For as long as man has been walking upright, he has dreamed of and sought out magic potions or cure-alls for what has ‘ailed’ him. Ponce de Leon sought out the fountain of youth, Eastern cultures tout the benefits of rhinoceros horn powder and many of us might love to find that ‘instant buffed body’ pill (as long as it doesn’t come from some endangered or otherwise poached species), oh yeah! Whatever it might be, if it ‘ails ya’ some unscrupulous and maybe even good intentioned folks will come up with solutions to ‘what ails ya’ that may not have merit or efficacy but will benefit them by selling it to you. Some solutions to ‘what ails ya’ may have merit or efficacy by design, composition or intent but in the end it may not be the optimal or right solution for ‘what ails ya’. Or, even more insidiously, (a) the tradeoffs of ‘benefits received’ to ‘costs given up’ in using the solution are not fully disclosed so as to make a good informed decision about using the solution in the first place and/or (b) the solution might even be deleterious to your overall financial plans.
The desire to find that silver bullet to solve a problem or to deal with a task goes beyond matters of health, personal appearance or hygiene. Investors, too, would love to have a magic pill or a silver bullet for achieving their financial goals or maintaining a desired lifestyle. Stepping up to the ‘we’ve got the cure for what ails ya’ investment plate are a number of investment products (or styles) and/or insurance contracts that provide ‘hedges and/or guarantees’ to the risks of investing in the marketplace. Risks such as loss of principal, variability of investment return and, perhaps, premature death are ‘protected’ by the product or contract offered.
My question to you is should we find comfort in the investment silver bullets of the day?
Let’s look at a few to see what you know about what you are getting for the solution offered. The attributes and tradeoffs offered herein are not exhaustive and are merely meant to stimulate your thinking. If we are lucky, your solution to what ails YOU won’t be a placebo!
Equity Indexed Annuities
Equity Indexed Annuities (EIA’s) are not-a-security (regulated by the SEC) even though they have a return associated with some measurement methodology of the returns of an equity index. They are offered by insurance companies with the promise of a minimum guaranteed return (might be somewhere between .005% and .01%, today) plus a participation in the return of an equity index (like the S&P 500). This would seem to cure the – I am afraid of losing money but I want get some of those equity returns (gains) when they occur ‘ailment’.
Subject to the future capabilities of the guarantor (the insurance company), you will have capital preservation with a floor minimum return. No FDIC (Federal Deposit Insurance Company) guarantees but, if the market does well, I get a kicker in a ‘participation’ credit added to my return for the year.
The directions on the investment product medicine bottle, before I take my medicine, ought to have described to me what the costs, real and ‘opportunity’, and the benefits, tax and nontax of subscribing to this cure are. I have blogged previously about tax differences of annuity investing versus capital asset investing (mutual funds or stocks) so you can look there for information in that regard.
On the cost side, what are the fees associated with my ‘buying’ this solution? These fixed annuity type of investments have general and administrative costs and, perhaps, some death benefit providing some ‘guarantees’ that also has real costs. You may have your money subject to some back end charge meaning that if you want to leave the investment (cash out or change companies), you may be subject to a contingent deferred sales charge (CDSC). Front end charges might be 5% to the agent selling the solution (that’s why they have a CDSC) and ongoing expense might be 1 to 1.5% annually.
After all is said and done, might you just as easily have created your own get well ‘investment chicken soup’. In the annuity if you only earned the 1%* per year for the 10 years you would have $11,046 if you invested $10,000 today and the stock market went nowhere – no gain or loss. A 10 year treasury is yielding (state income tax free) 3.28% today (03-18-2011) so if you invested $7,999 into the Treasury note and $2,001 in an equity index (say the S&P 500) at the end of the 10 year period you would have $11,046 from the Treasury Notes plus the equity index return, which was flat in our example so you would have your $2,001 remaining. There are a lot of what if’s and tradeoffs (*the annuity rate might go up during the holding period while the Treasury would not) that make the choice of this alternative one of ‘what fits your needs and capabilities’. My point is – understand what is being offered by understanding alternatives so that you can decide if the ‘cost’ of the strategy is worth the solution it is providing.
