Financial Abundance

If you are a business owner or work for a public corporation, a significant amount of your net worth may be in the form of your ownership in the company for whom you work.  You may be taking on significantly more investment risk than you have intended.  Let’s look at some ways to minimize the risk associated with this company ownership.

If a significant amount of your family’s net worth is the value of the company that you own or stocks and stock options in a public company for whom you work, it is important to include these values in the equity portion of your investment portfolios asset allocation.  Often, business owners and corporate executives do not remember that the value of their ownership in the company for whom they work is also an equity investment.

As we have often stated, portfolio asset allocation, in which you determine the percentage of total assets to be allocated between stocks, bonds, alternatives, and cash is a critical activity required to maximize your investment returns.  To properly allocate one’s assets, the value of your ownership in the company for whom you work must also be included with the equity portion of your portfolio allocation.

As an example, let’s assume that you are a fairly aggressive investor with a desired portfolio allocation of eighty percent equities and twenty percent fixed-income and cash investments.  Let’s further assume that your current net worth is one million dollars with $500,000 being in the value in your business and $500,000 in an investment portfolio.  In this example, you should have no more than $300,000 of your investable portfolio in equity investments, since you already have $500,000 of your portfolio invested in the equity (stock) value of your small business.

If you are a more “conservative” investor, and wish to have a sixty percent equities and forty percent in fixed-income and cash positions, only $100,000 of your $500,000 investable portfolio should be put into stocks.  While this is only 20% of your investment portfolio, when combined with your company ownership, your total equity investment is 60%.

It is also important to consider size and the market space of the company for whom you work.  A well diversified portfolio has equities in Small Cap, Mid Cap, and Large Cap companies.  If you own a small company, the equity purchases in your investment portfolio should be in Large Caps and Mid Cap firms.  However, if you work for a large corporation and have a significant amount of your net worth in that company’s stock and/or stock options, your investible portfolio should have a larger percentage of equity holdings in Small Cap and Mid Cap firms.

If your company ownership is in the high-tech industry, focus your investment portfolio on stocks of companies that are in other industries.  This approach helps maintain a well-diversified portfolio, one that is not overly dominated by any industry.   Having exposure to multiple industries helps to minimize the risk that all of your stocks will decline together, since companies in the same industry often have declining stock prices at the same time.

If you work for a publicly traded company, it is important to remember that both the stock that you own and your paycheck are dependent upon the continuing success of your firm.   With so much at stake with one company, it is usually best to have no more than 10% of your liquid net worth invested in the stock of the company for whom you work.

Risk diversification is an important aspect of safely accumulating the resources required for an abundant retirement.  Often, small business owner’s and senior executives forget that the value of their ownership in the company for whom they work is an equity investment that should be included in their investment portfolio.  By honoring this important fact, your total portfolio will be better diversified.

For many years it has been well understood that a well diversified portfolio is critical to an investor’s long term success.  By including your ownership in the company for whom you work in your equity allocation, you will lower your long-term investment risk and help assure your pathway to an abundant retirement .

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I have found that some of the commonly accepted investment “advice” can be misleading, creating potential pitfalls for investors.  Some of this misleading “expert advice” comes from such respected journals as Money Magazine or the Wall Street Journal.

Let’s look at some ways to avoid the more common investment pitfalls.

1.  Always differentiate between investing and trading – Based on Benjamin Graham’s definition, buying a stock or fund to hold for a long period is typically considered an investment.  Other equity transactions are considered trading, with different rules and approaches because of their more speculative nature.  Before buying a stock or fund, always determine whether the transaction is an investment or a trade.

2.  Only use Stop/Loss orders when trading – Stop/Loss orders should only be used when trading.  If you use a Stop/Loss order with an investment, your investment could be sold at the worst possible time.  On May 6, when the DOW fell almost 1000 points before recovering, outstanding Stop/Loss orders were likely executed.  An investment portfolio, with Stop/Loss orders to sell at 15% below the opening price, would have lost 15% on May 6 instead of the 3% loss that the market suffered.

3.  Avoid redundant mutual funds – I recently reviewed a $500K investment portfolio that is being “professionally managed” by a well known discount brokerage and mutual fund company.  This portfolio contained 50 different mutual funds, with 13 US large Cap funds and nine Foreign Large Cap Funds.  A diversified fund portfolio requires no more than one fund for each Morning Star “style box” category.

