For many investors, the stock and bond markets are just too risky.  These investors are often choosing such investments as one year CDs.  One year CDs yield approximately 0.6%.  At the end of August, the US inflation rate for the past 12 months was 3.8%.  When we consider the real rate of return (total return less inflation rate) for one year CDs, they currently provide a -3.2% real rate of return.

On the opposite extreme is an investor that is 100% invested in the US stock market.  From the beginning of 2007 through the end of Q2 2011, the annualized investment rate of return for the S&P 500 (with dividends reinvested), was 0.4%.  With the recent volatility the S&P 500 annualized return declined to -2.6% by the end of Q3.

Is a guaranteed -3.2% real rate of return better or worse than a volatile rate of return created by investing in the markets?  Investment studies have shown that the most critical requirement for investment success is to develop an investment plan and stick with it through both good and bad markets.

Studies show that investors consistently underperform stock market benchmarks.  This performance is not related to an investor picking the wrong stocks or mutual funds.  Most of the long term investment underperformance occurs because investors often buy when markets are high and sell when markets are low. Whether the investment approach is conservative or aggressive, these studies show that long term investment results are consistently higher when the investment approach is maintained throughout a full market cycle.

A conservative investor will typically significantly outperform an aggressive investor in down markets.  Unfortunately, in frothy up markets, conservative investors are often tempted by the significant gains that their more aggressive investor friends are receiving.  At the worst possible time (when stocks are overpriced) these conservative investors often decide to become more aggressive investors.  By changing their investment approach, their funds are often decimated by the next market downturn.

Aggressive investors will typically significantly underperform their conservative counterparts during a down market.  In desperation, aggressive investors often sell much of their stock market investments at the worst possible time (when stocks are underpriced).  By changing their investment approach, aggressive investors will not be fully  invested in the stock market when the markets stages its next recovery.

Financial Abundance, LLC, uses a diversified investment approach that includes US and international stocks and stock funds, US and global bonds and bond funds as well as some exposure to “alternatives” such as REITs, gold, commodities and currency funds.  We seek out value oriented investments that typically provide better than average dividend payouts.  This approach helps decrease a portfolio’s volatility and increase the total return.  From the beginning of 2007 through Q3 of 2011, our consistent investment approach has provided for average client return that exceeds the S&P 500 (with dividends reinvested) by over 6% annually.

Whether your investment approach is conservative, aggressive or somewhere in between, the key to long term investment success is maintaining a consistent approach through up and down markets.  Fear and greed are two of our most common investment nemeses.  If you are susceptible to one or both of these, find a fee only investment advisor to help manage your investments.  At Financial Abundance, LLC  our primary added value is our ability to remain consistent with our investment approach, through up and down markets.

After reading many investment studies, a consistent conclusion is that investors can be successful as aggressive investors, conservative investors or anywhere in between.  Regardless of investment approach, the two primary components of successful investing are portfolio diversification and consistency.

Financial Abundance Guide (available free at www.finabguide.com) identifies many areas of personal finance that can be controlled.  I also developed the Seven Steps to Financial Abundance to help people reach their financial goals.  With so much fear of the financial future, following the seven steps can help increase our power to control our financial future.

“Spend less than you earn,” is the required first step.  Over a 40 year career (age 25 to age 65), assume that your average income is $80,000 (in 2011 dollars) and the annualized investment real rate of return is 5%.  Saving 10% of income ($8K) each year will produce savings of over $1 million (in 2011) dollars at age 65.

By “maximizing your financial resources” (step 2) , savings can be increased with no negative impact on spending.  If a company offers a 4% of salary match with their 401(k) plan, by contributing at least 4% of salary, this amount is matched by the company. Using the previous example, annual savings are increased from $8,000 to $11,200, increasing the savings available at age 65 to almost $1.5 million.

“Minimizing your taxes” (step 3), also provides additional savings with no impact on spending.   Financial Abundance Guide provides many tax savings techniques available to people of all income levels.  One example is a spousal IRA, allowing a non working spouse to contribute $5,000 per year to an IRA.  For a couple paying 25% in federal taxes and a 5% state income tax, a $5,000 IRA contribution would yield $1,500 in annual tax savings.  Continuing with our example, the additional $1,500 in annual tax savings would  provide almost $1.7 million in 2001 dollars by age 65.

“Managing your investments” (step 4), can significantly increase investment returns.  This may require the help of an investment professional.  If so, carefully choose an investment advisor and be wary of anyone providing “free” advice.  A “free” advisor must be compensated through commissions on the investment products they sell.  Fee only advisors are compensated by the fees they charge to manage investments.  Continuing the above example, if the real rate of investment return is increase by only 0.5%, the couple would have almost $1.9 million at age 65.

