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ID YOU MAKE ANY New Year's resolutions? If so, they're probably about physical fitness and health. But what about your fiscal fitness and financial health? You may want to add some Investor's New Year's Resolutions to your list. They'll probably be easier to keep than your promise to skip dessert and run a mile every day.
And speaking of fiscal fitness, you might be interested in finding out about One Investment You Really Don't Need. Falling for this one could be dangerous to your financial health.
As always, we'd like to hear your comments and observations. We'll get back to you and may even air your opinions on a future page.
1. I WON'T CHASE THE HOTTEST STOCKS OR MUTUAL FUNDS. With the equity market coming off three remarkably strong years, there's a temptation to jump on those stocks or funds that have been the best performers. Resist the temptation! Historically buying last year's winners has been a losing proposition. What it amounts to is buying high and probably selling low. In fact, some of the best strategies have involved buying previous laggards -- those that have been left behind and consequently still have some appreciation potential. A value strategy is just such an approach. It's the basis of this site.
2. I WON'T DAY TRADE MY 401(k). Does your employer's retirement plan allow you to select from a menu of funds? Does it also have one of those 800 numbers you can call 24-hours a day, 365 days a year to change the mix? If so, don't use it. By its very nature, your retirement plan is a long-term investment. You've got to realize that over that time, there'll be some ups and downs. If you panic and switch from one investment to another or if you're simply trying to outguess the market, you'll lose. It's as simple as that.
A lot of folks made this mistake last October when the market fell over 500 points in one day. (More would have screwed up if they hadn't been prevented by the market's premature close.) By switching out that day -- essentially at the bottom -- they missed the over 200-point recovery the next day. You're much better off if you give your investment decisions time to work. As recommended in...[Structuring Your Portfolio], you should review your investment mix, but only at fixed intervals like once or twice a year. Leave the day trading to the fools.
3. I'LL PAY MY CREDIT CARDS IN FULL EACH MONTH. Credit cards can either work for you or against you. Unfortunately, they work against most cardholders. The average interest rate for outstanding balances is still about 18%. By paying this off, you receive a guaranteed 18% return. That's a lot better than you can realistically expect from any other investment.
Once the outstanding balance is paid off, the card can then work for you. If you pay it off each month, you're essentially receiving an interest-free loan for the grace period. Not even your brother-in-law will do that for you.
And by the way, contrary to what purported consumer-oriented publications say (hello Money and Consumer Reports), a credit card's high interest rate is not a ripoff. Quite the contrary, the issuing bank is making you an unsecured loan for the balance. You're not giving them collateral like a mortgage on your house or lien on your car. Without this to fall back on, they're taking on more risk and the high interest rate is their compensation. If you carry a balance and let them collect it, it's not because they're cheating you, it's because you're stupid.
4. I WON'T WATCH CNBC or if I do, I'll keep the sound turned off. The stock ticker's OK, but the daily pathos does more harm than good. You see, despite its recent performance, the stock market is inherently boring. On the other hand, the CNBC talking heads have to be on air about twelve hours a day, so they have to have something to hype. As a result, every little nuance, every little development, no matter how insignificant, is blown out of proportion and becomes a major event. Resist the temptation to be sucked in. If you want hype and excitement, watch a talk show or a soap opera.
5. I WILL INVEST ON A REGULAR BASIS. The most reliable way to build a portfolio is through systematic, long-term investment. As trite as it sounds, you really do need to put yourself first on payday. You don't have to set aside a lot, just do it systematically. You can dollar-cost-average into mutual funds, dividend reinvestment programs, or make periodic deposits into a money market where the funds can build for future investment. For more details and a list of "no-load" stocks, check out How Do I Get Started? in the archives.
6. I'LL MAKE INFORMED DECISIONS. Not everyone wants to follow the stock market every day. Most people couldn't care less about interest rate projections or the means to calculate a P/E. You may be one of them, and that's OK. But you do want to send your kid to college, retire comfortably, and not have to worry about paying the bills while you get there. To do any of this, you've got to save and invest.
If you don't want to follow the markets and do your own research, you'll need good advice. The best place to get it is from a good broker. Even when you've found one, you still don't want to blindly follow his or her advice. At the very least, you'll want to understand why he or she is making particular recommendations. If you really have a good broker, he or she won't mind explaining specific investments and strategies. If he or she can't or won't take the time to discuss this with you, it's time to find another advisor.
