many tools available to retirees and financial professionals. While they offer many advantages in both pre- and post-retirement scenarios, they also have some significant disadvantages which must also be addressed before making an investment.

Reviewing all of the pros and cons of these investments is especially important since most contracts have significant surrender charges if you terminate the investment within the surrender period, which can be a period of seven years or more. Thus, it’s not something that you can buy now and change your mind about next year.

You should also be aware that the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have both warned seniors about “free-lunch” seminars that subject attendees to high-pressure sales tactics in an attempt to get them to invest in variable annuities. According to these regulatory bodies, such seminars often misrepresent the benefits of variable annuities and downplay any disadvantages of these contracts. Be wary of any such invitations and never commit to purchase a variable annuity, or any other investment, before taking the materials home and thoroughly checking them out.

That’s it for this week. In my next Retirement Focus issue, I’ll continue discussing the various ways to invest during retirement. Until then, if you have any questions about the options given above, or would like me to cover a specific investment option, please feel free to contact me at info@halbertwealth.com.

Best regards,

Mike Posey

SPECIAL ARTICLES

Variable Annuities: Emerging From the Dark Side?
http://spwfe.fpanet.org:10005/public/Unclassified%20Records/FPA%20Journal%20March%202007%20-%20Focus_%20Reconsidering%20Annuities.pdf

"Free Lunch" Investment Seminars — Avoiding the Heartburn of a Hard Sell
http://www.finra.org/InvestorInformation/InvestmentChoices/InvestorNewsNewsletter/p036753