4.  Avoid all sales fees with mutual funds - While most investors know to avoid front or rear end “load” mutual funds, many funds have a “hidden load” called a 12-b1 fee.  This annual fee of .25% or more can greatly reduce long term investment returns.

5.  When allocating assets, include ALL investible assets – Investors typically have several different accounts including retirement accounts, taxable investment accounts, real estate and savings accounts.  Once a proper asset allocation is determined, all assets should be included in the asset allocation.

6.  Always consider investment tax consequences – When taxable, tax deferred and tax free (Roth) accounts exist, put tax efficient investments in taxable accounts and tax inefficient investments in tax deferred and tax free accounts.  Closely follow the tax law changes that will occur, starting in 2011.  Some investments, such as stocks with high dividend yields, could change from being tax efficient to tax inefficient in 2011.

7.  Avoid making purchases based on a stock’s P/E – While the market’s overall Price/Earnings ratio can be a useful indicator of whether the market is under or overvalued, the P/E of an individual stock can be very misleading.  A low P/E for a company that is not growing may not portend a good investment, while a higher P/E on a rapidly growing company may show good value.  Price earnings growth comparisons or owner’s earnings vs price comparisons are much better indicators of a stock’s value.

8.  Avoid “Target Date” funds -  A recent “panacea” from the mutual fund industry is “target date” funds.  The concept is for the investor to pick the year in which they will begin withdrawing funds for retirement or other purposes.  The fund management will then take care of the rest.  However, different mutual fund companies have different asset allocations for funds with the same “target date.” A better approach may be to assemble your own “fund,” consisting of low cost, indexed ETFs or mutual funds.  Annually, modify the asset allocation toward more conservative investments as the “target date” approaches.

Whether managing your own investments or using an outside investment advisor, be sure that your portfolio avoids these common pitfalls.

When using an investment advisor, always ask if they have a fiduciary responsibility for both the advice that they give and the products they offer.  A fiduciary advisor is legally required to always place their client’s interests ahead of their own interests.  Many brokers and agents are held to a lower “suitability” standard, where the products and advice offered may legally allow them to place their own interests before their client’s interest.

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When it comes to the stock market, are you an investor or a speculator? Many people believe that they are taking a “conservative” equity investment approach when they are actually using a very “speculative” approach.  Let’s explore the differences between a stock market investor and a speculator.

Benjamin Graham, the father of value based investing, made a simple distinction between investing and speculation.  In Chapter 1 of his famous book, The Intelligent Investor, he states: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return.  Operations not meeting these requirements are speculative.”

According to Graham, if your “investment” is done in any fashion that does not provide for safety of principal combined with and an adequate return, you are speculating.  Based on this definition, many mutual fund managers (especially those with high turnover rates) are speculators.  If your mutual fund manager is a “speculator,” then so are you!

Perhaps the speculative investment approach pursued by many mutual fund managers is why index based mutual funds and indexed Exchange Traded Funds have recently become so popular.  Buying an index fund that tracks the S&P 500 Index entails investing in the stocks of the 500 largest US companies.  As long as the stock market is reasonably valued (or better yet undervalued), this investment approach provides a reasonable expectation of safety of principal combined with an adequate return over time.

The analysis that must be done with index investing is determining when the stock market is undervalued and when it is over-valued.  As can be seen from the dramatic increase in stock prices over the past 14 months, the best time to buy into a market is when conditions look the bleakest.

Based on the press coverage in March 2009, it would be easy to assume that the investment world was coming to an end, with the S&P 500 trading as low as 666. In hindsight, it is now obvious that March 2009 was the best time to buy into the market, as almost all stocks were trading well below their long term valuations.

Fourteen months later, the S&P 500 is now trading at over 1150, a 70% increase from the March 2009 low.  Excepting the current European turmoil (and of course that pesky 9.9% unemployment rate), the press is now touting how well our economy has recovered.  An index fund investor, who may be considering an increase to their stock allocation, must determine if the market is still undervalued or whether there will be a better time to increase equity positions in the future.

Investors in individual common stocks must evaluate both the market and individual stocks.   As with index investing, investment principal is put at risk if the stock market is overpriced.  If the stock market is not overvalued, the investor must then analyze individual stocks to determine if they are reasonably valued.

There are many ways to analyze a stock investment.  We prefer the Owners Earnings (OE) approach, as defined by Warren Buffet.  A company’s OE provides the intrinsic value of that company.  Our initial screen is to find financially strong, high quality companies with low leverage and increasing dividends.  From this screen, we look for stocks whose prices are more than 30% below their Owner’s Earnings valuation.  Once purchased, we hold these stocks until the stock price exceeds Owner’s Earnings or the company no longer meets our financial and quality screen.  With this approach, our stock holding period is typically measured in years.