If you make your own investment decisions, don't just buy the hottest stock or follow the hype of some goober on CNBC. Make the effort to understand the investment, its risks and potential returns. Most importantly, find its intrinsic value -- what you're really buying. That's what this site is all about. Happy New Year.
What we're talking about here is a variable annuity. The Wall Street Journal often refers to them as, "mutual funds in an insurance wrapper." That's a pretty fair description. Traditional versions, now called fixed annuities, have been around for ages. Under these arrangements, the issuing insurance company would guarantee the purchaser a minimum fixed return on his or her deposit. The actual rate would fluctuate, being several percentage points below what the insurance company would earn on the funds. (The difference was the insurance company's profit.)
Favorable tax treatment of insurance products allows all earnings to grow tax-deferred until actually withdrawn. When the purchaser did begin to take distributions ("annuitize" -- don't you just love that word?) one option was to spread payments out over his or her lifetime. The specific amount of distribution was determined by the annuitant's life expectancy. If the annuitant lived longer than predicted by the actuarial table, he or she would actually receive more than the value of the annuity. Of course, if he or she died before reaching his or her life expectancy, the insurance company made out.
As interest rates came down from their highs of the 1980s, fixed annuities lost their appeal. At the same time, the equities markets began their ascent. Insurance companies struck deals with mutual fund families and variable annuities were off and running.
Like their fixed brethren, variable annuities allow the purchaser to "annuitize" over his or her lifetime. Until that time, the actual growth is determined by the performance of the mutual funds selected by the purchaser. Since they are within the annuity, all capital gains and dividends are tax-deferred until withdrawn. (Annuity hucksters love to point this out.)
In addition, the insurance company guarantees that should the purchaser die before annuitizing, his or her beneficiary will never receive less than the initial investment -- even if the underlying mutual funds have actually gone down in value. Some variable annuities go even further by periodically upping the guaranteed benefit. (Annuity hucksters make a big deal out of this, too.)
So what's wrong with these jewels? Plenty. Since tax deferral is usually touted as the major benefit, let's start there. While it's true that you defer taxes on the earnings while accruing within the annuity, you're actually in worse shape when you pay the taxes upon withdrawal. Why? Well, it's the difference between capital gains and regular income.
You see, most variable annuity owners invest in stock mutual funds. The majority of the return on these funds comes in the form of price appreciation or capital gains. Capital gains are taxed at favorable rates -- soon as low as 18%. On the other hand, regular income is taxed at the taxpayer's highest marginal rate -- as high as 31%. But all earnings are taxed as regular income when withdrawn from a variable annuity. In essence, variable annuities convert capital gains (which would normally be taxed at favorable rates) into regular income (which will be taxed at the taxpayer's highest marginal rate). Projections vary widely, but you'd have to hold a variable annuity for somewhere between ten and twenty years before the additional growth from tax deferral would offset the additional taxes you'd pay when withdrawing your capital gains as regular income.
But that's not the worst of it. If you died before annuitizing your variable annuity, its total value would be included in your estate for estate tax purposes. This is one of the nastiest taxes out there, starting at about 37% and quickly rising to 55%. In itself, this isn't unusual, but most assets included in your estate pass to your heirs with what's called a "stepped-up basis". This is the asset's value at the time of your death, rather than your initial cost basis. This can make a big difference to your heirs because when they dispose of an asset with a stepped-up basis, there's little if any capital gain so there's little if any tax to pay. But guess what? Not only is your variable annuity subject to estate tax, it doesn't receive the stepped-up basis. If it's substantially appreciated from your initial investment (and we all know it will be due to the marvelous wonders of tax-deferred growth), your heirs will be hit with the double whammy of estate and income tax. Isn't that special?
But why should they complain? They've been guaranteed to receive no less than your initial investment. Even if you pick the absolute worst funds and rack up big losses, they won't be penalized for your mistakes -- at least that's what the hucksters say.
But you know what? Everybody's penalized. If your annuity is growing (that's the purpose of using mutual funds, isn't it?), this guarantee will mean nothing after the first year or so. But even when it's no longer meaningful, you're still paying for it. That's right, you're not getting something for nothing, you're getting nothing for something.