Using the simplistic assumption that a couple, at age 65, can withdraw at least 4% of their investments each year and never run out of money, $76K (in 2011 dollars) can be withdrawn each year throughout retirement.  Since their previous annual expenses were $72K, with $8K per year in savings, even with no Social Security or other retirement benefits, our couple can more than maintain their lifestyle throughout retirement.

Fear of the unknown often produces a sense of financial scarcity.  “Protecting your financial resources” (step 5), through appropriate, lower cost insurance products can help keep this fear at bay.   An insurance product that is often overlooked is a $1 – $2 million umbrella liability policy.   In our litigious society, one may be sued because someone was hurt on their property or by a car driven by a family member.  For very little money, peace of mind can be secured by adding an umbrella liability policy to your auto or home insurance policy.

Financial planning helps “control your personal finances” (step 6). There are many available resources to help you produce you own financial plan.  If you have neither the time nor interest in financial planning, engage a fee only Certified Financial Planner (CFP^®)  who will listen to your concerns and provide a comprehensive plan that enumerates the options available to meet your financial goals.  A financial plan helps increase control over personal finances.  Planning will reduce the fear of scarcity, providing more financial security on the path toward financial abundance.

“Have faith in continued abundance” is the seventh step. Implementing the first six steps addresses what you can control in your personal finances.   Faith that financial abundance will continue helps eliminate the doubts and fears of the unknown often caused by events over which you have no control.

Financial abundance is a lifetime pursuit.  There will always be ups and downs in the economy and markets.  By applying the seven steps and seeking appropriate outside support as required, you will be on the pathway toward financial abundance.

John Bogle is the founder of Vanguard funds and arguably the world’s most famous proponent of low cost investing.  In a recent Financial Times article, Bogle does an excellent job of deconstructing the misleading numbers that are often provided by purveyors of financial products.  Let’s examine his logic:

Bogle first reminds us that a stock’s value is NOT its current price.  As Benjamin Graham first recognized in the 1920s, the value of a stock is represented by the discounted value of the company’s future cash flow.  He called this the “intrinsic value” of a company.  At any particular time, the price of a share of stock may greatly exceed or be significantly less than its intrinsic value.  However, in the long term, a stock’s price will center around its intrinsic value.

Bogle next states that, due to the reduction of the stock dividends from the historic average annual rate of nearly 4.5% to the current rate of approximately 2%, nominal annual stock returns for the next decade will likely center around 7% instead of the historical 9.5% rate.  Thus, if a 9.5% rate of return for future stock appreciation is used in financial projections, these projections will likely be significantly overstated.

As an example, if you invest $50,000 for 20 years, with a 9.5% nominal rate of return, $50,000 would become $307,080.  However, if the nominal rate of return is 7%, in twenty years the nominal value of $50,000 would be $193,484.

A second “mistake” that Bogle notes is when projections show investment returns in nominal terms instead of their “real rate of return.”  The real rate of return is the nominal return return less the rate of inflation.  If the expected nominal rate of return is 7% and inflation over the next 20 years is expected to match the historic long term annual rate of 3%, the real rate of return is 4%.  Thus, using the same $50,000 investment over a 20 year period, the “spendable dollars” returned is only $109,556, a $200,000 reduction from the originally projected amount.

The third “mistake” is not including investment costs when considering total investment returns.  Investment costs include fund operating expenses, trading costs, loads (including 12b-1 fees) and asset management expenses.  These combined annual expenses can easily be 1.5% or more of your invested assets.  If these fees are included, your annual real rate of return can be reduced to 2.5% or less.  Including the reduction from investment fees, the $50,000 equity investment may only grows to a “spendable” $81,931 in 20 years.

All of the above calculations assume that the invested funds are held in a retirement account.  If not, tax consequences could further reduce the investment returns.

After considering these dramatic reductions in projected investment returns, it may seem prudent to forgo investing in stocks.  However, keeping money in a “safe” CD or money market fund will likely provide the historic long term real rate of return of -1% for these types of investments.  With this real rate of return, these “safe” investments will provide a “spendable” $40,895 on the original $50,000 investment in twenty years.  The “safe return” is approximately ½ of the return from the equity investment.

The message behind Bogle’s article is to be wary of future performance projections portrayed by many mutual fund companies and other financial service organizations.  By avoiding these three common mistakes, often ignored by investors and pension fund plans as well, you can identify more appropriate investment rates of return.