There are many other ways to evaluate individual stocks.  As long as the analysis approach chosen will identify stocks that should retain their value (safety of principal) and provide an adequate return, the approach meets Graham’s definition of investing vs speculation..

Many of my clients, friends and relatives have tried short term trading and other speculative investment approaches.  While some people may succeed at speculating,  I have never met any “speculator” who has been consistently successful over a multiyear time period.  For me, speculation is like Las Vegas, while you sometimes win, in the long run the “house” ends up with the money.

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There are indicators that the real estate market may be reaching its nadir.  If so, now would be the time to consider investing in either rental property, for those interested in active management, or REITs, for those who prefer passive real estate investments.

The Wall Street Journal recently published a study prepared by LPS Applied Analytics, a leader in the collection and analysis of mortgage data.  The results of this report demonstrate that the housing market is far from fully recovering.  This article focuses on the “shadow inventory” of homes.  These are homes that are delinquent in their mortgage payments but have not yet been foreclosed upon.

The LPS report states: “As of July, mortgage companies hadn’t begun the foreclosure process on 1.2 million loans that were at least 90 days past due, … An additional 1.5 million seriously delinquent loans were somewhere in the foreclosure process, though the lender hadn’t yet acquired the property. The figures don’t include home-equity loans and other second mortgages.”

From this we can see that the “shadow inventory” is at least 2.7 million mortgages, that have not been foreclosed upon and are at least 90 days past due.

Another section of the report states: “Moreover, there were 217,000 loans in July (2009) where the borrower hadn’t made a payment in at least a year but the lender hadn’t begun the foreclosure process. In other words, 17% of home mortgages that are at least 12 months overdue aren’t in foreclosure, up from 8% a year earlier.”

This demonstrates that the problem of delayed foreclosures is increasing and is almost double the number from one year ago.

It is interesting to understand the reasons behind this increasing “shadow inventory” of homes that are (slowly) on their way to foreclosure.

The first reason is that the banks are having difficulty with determining which homes qualify for the government’s mortgage assistance policies, which may allow the banks to modify loans with government subsidies.

The second reason is the inability of banks to handle the paperwork required for such a large amount of impending foreclosures.  Most banks do not have adequate personnel to handle all of the required foreclosure documents in a timely fashion.

The third reason is the most insidious.  Some banks may not want to foreclose on all of these homes.  Banks are only required to write down their mortgages after they have been foreclosed upon.  Up until that point, banks are allowed to maintain the full amount of the mortgage as an asset on their financial statements.  If banks were forced to write down all of their delinquent mortgages, their reserves could be greatly depleted and their ability to lend could be significantly curtailed.  This could lead to another banking crisis (or in reality the ultimate conclusion of the one that began in late 2007).

Amherst Securities Group LP has found that the total number of mortgages with delinquent payments tops 7 million.   If that number is accurate, over 10% of all homes in the US are delinquent in their mortgage payments.  Their bearish analysis considered the impact of over 7 million homes that could eventually be foreclosed upon.

It seems likely that the number of homes that will eventually hit the housing market due to foreclosure is between 2.7 million and 7 million.  With this huge overhang on the real estate market, it would seem prudent to be very cautious of new real estate investments at this time.

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I am often asked, “What should I do with a 401(k) or 403(b) retirement plan that I had with a former employer?”  Most former employees are allowed to keep their funds in the former employer’s plan or “roll over” their former plan assets into a new employer’s 401(k) plan.  However, for many people, the best option may be to roll over the retirement plan funds into an IRA.

Let’s look at some of the areas where having an Individual Retirement Account may be advantageous to continuing with your former employer’s retirement plan

Diversification – When you roll over your retirement plan assets to an IRA account with a discount broker such as Schwab, Fidelity or TD Ameritrade, your investment options become virtually unlimited.  For a small trading fee (typically under $10 per trade), you can have a well diversified portfolio consisting of Exchange Traded Funds (ETFs) and mutual funds.  Some retirement plans have such limited choices that providing adequate diversification is virtually impossible.  TIAA-CREF is an example of a large sponsor of retirement plans with such limited investment choices that it is difficult to produce a well diversified portfolio.