The guarantee comes from the insurance element in the annuity, and unless you're buying it from the Salvation Army, it isn't free. No, you're paying for it. In fact, you're probably paying around 1% of your market value per year for it. You're probably paying even more if you're "lucky" enough to have one of those variables that periodically ups the guaranteed amount. What do you think that expense does to your investment performance? What do you think it does to it over the long-term?
In fact, variable annuities have total annual expenses ranging from 1.4% to 3.0%. Besides the insurance element, these expenses include the insurance company's overhead, fees paid to the mutual fund families for use of their investment funds, and of course, commissions for the huckster who sold you the annuity in the first place. To put it in perspective, variable annuity fees are about twice those of the average equity mutual fund. While 2 or 3% may not seem like a big deal when the average stock fund is up over 20%, it is when the market reverts to the mean and goes up 10% or less. Remember, this is supposed to be a long-term investment.
And don't think you can get out of a variable annuity, either. You can't, at least not without incurring a major hit. Most carry surrender penalties that start between 7 - 9% and decrease 1% each year. Some actually impose the penalty on each contribution. Needless to say, they don't want you taking your money out. The main reason for this is the large commission paid to the broker who sold you the annuity. Since the insurance company fronts this commission, they're compensated by holding your funds for a substantial period of time (until the surrender period expires) or from the penalty you pay when you remove your funds "prematurely".
OK, but what other investment will guarantee an income stream that you can't outlive? Well, there aren't any others, but then again, 95% of annuity owners don't annuitize. That's right: Less than 5% receive annuity payments, the rest take their funds in lump sums or other forms of payments. Odds are, if you own one, you won't annuitize either. So much promise, so little return.
As you've probably guessed, it's the high commission that accounts for the vast majority of variable annuity sales. In fact, with the demise of limited partnerships (another delightful "investment"), variables are one of the highest commissioned products in the broker's arsenal. They may not be appropriate for you to buy, but they sure are appropriate for commission-hungry brokers to sell.
Now don't misunderstand, there are a handful of people for whom this is an appropriate investment. For example, if you know you're terminally ill but don't want to keep your funds in a mattress, a variable annuity can work out nicely. It will allow you to share in the short-term gains of the stock market without exposing your capital to any real risk. In fact, if you should incur a loss, you can pull the majority of your remaining funds back out of the annuity and keep the remainder as insurance -- insurance you probably couldn't purchase if terminally ill.
Here's how it works: Supppose you initially invested $100,000 but after a market correction, your variable annuity dropped in value to $70,000. Remember, most variable annuities would guarantee a $100,000 death benefit. They also reduce this guarantee dollar-for-dollar for funds withdrawn. So if you withdrew $69,000 (yes, you'd have to deal with the surrender penalty), the variable annuity would still guarantee a $31,000 death benefit ($100,000 - $69,000). You would, in essence, receive $31,000 worth of insurance for a "premium" of $1,000. Not bad for someone diagnosed as terminally ill.
The rest of us are better off using mutual funds or individual stocks. Yes, they're taxable, but you control when by deciding when to sell. And then, you'll be taxed at the favorable capital gains rate. Your heirs won't get stabbed by an extra onerous tax, and you can freely move between investments without fearing usurious surrender penalties.
So when your broker suggests a variable annuity, just say no.
"People don't do what they really believe in. They just do what's convenient and then they repent." -- Bob Dylan
ERE'S A HANDFUL OF New Year's resolutions that probably apply to most long-term investors. There's no significance to the order. Do you have any others to add? If so, send 'em in.
"Nobody ever lost any money by underestimating the intelligence of the common folk." -- P.T. Barnum
UPPOSE THERE WAS A WAY you could buy and sell a wide array of mutual funds, defer taxes on all your trades, and be assured that regardless of your investment decisions and the market's twists, your heirs would never receive less than you initially invested? In addition, suppose it would pay you income for as long as you and/or your beneficiary lived, even if the amount paid to you exceeded the value of your initial investment and earnings? Would you be interested? Of course you would, but unfortunately, the investment makes snake oil look like a wonder drug -- and a bargain at that.
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