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The bias toward mutual funds in the mass media! October 28, 2008

Posted by shaferfinancial in Uncategorized.
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The New York Times ran a recent article on what they call a new financial product aimed at seniors now that we are in a bear market.  As usual the slant of the article is toward mutual funds (Wall Street), although they did let the cat out of the bag with some actual evidence.

First, let me say the financial product is really not new, but is thought to be so much a threat to Wall Street interests that the SEC is trying to take control of this insurance product so only those licensed for securities sales can offer it!  This product is called deferred indexed annuities.  Now I want to be clear that this is a different product than the indexed universal life insurance products I like for hedging against inflation and taxes.  Also I want to be clear, that generally I don’t like this product for anyone.  More on that later.

For those of you registered at the NY Times web site here is the article on indexed annuities.  Indexed annuities work similiarly to indexed universal life in that there is an underlying investment in options on a index.  There is a guarantee interest rate, usually around 2-4%, and a ceiling usually 6-8%.  Also annuities never go negative even if the index goes negative.  Other than that there is little the same.  Deferred annuities, which is what they are talking about, is a savings vehicle that has much fees involved.  On top of that there are usually surrender fees that go on for generally 5-10 years.  The interest rate credited goes up as the surrender fees go longer.  There is also a tax deferral function that works similiarly to IRAs.  You can annuitize these products down the line if you want to.

The NYT article made an astonishing admission for an article basically telling folks not to buy these products.  Here is the comparision of an indexed annuity to the S & P 500 (not a S & P 500 mutual fund with expenses). 

The result? The index annuity, which started with $100,000 in October 1998, would have had an account value of $176,478 as of Friday’s market close. The S.& P. 500 index fund, which also started with $100,000, would have actually lost money over 10 years, ending with a balance of $81,890.

The NYT article goes on to explain that this annuity is very complicated with alot of moving parts and then recommends a combination of Zero Coupon Treasury Bonds and a S & P 500 Index fund.  But it gets better, they run some analysis assuming a 10% annual return on the S & P 500 and found that their suggestion beats the annuity 82% of the time.  By now the astute reader will notice that all this is saying is that when we are in a bull market it is best to be in stocks.  DUH….  What about the bear market which they described above in giving actual results????  How does $176K including  all those fees compare to $81K without any fees in real life????? 

Readers will also recognize I did this actual results test for an EIUL versus S & P 500 recently.  The EIUL outperformed by a large margin after fees and insurance costs!  Look here is the bottom line, annuities and EIULs perform well in a mixed bull and bear market.  Indexed equity funds perform well in a bull market.  But no one can actually predict these things in the long run.  What we do know is that, on average, we have a bear market every 6 years, and three times in the last hundred years we have had an extended bear market of around 15 years.

Now to my issues with the deferred annuities.  All the expenses and fees loaded in these products provides a cost.  Unlike EIULs, there is no reason to assume this cost if you don’t have a great reason, like tax free access at any time.  You are tying up your money, with hefty penalties for access either through surrender fees or tax obligations.  This is of course why people sue over this product.  They think they have found a better deal or just really need to get to their money and realize the cost of getting out early is high, so they sue the insurance companies to get their money (most deferred annuties allow borrowing only up to 10% of the principal each year).  I think either you buy an EIUL and get the tax advantages and a better return or you keep the money liquid by buying treasuries or even the zero coupon bonds suggested in the NYT article.  Very little risk and a small return that should hedge you against inflation and the variation in the stock market.

Finally, I really like immediate annuities.  When you annuitize it means you give an insurance company a chunk of immediate money in exchange for a lifetime of fixed installments.  Basically, you are betting that you will live longer than average.  If you live a shorter life then you end up losing on the deal; but who cares you are dead!  This guarantee of life time income is a great bet for the middle class reducing their risk to zero.  Of course inflation will degrade their income over time, but their expenses generally will go down once they hit their 80’s.  Of course we are all here at UFW trying to avoid having meager funds to retire on, so if we are successfull an imediate annuity might not be necessary or might be one of several income producing strategies employed! 



1. Artur | Phoenix Real Estate - October 29, 2008

I wonder – in the coming deflationary economy – how does one invest to increase wealth? Especially when most of the investing has been based on inflation. Most of us have not been in such a situation and see the future based on personal experience which will not be adequate. There are probably very few people that know what to do or what they are doing and it’s certainly not mutual funds managers.

2. shaferfinancial - October 29, 2008

Great question. But first I don’t share your pessimism on the economy. I am more attuned to the Warren Buffett vision. Even in real estate, although still with some issues, here in St. Petersburg, we have seen values stabilize for 5 months now. In fact, I just picked up a share of BRKb for less than $3700 the other day, a fabulous deal in my opinion! I am long on all my stock portfolio.

However, if one had your vision, then one would want to own lots of gold! They would also move to the safest place possible which would be treasuries and zero coupon treasuries.

