Annuities - An Investment Tool

Chapter 8

Variable or Fixed?

Which is better, variable or fixed rate?

  In this chapter we are going to discuss variable and fixed rate options.  A variable rate is more complex and is lengthier to discuss, so we will be discussing the fixed rate first.

Fixed Rate

  All fixed rate annuities have the following features, which will be explained in detail:

1. a guaranteed amount at the end of a specific time period,

2. a free bailout option,

3. the ability to add new contracts,

4. a secured future program, and

5. tax benefited annuitization.

  The guarantees of a fixed annuity are guaranteed every day; a person can count on that.  At the end of a certain period of time, you can count on the amount.

  When a person decides to invest in a fixed rate annuity, they decide the rate of return to lock in.  Normally, the longer a person is willing to commit, the higher the rate will be.  When looking at annuity contracts, a person makes choices like:

· one year at 3%,

· three years at 3.33%, or

· five years at 4.10%

  Whatever the person decided to choose, the rate of return would be guaranteed to be what is stated.  If the person chose the three year option at 6.33 percent, the person would be guaranteed 6.33 percent for exactly three years whether or not the interest rates went up or down, the stock market declined or the economy went into recession.  Again, these are just examples of the options a person may encounter.  These will vary from company to company and annuity to annuity.  Normally the rates offered by annuity contracts are higher than those offered by CDs or money market accounts.

  At this point, an investor may wonder how long they should tie up their money.  The answer depends on what one thinks will happen to interest rates in the future.  If they think the interest rates will go up during the next several years, they may want to choose a one year contract.  At the end of that year, they could roll over the annuity into a higher rate, whether they stay with that company's annuity or switch to another.  If, though, the person thinks interest rates are going to fall, they may choose one that offers the longest term, which is usually five to ten years.  If the person is uncertain about the direction of the interest rates, they can opt for a term in the middle, maybe a two, three or four year guarantee period.  It may allow the investor to be a little more versatile than the longer terms.

  In addition to the previously mentioned guaranteed rates and periods, fixed rate annuities provide an absolute minimum guarantee, exclusive of other interest rates or the state of the economy.  This exclusive rate ranges from four percent to six percent, but normally it is four percent.

  The free bailout option is closely tied to the guaranteed interest rate provision of a fixed rate annuity.  This can be very advantageous to the investor, the contract owner.

  Since we have already discussed the bailout option, we will just briefly review it.  If, after the guaranteed interest rate period is over the renewal rate is ever less than one percent of the previously offered rate, the investor can liquidate all or part of the annuity - principal and interest without cost, fee or penalty.  This gives the investor the security that they will always be receiving a competitive rate.  If the investor wants to change, and the renewal interest rate is not less than one percent of the previously offered rate, the insurance company may charge a back-end penalty.

  Normally if a person wants to add to their annuity contract, they must purchase another annuity.  The fixed rate annuity is a contractual relationship.  The insurance company is guaranteeing a rate of return on the specific invested amount - no more, no less.  Only a few insurance companies allow a person to add to an existing annuity contract.

  The fixed rate annuity always provides a secure future in that you always know where you stand.  There will be an exact amount of money at the end of the specified period.  The annuity contract will spell out what a person can expect in the way of growth of principal, and it will detail the exact amount of any penalties or fees that may exist and when and if such costs disappear.

Annuitization provides an even distribution of both principal and interest over a period of time.  The amount of each check can depend on:

· the competitiveness of the insurance company,

· the level of current interest rates,

· the amount of principal that is to be annuitized, and

· the duration of the withdrawals.

  Competitiveness will vary from company to company.  Shopping around for the insurance company that offers the best interest rates is an obvious chore, but one may not realize that insurance companies vary also in the returns they hand out during distribution (annuitization).  When a person is initially shopping for an annuity contract, this may be a factor to consider.  A person could also decide to change insurance companies when they go to annuitize.  Whichever they choose, knowing there are options available can be very advantageous.

  When an investor decides to annuitize, the amount of each check on a fixed rate annuity will depend on the current interest rates.  A person can decide to only annuitize a portion of the contract so that some of the investment left invested is still earning interest.