Variable Annuities are securities (SEC regulated) and are similar to EIA’s in that you can invest into a fixed (sub-account) and or an equity investment (sub-account). The equity investments in this product are, for time consideration in providing you a simple description, ‘mutual-fund-like’ investments offered as choices in the sub-accounts.
These products offer you guarantees of return of principal subject to the paying ability of the guarantor, the insurance company, unless in equity sub-accounts which are ‘insulated’ from liabilities of the insurance company should something happen. The insurance companies have also gone so far as to provide minimum guaranteed returns, minimum annual income riders, return of principal riders, you name it (theoretically), to address whatever investment ‘ailment’ you have.
The same questions asked about an EIA could be asked here. What am I paying in costs, i.e., sacrificing in gain that would otherwise go into my pocket, in adding the bells and whistles associated with this type of cure-all?
As with many fixed annuities there may a death benefit feature (return of principal and or some ‘high contract’ value amount) that are designed to overcome bad , investment performance results. Again, what are the costs of adding the ‘cure’ and might I have benefitted from buying ‘death coverage’ through a standalone insurance contract? Total expenses for this one-pill-cure-all might run you 2.5 to 4.0% annually. When all is said, as with the EIA, understand the tradeoffs of benefits provided for costs paid as VA’s can be useful medicine in medicine cabinet.
Target Date Funds
Investing rules of thumb are plentiful but a constant abounds in that, general speaking, in your early years you can take more risks in your investing because you have ‘time on your side’. As we get older, our blend of risky assets to conservative assets should be shifting to the more conservative because you do not have time to make it up. When we transition from the accumulation phase of our investment life to the distribution phase, our investment mix will change to an income focus.
Well what if I could automate that process – would that be cool or not? Target date funds are intended to do this process of managing your portfolio for your age in the investment cycle. Again, what costs of management am I going to incur to have this investment process ‘managed’ for me? Harder to gauge are the appropriateness of the target date fund allocations to your personal circumstances. Everyone’s financial circumstances and wherewithal are different, risk tolerances are different, wherewithal to earn and accumulate over a working lifetime are different; so in the totality of an individual’s situation does the investment have merit? Clearly, the answer can be yes. The fact that the investment process can be professionally automated does provide benefit for segments of the investing population. As with the other alternatives, understand the tradeoffs.
A long standing argument in the investment community is whether or not there is benefit to active portfolio management. Studies show that in 2010, for example, 49.31% of equity funds actively managed were outperformed by the S&P 1500. Alternatively stated, 50.69% of actively managed funds outperformed the S&P 1500 benchmark. For the S&P 500 only 35% of equity managers beat the index. So, the argument would go, ‘why would you try to beat the S&P 500 index, for example when you only have a 1 out of 3 chance that your money manager will outperform the market?’ Proponents of active investment might counter with – ‘why would you want to only have an average (index) return?’
Here too, costs can be a drag on the active management after expense return to you the investor. So the active management portfolio will need add alpha (return in excess of the index) that exceeds those active management expenses in order to add benefit to your portfolio. Again, depending on the index, money managers do beat their indices and quite a few have done it very consistently!
Conclusions and Summary
Unlike things that are too good to be true, potions, elixirs, tonics and silver bullets of the sort talked about here might have merit in the right circumstances and situations but their ‘side effects’ and ‘collateral costs’ should be understood completely and clearly before they are weighed against the benefits touted and an investment is made. Don’t be misled by the ‘sideshow’.
Just as we are all unique individuals, our investment and financial needs are unique. Consider your investing options in the totality of your plans. Keep yourself flexible and nimble in your investment choices and understand the many trade-offs to solutions considered or offered. Monitor and review your portfolio on a regular basis, most likely at least annually and avoid short-term thinking when considering long-term objectives.
Remember, there are multiple ways to build an investment house so make sure it is built to fit your family’s needs efficiently and comfortably.