If your 401(k) has a good selection of mutual funds from Vanguard or Fidelity, you can roll your IRA over to a mutual fund account with Vanguard or Fidelity.  Not only will the funds in your 401(k) be available, the entire family of funds will be at your fingertips.

Fees – Fees are a significant contributor to the success or failure of an investment portfolio.  Every employer must disclose the retirement plan’s annual fees to the plan participants.  If your 401(k) plan is with a large employer, the 401(k) fees are likely fairly low.   If your employer is a small to medium sized companies, annual fees could be over 1%.  Combining this fee with the typical 1%+ annual operating cost for mutual funds in the plan, your plan’s total annual fees could be as high as 2-3%. 

At most discount brokerages, a well diversified, index-based ETF portfolio can be developed for approximately $100 in trading costs. Most index-based ETFs have annual operating costs of 0.25% or less.  Thus, the IRA option could have total annual fees that are over 2% less than the total fees of many 401(k) plans.

Investment Management – Larger employers often provide 401(k) investment advice to their employees.  However, when you leave the employer, you may find that this advice is no longer available.  Smaller employers typically offer both limited investment options and limited investment advice, with no advice available for past employees.

Fee only asset management is available to provide investment management advice to investors that have neither the time nor interest to manage their own portfolio.  Annual fees for fee only asset management may be as little as 0.75% of the assets under management.  If your asset management firm uses indexed based ETFs, the total annual costs of both management and fund operating expenses may be just 1% or less.  With this approach, you can have individualized professional investment management advice with total fees that are less than ½ of many 401(k) plans.

If you have well diversified investment options, a low cost retirement plan and the time and interest to personally manage your plan, there may be no need to roll it over to an IRA.  However, if diversification, fees or the investment management advice supplied by your former employer’s plan are not adequate, you will likely find that the IRA roll over option is the better approach.  

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Your largest single asset is likely to be your ability to generate earned income.  This asset is commonly call “human capital.”  When developing appropriate asset allocations for investment portfolios, it is important to include the human capital asset.  Let’s look at some ways that including human capital could change your approach to allocating assets in your investment portfolio.

There are three major components of human capital.  These include: 1) your annual income from work,  2) the number of years remaining to work, and  3) the variability of your annual earned income.   Variability can be fairly large if your income is based on commissions.  It also can be large if you have a job in which you may be furloughed or laid off when economic conditions deteriorate.

There are studies that correlate various occupations with stocks, bonds and treasuries/cash.  We will look at only three occupations to demonstrate how human capital can be included in asset allocation decisions.

Tenured Professors – There are few professions more secure than that of a tenured professor.  Their annual income has historically been very predictable, with the main variance being additional income generated by consulting, research or publishing.  Thus, a tenured professor’s income is very similar to the yield from a high quality bond. 

Since there is little variance of annual income, younger professors should typically have higher asset allocations in riskier assets, such as equities and alternative investments.  As a professor approaches retirement, with a decreasing number of remaining work years, the amount of riskier assets should also decrease.

Real Estate Brokers – Real estate brokers receive most, if not all of their income from commissions.  While established brokers have some expectations about annual income, their income is highly variable, depending housing market conditions, interest rates etc.  While a realtor can often work for as long as they wish,  the variability of income makes their human capital asset very similar to equities (stock). 

If you are a realtor, you might be better served by having a greater portion of your investible assets in fixed income (bond) investments.  This will make your investment portfolio more stable as your income varies.  Stable investment income can be very beneficial in lower earning years, which often occur when the stock market is also in decline.

Entrepreneurs –  If you work for an entrepreneurial company, both your income and the number of years that your income will continue are variable.  In down years, entrepreneurial companies are typically the first to cut salaries and benefits as well as to have layoffs.  Having worked most of my life as a “high tech” entrepreneur, I am very familiar with the “bipolar” nature of many entrepreneurial companies.  As an entrepreneur, your human capital is similar to microcap stocks and commodities, either going up dramatically or dropping to $0. 

Not only should an entrepreneur have higher than normal fixed income positions in their investment portfolio, they should only buy equities in relatively risk free companies.  Entrepreneurs have their human capital linked to the success of their companies, which are typically small and highly vulnerable.  It is important that they take less risk in their investment portfolios to offset the high risk of their human capital.

While you may not work in one of these three occupations, your human capital will likely have characteristics of one these.  When you and/or your financial adviser are developing your asset allocations, be sure to consider your human capital as an asset that can compliment your other financial assets.

Regardless of your type of human capital, it can always be terminated by death or disability.  Life and disability insurance need to be a central component of any financial plan.  Properly constructed, they will provide the funds required for you and your family, if you are no longer able to contribute the expected human capital.