If you are interested in personal finances and are willing to invest the time required in learning how to manage personal finances, DIY may be appropriate.   Financial Abundance Guide was written as an aid for these individuals, helping them identify strategies to effectively manage their financial resources.  Unfortunately, I have found that most people have the same amount of interest in learning how to manage their finances as I have in learning how to re-tile my roof.  None!

If you are not interested in learning to DIY personal finances, here are some ways to identify the financial advisors that can meet your requirements.

The first area to consider is the type of advisor who fits your needs. There are basically three types of financial advisors:

1.    Commissioned based financial advisers typically present their services as “free.”  These advisors sell commissioned financial products such as mutual funds and deferred annuities. Sometimes, it is difficult to identify the commissions being paid to the advisor, such as mutual funds with12b-1 fees or products which must be held for several years to avoid a reduction in payout.

2.    Fee based advisors usually work for a broker/dealer.  These advisors charge a fee that is often based on a percentage of the assets in your brokerage account(s).  When an advisor is “fee based,” part of their compensation also comes from commissions for selling mutual funds and proprietary products.

3.    Fee only advisors receive compensation either on an hourly basis or based on a percentage of the assets they are managing.  These advisors receive no commissions.  They are only compensated by fees paid by their clients.

The second area to consider when choosing a financial advisor is the scope of personal financial services they offer.  These services also fall into three categories:

1.    Investment management firms provide services related to managing your investments.  While they may be compensated in any of the three methods described above, their financial services are often limited to helping clients manage their assets.

2.    Wealth management firms primarily focus on helping their clients effectively manage their assets.  However, a wealth management company typically provides other personal financial services such as creating retirement income plans, retirement planning and risk management (insurance) assessments.

3.    Financial Planning firms provide asset management services as a component of a comprehensive financial planning process.  While most financial planning firms provide an a la carte selection of services, they will have at least one CFP^® who is capable of providing comprehensive financial planning for their clients.

If the only financial support you require is investment management, virtually all financial advisory firms can provide these services.  If investment management is your only financial concern, you need only to decide whether you wish to pay for this service through commissions, fees or a combination of the two.

If more than investment management support is required, you must determine if the advisory firm is capable of providing the required services.  A Certified Financial Planner (CFP^®), offering comprehensive financial planning services, will typically be capable of supporting your planning requirements.  A CFP^® will also have completed extensive financial planning educational training and will have met both the experience and ethics requirements of the CFP^® Board of Standards.

Whether you need only investment advice or require a complete financial analysis and plan, be certain that your adviser listens to and understands your tolerance for risk.  If you find an investment adviser or financial planner who treats your financial future as well as they treat their own, you should be well on your way to a prosperous financial future.

Now that Congress has approved an extension of the investment income tax rates, it is important to examine investment holdings.  If possible, have only tax efficient investments in taxable accounts.  Let’s examine what types of investments are tax-efficient.

Through at least 2012, “qualified” stock dividends and long term capital gains are taxed at a maximum rate of 15%.  Most stock’s dividends are “qualified”, as long as the stock is held for more than 60 days. Stocks held for at least one year and a day will have their appreciation (capital gains) taxed at the maximum rate of 15%, making them very tax efficient.  Indexed stock funds, including most Exchange Traded Funds (ETFs), are also considered tax efficient, if held over one year.  Unfortunately, actively managed mutual funds require some research before determining their tax efficiency.

Each year, mutual funds must distribute all realized capital gains and dividends.  Mutual funds with high turnover rates will likely produce short term capital gains.  Regardless of how long a mutual fund is held, income taxes must be paid each year on all realized capital gains and dividends.  High turnover rate funds may have a significant amount of short term gains, taxed at ordinary income rates. This type of mutual fund is not  tax-efficient.

Stock based ETFs generally avoid year end taxable distributions, as do many stock index based mutual funds.  As long as the fund is held for over one year, actively managed mutual funds with low turnover rates and index based ETFs and mutual funds will typically be tax-efficient.

Whenever possible, place tax-inefficient investments in your tax-deferred or tax free (Roth) retirement accounts.  Tax-inefficient investments are investments in which most, if not all of their income is taxed at ordinary income tax rates.  Interest payments on bonds and bond funds, as well as “nonqualified” dividends are taxed at ordinary income rates.

Investments that generate short term capital gains are also tax inefficient, since short term capital gains are taxed at ordinary income rates.  If you plan to trade stocks on a short term basis or wish to invest in high turnover rate mutual funds put these investments in your tax deferred account.