  The amount of the check received depends on the amount of the investment annuitized.  The larger the investment is, the larger the check received will be.

  The time allotted to the annuitization will also affect the size of the check received.  Obviously the check will be large if a shorter annuitization period is selected (such as ten years versus 20 years).

  When a person is applying for an immediate annuity, a payment mode is selected.  This may be either a monthly, quarterly, semiannual or annual payment.  The first annuity payment must be made no later than the end of the modal period selected.

  There are tax advantages in annuitization.  Disbursements are tax favored.  Systematic and/or sporadic withdrawals are not.  The disadvantage is that once the process is started, it cannot be altered and the rate of return during annuitization may be artificially low.

Variable Rate

  Inflation can cause a person to think twice before choosing a fixed rate annuity.  When a person invests in a government, corporate, or municipal bond, either directly or indirectly through a mutual fund, they are investing in something that is referred to as a fixed rate instrument.  This fixed rate of return would be ideal for every one if we lived in a fixed rate world with fixed rate expenses.  Unfortunately, we do not.  Inflation hits us all, and it is constantly going up.  Thus when expenses go up so does the need for the income to rise.  The variable annuity was designed to overcome the problem of inflation depleted income.

  The more an investment outperforms inflation, the riskier it becomes.  So, before a person rushes out to invest all their money in an investment that is considered an inflation hedge, they must first determine the risk level.  For the insurance producer recommending such investments, they need to understand the entire scope of the investment.  This then can be translated to the investor so that they can invest their money with all the information, including the risks, they will need to have.  No matter how much the inflation threat worries a person, there is always a price to pay for an investment that has the potential for growing at rates far above guaranteed accounts.  One price can be some sleepless nights due to increased volatility of the investment chosen.

  There are various investment options available to the variable annuity investors.  We will be elaborating on each option.  The options available are:

1. Aggressive Growth

2. Growth

3. Growth & Income

4. International Stocks

5. Balanced (Total Return)

6. Corporate Bonds

7. Government Bonds

8. High-Yield Bonds

9. Global & International Bonds

10. Specialty Portfolios

Aggressive Growth Object:  Maximum Growth

  The Aggressive Growth objective is maximum growth of the investment.  These types of funds usually invest in the common stock of very young companies and tend to stay fully invested over the market cycle.  These portfolios, or subaccounts of an annuity, may at times use leverage and may even engage in trading stock options or index futures.  Many aggressive growth subaccounts concentrate their assets in just a few industries or segments of the market.  The degree of diversification may not be as great as other types of funds.  These investment strategies result, of course, in increased risk.

  Aggressive Growth portfolios can provide low-income distributions.  This is because they tend to be fully invested in common stocks that pay small or no cash dividends.  A small or nonexistent dividend stream is unimportant for the annuity investor since tax consequences are not an immediate concern.  A high turnover rate can result in a large capital gain liability for the mutual fund investor, but not for the annuity investor who has opted for deferred growth.

  Long-term investors who need not be concerned with monthly or yearly variations in the investment return may find aggressive growth investing rewarding.  Though, short term investors who are uncomfortable with the extreme volatility of return may find that these funds can be offset by a greater allocation of an investor's total assets to a relatively risk-free investment, such as a money market fund.  During a prolonged market decline, aggressive growth funds can sustain severe declines in net asset value.

Growth Object:  Growth with Cash

  The Growth accounts normally are more stable than the aggressive growth portfolios.  They normally do not engage in speculative tactics such as using financial leverage.  They invest in growth oriented firms that pay cash dividends.  The concentration of assets is not as limited as the aggressive growth subaccounts.  Moreover, these accounts tend to move from fully invested to partially invested positions over a market cycle.  They build up cash positions during uncertain market environments.

  During prolonged market declines growth portfolios can sustain severe declines.  Since some portfolio managers of growth accounts attempt to time the market over a longer cycle, switching these funds often may be counterproductive.  Although market timing is strongly discouraged, doing so with variable annuities will not trigger a tax event that may occur with mutual fund market timing.