Human capital is an asset that should not be ignored.  Including your human capital when allocating your investments portfolio can help you choose the amount of risk that is most appropriate for you and your family. 

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Did you know that many financial advisors are not required to act in the role of a fiduciary?  Many financial advisors are instead subject to a business standard that only requires that the recommended investments be “suitable” for their clients.  Other financial advisors are subject to a more strict fiduciary standard which means the advisor has “a duty to act in the best interests of their client.”

To understand the difference, we must look at the current regulatory environment.  Commissioned based brokers or a broker-dealers are regulated by the Financial Industry Regulatory Authority (FINRA).  Brokers are often called “registered representatives” and work for such firms as Merrill Lynch, Smith Barney, Edward Jones, Wachovia, UBS or Wells Fargo.  Insurance agents, who offer investment products, are also almost always brokers.

FINRA only requires registered representatives and broker-dealers to provide a “suitable” investment to their clients, based on the client’s financial situation and their other holdings.  FINRA does not require for registered representatives and brokers to act in the client’s best interests.  Since FINRA only requires the “suitable” business standard, the registered representative or broker-dealer does not need to disclose any potential conflicts of interests that their investment advice might include.  This often leads to a broker recommending a product with a commission fee (load) when the same product is available as a “no-load” product.

Investment advisors, often called registered investment advisors or RIAs, are a different type of financial advisor.  RIAs are regulated by either the SEC or their state securities regulator.  RIAs are subject to the Investment Advisory Act of 1940, which requires that they have a “fiduciary duty to act in the best interests of their client”.  Investment advisors are paid through a fee structure, either on an hourly basis or as a percentage of assets under management (AUM).  RIAs are typically “fee only” advisors that do not receive any commissions and are always held to a fiduciary standard.

Some financial advisors present themselves as “fee based” advisors.  These advisors will be acting in the fiduciary capacity of an RIA when providing financial planning advice and typically charge a fee for this advice.  However, when these same advisors implement the proposed plan, they sell commissioned-based products.  When they sell commission-based products, they are operating as a registered representative/broker and are regulated by FINRA.  When these products are sold, the advisors are no longer acting as a fiduciary and need only to meet the “suitable” standard for the product that they sell..

If this seems confusing, you are not alone.  New government regulatory proposals are intended to undo this morass.  However, it is unclear how a broker can maintain a fiduciary relationship with their client while selling a commissioned based product, when a similar (or even the same) non-commissioned product is available.  

Since major banks, brokerages and insurance companies are dependent upon the revenues from their commissioned based products, it is doubtful that registered representatives who sell these products will ever be required to have a fiduciary duty when selling products to their clients.   Hopefully the new regulations will require the up-front disclosure of the commissions being paid to the sales person for each product sold, before it is sold, as well as any other potential conflicts of interest.  With this disclosure, the consumer will know how much of the total cost of the products is being used for compensating the broker-dealer and the sales person.

I believe that every financial advisor should have a fiduciary duty to put their client’s interest before their own.  However, until government regulations require this, consumers should be aware of the difference between commissioned based sales people with only a “suitability” standard and fee only planners who have a fiduciary duty to their clients.

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Since March 9^th, the S&P 500 has increased by almost 35%. In normal times, this increase would signal a major bull market rally. However, these are not “normal times.”

As an asset manager, I must continually consider whether I should be increasing, decreasing or maintaining my clients’ equity (stock market) allocations. My decision has been to use the market rally to lower my clients’ equity positions. While my crystal ball is no better than yours, here are a few of the factors that that I believe could negatively impact the market.

1) Valuation – Most economist are predicting that the S&P 500 will end 2009 with operating earning per share (before write-offs) of between $45 and $55. With the S&P 500 index at approximately 900, these earnings provide (pre-write off) P/E (price earnings) ratios of between 16 and 20. In a healthy, growing economy, those P/E values would signify a fully valued market. Can these P/Es be justified in our current environment?

2) Federal Debt – Many ‘bulls” argue that low interest rates justify paying a higher P/E on equities. In normal times, they would be correct. However, with the $700 billion stimulus package, a $1.8 trillion 2010 federal deficit and over $1 trillion dollars committed to federal bail outs, our federal debt will likely increase by well over $2 trillion in the next 18 months. (Remember, a trillion is 1,000 billions)

At some point, China, Japan and other “saving” countries will only buy our federal debt if it is offered at much higher interest rates. When interest rates increase, debt oriented investments become more attractive and equity investments less so. Higher interest rates will also make corporate borrowing more costly, which could easily damage our economic recovery.