Now if one were really sure of your deflationary vision, then you could find many investments that would pay off in a deflationary cycle. One of my readers, Sean, invested in SRS which basically shorts the American real estate industry. There are other funds that basically shorts the entire stock market. Pick an asset or company that you think will devalue and you can find a way to make that bet! Of course these are highly risky bets because you are betting against the long term trend which is up for almost all assets.

But beware, there are alot of very smart people who, while acknowledging the issues are betting on a recovery in the next couple years! Also big capital has started back into the American Real Estate Market. Lots of people betting on recovery.

Thanks again for the great question!

3. Artur | Phoenix Real Estate - October 30, 2008

It’s not that I’m a pessimist: it’s that it may be prudent to acknowledge and prepare for both possibilities or at lease know how to handle them. A lot of “very smart people” sure were not smart enough prevent what happened or in fact they wanted it to happen. It’s a very complex world, much more complex then most people read in the headlines and I’m not insinuating any conspiracies.

4. shaferfinancial - October 30, 2008

Totally agree with the complex world! And there are many people out there that have gone to cash, gold and treasuries to “ride out the storm.” Its just not my nature to follow the herd. Call it a personality disorder. 🙂

On top of that I take my clues from Warren Buffett et al. who have much more experience than I. You have given me a new idea for a post. Most people don’t fully appreciate the history of finance and stock market gyrations. Maybe putting the current issues in the longer view would be useful for some?

5. Brian - October 30, 2008


What did I miss? The example shows the Index Annuity performing better ($76,000. gain over 10 years), than the S&P index fund. Is the annuity in that example ‘deferred’ I’m assuming? If so, isn’t that a decent rate of return, assuming it had a downside guarentee?

Not sure if I’m reading your post correctly.


6. shaferfinancial - October 30, 2008

Brian, sorry for any confusion in the post. Yes, it is a deferred annuity and yes it did outperform the S & P 500 Index Fund. Here are my issues:

1. I think a EIUL is a better product for most folks because of the tax favorability. An EIUL should outperform the indexed annuity even accounting for the insurance costs because the ceiling is usually 4-5% above the annuity.

2. If this is all or most of your retirement wealth, and you have 10 years + before retirement, then you need to apply the rules of wealth creation to this money. Learn to become an active investor, build your plan and implement it. The rate of return inside a deferred annuity will never create wealth, only hedge against inflation.

Bottom line is you have either created wealth that you want to protect or you are still in the wealth creation stage and need much higher rates of returns than either an EIUL or indexed annuity will give you.

Hope this is clearer now. Thanks for the great question.

7. Wil - November 14, 2008


So if you’re a senior citizen and you are in the protection stage, you would recommend a EIUL vs. a EIA? Right now my parents have about $700k in mutual funds at the suggestion of their financial planner and of course have lost money. Would the EIUL or the EIA be a good switch for them?


8. shaferfinancial - November 14, 2008

Will, the short answer is no/ well maybe.

Generally, EIULs for those over 60 are used for estate planning purposes if the estate is likely to trigger the estate tax ($3.5M in 2009). They need about 10 years to really start performing because of the up front fee’s if you are going to use them for reitrement income. The equity indexed annuity is a deferred annuity and useful for those who are not insurable. However, the best use for those funds, in my opinion is an immediate annuity. An immediate annuity guarantees a fixed lifetime income in exchange for the principal. It is basically a bet that you will outlive your actuarial life span. The amount of your income is determined by your gender, age, and possibly your health if it is not good.
Without understanding your parents full financial picture I couldn’t make a recomendation but here are some things to think about:

1. What are the total assets and where are they located (home equity, IRA, mutual funds, etc.)?

2. Can they afford more market losses or variability in their investments?

3. How is their health?

4. How much do they worry about their money? (as people age this becomes a HUGE concern)

5. Are they likely to have estate tax problems?

6. What is their living arrangements (are they still living in the large family home, etc.)?

7. What happens when they lose the ability to drive?

8. What will the effect of inflation do to their savings?

9. Now, the damage is already done in their mutual funds. But how can they handle further damage both emotionally and financially?

Is some cases I have suggested a phased set of changes. This might include, taking $500,000 into an immediate annuity for income (single person annuity could provide around $40K/year) and leaving $200K for capital growth. Making a plan on when to sell the home and move into a senior planned community (I know many seniors who were reticient to do this, but absolutely think it was the most important and best decision they made for their retirement). Estate tax planning. Developing health proxies and identifying who will handle their finances when they can’t, etc. The time to develop the plan is now, while they are still healthy enough to deal with the issues in a rational matter. Believe me,as one that has gone through their parents end-of-life issues, everyone is better off to have these decisions made up front.

If they have pension income that is sufficient for the time being, then they might want to do nothing for a few years with that $700K and wait for the market to come back or switch to lower expense financial instruments like ETFs (exchange traded funds). But whatever they do with the mutual funds, they should start creating a plan. I would be more than happy to talk to you and them if you like. Just contact me through the contact David Shafer tab on top.

Best of luck!

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