Growth & Income:  Well Established

  The Growth and Income subaccounts normally invest in the common stocks and convertible securities of well established, dividend paying companies.  Most of these companies attempt to provide shareholders with income along with long-term growth.  One tends to find a high concentration of public utility, common stocks and corporate convertible bonds in the growth and income portfolios.  The accounts also provide higher income distributions, fewer variations in return and greater diversification than growth and aggressive growth positions.  Equity income, income and total return are subaccounts that are characteristics of growth and income portfolios.

  The tax consequences should be kept in mind because of the high current income offered by these kinds of investments.  Use variable annuities whenever possible.  It has been suggested that growth and income may be the most cautious US stock play an investor can make.

International Stocks:  Foreign Companies Only

International Stocks invest in securities of foreign companies only.  They do not invest in US stock at all.  Some portfolios specialize in certain regions, such as the Pacific Basin or Europe.  Global funds invest in both foreign and US stocks.  International funds provide an investor with added diversification.  The most important thing to factor in when diversifying a portfolio is selecting assets that do not behave the same under similar economic scenarios.  Within the US, investors can diversify by selecting securities of firms in different industries.  In the international realm, investors take the diversification procedure one step further by holding securities of different firms in different countries.  The more independently these foreign markets move in relation to the US market, the greater the diversification potential for the investor, thus lowering the total risk to the investor.  International stock overcomes some of the difficulties investors would face in making foreign investments directly.  The individual investor would have to understand thoroughly the foreign brokerage process, international taxes, and various marketplaces and their economics.  They would have to be aware of currency fluctuation trends as well as access to reliable financial information so a proper investment decision can be made.  This is nearly impossible for the individual investor; it would take much time that the individual may not be able to afford.

  Investing abroad may be a wise consideration since different economic experience prosperity and recession at different times.

  The economic outlook of foreign countries is the major factor in international investing.  A secondary concern may be the value of the US dollar relative to the foreign currencies.  A strong dollar will lower a foreign portfolio's return.  A weak dollar will enhance international performance.  Investors who do not wish to be subjected to the currency swings may opt to use a variable annuity subaccount that practices currency hedging.  Currency hedging is basically an insurance policy to protect one's investment if the dollar is making a killing in currency futures contracts.  It only pays off if the dollar becomes strong, increasing in value against the currencies represented by the portfolio.  The cost of such insurance contracts becomes part of the cost of doing business.  In the case of currency contracts, the contract expires and a new one is purchased, covering another period of time.  When properly handled, the gains in the futures contracts (the insurance policy) can offset most or all of the security losses attributed to a strong dollar.  A person may believe that buying currency contracts is a risky business for the fund, but if done properly it is not.

  The key thing to remember is that international investing reduces the overall risk of an investor's portfolio.  Besides reducing risk, they can also provide excellent returns.  According to a Stanford University study, overall risk is cut in half when a global portfolio of stock is used instead of one based on US issues alone.

Balanced or Total Return:  Decreased Volatility

  The Balanced or Total Return accounts mix investments in common stocks, bonds and convertible securities to decrease volatility and stabilize market swings.

  Balanced portfolios, like the growth and income accounts, provide a high dividend yield that is sheltered from taxation within a variable annuity, but not within a mutual fund.  High tax-bracket investors should consider this point before they invest their money in a mutual fund.

  The main objective of balanced subaccounts is to provide both growth and income.  This is done by taking advantage of market rises through stock holdings and providing income with bond holdings.  Balanced portfolios provide neither the best nor the worst of both worlds.  They often outperform the different categories of bond funds when things are good but suffer greater percentage losses during stock market declines.  When the interest rates are on the rise, balanced accounts will typically decline less than bonds.  When rates are falling, balanced subaccounts will also outperform a bond portfolio if stocks are doing well.

  Balanced accounts provide a buffer against market volatility for those investors who want to avoid such things.  Balanced portfolios have outperformed the bond indexes since this category of annuities includes common and preferred stocks.