3) Commercial Real Estate – The recent financial crisis, requiring $700 billion in TARP funds (not to mention TALF and PPIP), was mainly created by consumer debt. Defaults on mortgages, home equity lines and credit card debt created most of the current “toxic assets.” However, the next “shoe to fall” is commercial real estate. Large commercial real estate bankruptcies are beginning to proliferate. As these failures continue, expect to see more toxic assets appear on our bank’s balance sheets.

4) Toxic Assets – Many banks have balance sheets filled with toxic assets, with more likely to come. The Treasury has proposed the PPIP program to help banks remove these toxic assets to a “private/public partnership.” It seems unlikely that these assets are worth the value at which they are carried on the banks’ balance sheets. Assuming these toxic assets are purchased, much of any losses suffered, as reflected in the difference between their final value and the price paid under the PPIP program, will be assumed by the tax payers (you and me). These losses will increase our federal debt, putting even more pressure on interest rates.

5) International Event – Shortly after the election, our new Vice President predicted that the administration would be tested with an international crisis within its first six months. Most recent administrations have been tested during their early phases. Needless to say, there are many candidates to test our will and resolve. If such an incident occurs, the market will react negatively until the situation is resolved.

While “green shoots” may be appearing, along with signs that the recession may be slowing, our economy still faces many daunting problems. Until there are workable solutions to these problems, it will be difficult for the economy to have a significant recovery.

Considering the problems facing our economic recovery, it is hard to see significant stock market upside at current market prices. While it never pays to time the market, practicing “market intelligence” is always wise. If you are a long term investor, it may be prudent to stay at the low end of your investment policy’s equity allocation. In turbulent markets, investors should focus on asset preservation. The goal of asset preservation is to have the maximum assets available to invest when the economy truly begins to recover and grow.

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With the stock market in turmoil and interest rates at all time lows, you might be tempted to purchase a deferred annuity. The deferred annuity sales person will tell you about the tax deferred benefits, the guaranteed return if you were to die and may even provide a product that gives you market related returns when the stock market is up, while guaranteeing that you will not have a loss in value during a down market. If this sounds too good to be true, it probably is.

Since the deferred annuity sales person will be paid a commission as high as 10% on your deferred annuity purchase, let’s take a closer look at what he/she is trying to sell you. Here are some areas that are not always well explained by the deferred annuity sales person.

1) Mortality and Expenses (M&E) Charges – All deferred annuities have M&E charges to pay for the life insurance guarantee, the sales person’s commissions and the administrative expenses of the contract. M&E charges are usually between 1% and 2% of the contract value, paid every year. If your deferred annuity has a value of $100,000, up to $2,000 annually will be used for M&E expenses. Even though you will likely never see these charges, they are being taken from your investment each year.

2) Surrender Charges – Virtually all deferred annuities that are sold through commissioned sales people will carry a surrender charge. Typically, these charges begin at 7% for the first year of the contract and decrease by 1% per year. Seven years after you purchase the contract, you may still have to pay 1% of its total value if you want to cash it in. Sometimes, you are allowed to withdraw up to10% of contract value yearly. However, the surrender charges assure that the insurance company will have your money long enough to pay for the high sales commissions required.

3) Management Fees – If you buy a variable annuity, the subaccounts are very similar to mutual funds. A typical subaccount will have a 1% or higher management fee. This expense is over and above the M&E fees that were previously discussed. While these fees are somewhat consistent with the fees charged for actively managed mutual funds, they are up to 5 times as high as the fees charged for indexed mutual funds and Exchange Traded Funds (ETFs). The subaccount returns will be net of the management fees, but they will not show the M&E fees that are assessed each year.

While it is true that a deferred annuity will be tax deferred until you cash it in or annuitize it, all gains of the deferred annuity will be taxed at your ordinary income rate when you receive your returns. Since the deferred annuity is typically held for 10+ years, this tax advantage may completely disappear when you cash it out.

If you believe that a deferred annuity is right for you, before you buy the product that your sales person is offering, contact Schwab, Fidelity, Vanguard or another discount brokerage house. They will likely have a similar deferred annuity product. Compare M&E expenses, surrender charges and management fees of the non-commissioned product with the one you are being sold. You will likely find that the non-commissioned product provides a better total return than the one that you are being sold.

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