Corporate Bonds:  High Interest Payments

  The Corporate Bond subaccounts invest in debt instruments issued by corporations.  Bond portfolios have a wide range of maturities.  The name of the portfolio will often indicate if it is composed of short term or medium term obligations.  If the account does not specify one of these two, then the average of maturities is over 15 years.  The greater the maturity, the more the portfolio's unit price can change.  There is an inverse relationship between interest rates and the value of a bond.  When the one moves up the other goes down.

  Corporate and Government bonds normally generate high interest payments, so the ideal investment vehicle is the holding of such an instrument in a variable annuity.  The risk reduction that bonds provide coupled with a tax deferral benefit, make a strong case for owning these within a variable annuity contract.  There has only been six years over the last 66 years in which both bonds and stocks declined.

Government Bond:  Diversification

  The Government Bond subaccounts include both mortgage backed securities and US Treasury obligations.  These portfolios can be attractive to bond investors because they provide diversification and marketability that are not as readily available in direct bond investments.

  As with all bonds, government bonds have a wide range of maturities.  These bonds subaccounts can provide diversification.  Investors will want to invest in the larger portfolios because these tend to operate more efficiently in economies of scale.

  Since variable annuities charge a mortality charge of normally one percent, it is best to minimize bond subaccount holdings.  Expenses can eat away at the returns.  For bond accounts to be most effective, they would need to be held on average at least ten years to make them more worthwhile than mutual funds or direct ownership.

High-Yield Bonds:  Less Interest Rate Risk

  The High-Yield Bonds invests in lower-rated debt instruments.  Bonds can either be characterized as "bank quality," (also known as "investment grade") or "junk."  On the rating scale, bank quality bonds are those that are either AAA, AA, A or BA.  Junk bonds would be on the other end of the scale of BB, B, CCC, CC, C and D.  High-yield bonds can offer the investor higher returns due to the additional risk of default.  High-yield bonds are subject to less interest rate risk than regular corporate or government bonds.  However, when the economy slows or investors panic, these bonds can quickly drop in their value.  The high current income can only be sheltered in a retirement plan or variable annuity.  A dividend and/or interest reinvestment program with a mutual fund does not minimize any taxes due.

  The world of bonds is not black and white as other investments may be.  There are several categories of high-yield bonds.  The junk bonds on the higher end of the rating system have been able to withstand the general beating that was incurred during the late 1980s and early 1990s.  Moderate and conservative investors who want high-yield bonds as part of their portfolio should focus on subaccounts that have a higher percentage of their assets in higher rated bonds.

Global & International Bonds:  Global Diversification

  The Global and International Bond portfolios invest in foreign fixed-income securities.  These fixed-income obligations are denominated in various currencies such as francs, pounds, yen and deutsche marks.  The fixed-income markets do involve some risks, which can be reduced through global diversification.

  Since countries move in different economic cycles, so do the capital gain prospects of the bonds issued in those countries.  At any one time, a certain country may offer the highest returns.  As global economic cycles shift, a different country may then hold out the greatest opportunities.  International bond portfolios have outperformed their US counterparts over the past 25 years.  Global diversification also reduces the investor's risk level.  There are not many variable annuities that have international or global bond subaccounts, but they are not impossible to seek out if this is a portfolio that is chosen.

  Prospective investors need to be aware of the potential changes in the value of foreign currencies relative to the US dollar when investing in international subaccounts.  Global portfolios invest in securities all over the world, including the United States.  A global account usually invests in bonds issued by stable governments from a handful of countries.  Management tries to avoid purchasing foreign government debt instruments from politically or economically unstable nations.

  Global bond accounts seek higher interest rates no matter where the search may take them.  Inclusion in the portfolio depends on management's perception of interest rates, the country's projected currency strength against the US dollar and the country's political and economic stability.

  Foreign markets do not necessarily move in tandem with US markets.  Each country represents varying investment opportunities at different times.  Variable annuities that invest in global securities, particularly those that have a high concentration in foreign issues, are an excellent risk-reduction tool that the vast majority of investors should look into.

Specialty Portfolios:  Single Industry Invested

  Variable annuities that are described as sector or "specialty" portfolios invest primarily in stocks of a single industry.  Using specialty portfolios should not dominate the total holdings.  In fact, it has been suggested that it only takes up to 15 percent of the total holdings.  There are two reasons why this limitation may be recommended.  They are:

1. By choosing a specialty account, the investment is tying investment management hands.  Their ability to find worthy stocks are limited by prospectus to a certain industry.  If this industry or sector is not performing well, the subaccount will not do well either, no matter how experienced the management team is.  This would hinder the versatility of the investment.

2. Specialty or sector plays are considered very risky.  The entire subaccount is prone to the fortune or misfortune of particular industries.  Equally important, if a person reviewed the performance of all sector and specialty portfolios combined, they would find that they have the worst of both worlds:  substandard performance and above-average risk.

  Even though we have just stated some very big disadvantages, there are some advantages that should not be overlooked.  First, these accounts allow a person to invest in, for example, real estate without going through the trouble of buying and managing their own properties.  The second advantage is that sector plays combined with a well-considered portfolio can actually reduce the overall volatility.  When combined with other categories such as growth, international and high-yield, this can lower the total risk of the investment.

  Insurance producers are often called upon to answer questions for their clients that can be answered by their own in initiative.  Informing the policyholders of this can alleviate some questions that someone else can answer.

Besides calling the insurance company for performance results, are there any other sources that a person can go to?

  A person that is concerned about their investment could also subscribe to one of several periodicals such as Barron's, a weekly publication that lists several hundred variable annuities.  The Wall Street Journal has increased its coverage of annuities, running periodicals on the performance figures of the best and the worst performing variable annuities.

  Insurance producers may be able to divert questions that can eat up precious time by pointing the clients to other means of finding their answers.

What is DCA?

  Any investor that is concerned about the risk involved can opt for the solution of dollar-cost averaging (DCA).  This is a simple yet effective way for an investor to reduce risk, whether they are investing in stocks and/or bonds.  The principle behind dollar-cost averaging is that if several purchases of a variable annuity are made over an extended period of time, the unpredictable highs and lows will average out.  The investor ends up with buying some units at comparatively low rate and others at a much higher rate.

  Dollar-cost averaging assumes that investors are willing to sacrifice the possibility of having bought all their units at the lowest price in exchange of knowing that they did not also buy every unit at the highest price.  This is a compromise, a risk reduction decision.  Dollar-cost averaging is based on investing a fixed amount money in a given annuity at specific intervals.  Normally the investor will add a specified amount into the annuity contract at the beginning of each month.  Dollar-cost averaging works best for the investor if they continue to invest on a pre-established schedule.  A person will be buying more units when the price is down, but when the price is going up they will buy less.  The bright side of this is that existing units are gaining value.  If this program is followed, losses during market declines are limited while the ability to participate in gold markets is maintained.

  Another advantage to DCA is that is increases the likelihood that an investor will follow the investment program.  When goals are set, they are more likely to be met.

Is DCA similar to SWP?

  A type of dollar-cost averaging in reverse is a systematic withdrawal plan (SWP).  This allows the investor to have a check for specified amount sent to them monthly or quarterly or sent to anyone they designate from the annuity.  There is normally no charge for this service, depending on the insurance company.  This method is ideal for the income oriented investor.

  When the market is low, the number of units that is being liquidated will be higher than when the market is high.

  Another selling point is this:  A systematic withdrawal plan is designed to maximize the income and offset something the CD, T-bill and bond sellers never mention - inflation.  This program can easily be used with annuities as well as mutual funds.

What is an allocation portfolio?

            For investors that do not like or want to make all of the investment decisions, they can opt for experts to make the choices for them.  This is called an allocation portfolio.  Professional managers view current market and economic conditions to determine the best mix of investments of achieving a portfolio's objective at any time.  The objective of an asset allocation portfolio is to provide a predetermined level of total return consistent with long term preservation of capital.

            An investor can change their investment portfolio whenever they wish.  But they should not overlook that monies left in investments for longer periods of time achieve maximum growth.  There are normally no restrictions on subaccount switching within variable annuity contracts.

End of Chapter 8