Real Estate Investment Trusts (REITs) or REIT funds pay nonqualified dividends.  Bonds and bond based funds pay taxable interest income.  Since these payments are taxed at ordinary income rates, these investments are considered “tax-inefficient” and should be kept in your tax deferred accounts, when possible

With ETFs, owning gold or silver is now as easy as buying a stock.  However, with precious metal ETFs such as GLD (SPDR Gold Shares) or SLV (iShares Silver Trust), the shareholder is treated as if they own the actual gold or silver that backs the ETF.  The IRS considers precious metals to be collectibles.  Collectibles have a long term capital gain tax rate of either 25% or 28%, depending upon the taxpayer’s marginal income tax rate.  Precious metal ETFs are therefore tax-inefficient investments to be kept in tax deferred or tax free accounts.

Commodity ETFs such as DBC (PowerShares DB Commodity Index) often invest in futures contracts.  At the end of each year, the capital gains from a fund’s futures contracts holdings are taxed at 60% long term rates and 40% at short term rates.  This income is reported on the annual K-1 form.  When possible, minimize both your taxes and tax reporting hassles by holding these investments in a tax-deferred account.

Step 3 of the Seven Steps toward Financial Abundance is “minimize your taxes.”  By paying close attention to the types of accounts in which investments are held, you can minimize your taxes while maximizing your after-tax investment return.

I often hear people say that gold is an inflation hedge.  However, when one looks at the price of gold (on an inflation adjusted basis) there is little correlation between the price of gold and the annual inflation rate.  In my opinion, a much better prospective on gold is that of a currency hedge.

In the past ten years, gold has increased in nominal value by 400% against the US dollar.   Over that same time period, gold has increased 250% against the Euro, 190% against the Swiss Franc and “only” 150% against the Japanese yen.  This demonstrates that, while gold has indeed appreciated over the past 10 years, the larger story may be the dramatic decline in the value of the US dollar over this time period.

To get more perspective on the value of gold as a surrogate for the decline of the US dollar, we compared the (inflation adjusted) value of gold over the past 40 years against the value of the Swiss Franc over that same time frame.  We priced both “currencies” in US dollars.  The Swiss Franc was chosen because it is (arguably) one of the most stable currencies and countries in the world.

When these two “currencies” were compared against the US dollar over the past 40 years, an interesting correlation arose.  From 1971 to 1980, the dollar declined 59% against the Swiss Franc.  During this same time frame, the dollar decreased 86% against the price of an ounce of gold.  In the 1980s and 1990s, the value of the dollar to the Swiss Franc was reasonably stable, while the price of gold fell from its (inflation adjusted) high of $2358 to approximately $350 in 2000.

The 2000s have seen a repeat of the same easy money policy that plagued the seventies.  From 2000 through 2010, the value of the dollar has declined 38% against the value of the Swiss franc and the value of the dollar has declined 73% against the price of an ounce of gold.  Thus, the question for a potential gold investor is what policies are being implemented that will strengthen the dollar and cause a decline in gold prices as occurred in the 1980s.

Only time will tell if the dollar will stabilize, as it did in the 1980s, or if it will continue its decade long decline.  Until concrete policies are implemented by the Fed and the Treasury to strengthen the US dollar, a small gold position might be a reasonable hedge against the possibility of the US dollar’s continued decline.

For the next two years, long term capital gains and qualified dividends will be taxed at a maximum rate of 15%.  In 2013, capital gains tax rates will likely increase to at least 20% and could increase to 28% on the “wealthy” (couples earning $250K or more per year).  On top of this likely tax increase, 2013 will also usher in increased Medicare taxes which could add 3.8% in taxes to all investment income.   Let’s look at what this could mean if you are considering the sale of your business interests.

We assume that you are married and that you and your spouse’s Adjusted Gross Income is $250K.  Let’s also assume that your business ownership interest has a net value of $1 million.  If you sell your business ownership interest by the end of 2012, the federal income taxes owed from the sale of your business interests will be $150K, allowing you to keep $850K.  However, if the same business ownership is sold at the end of 2013, federal taxes owed will likely be significantly higher.

Assuming that long term capital gains rates “only” rise to 20% in 2013, you will owe $200K in capital gains taxes, an increase in federal taxes of 33%.   However, since your 2013 AGI remains at $250K, the $1 million income from the sale of your business will be fully subject to the 3.8% Medicare tax, providing an additional $38K in federal taxes owed.  Selling your business at the end of 2013, instead of 2012, will likely add a minimum of $88K to your federal tax bill, representing a 58% federal tax increase.

Many people believe that the capital gains rates for the “wealthy” could increase to the 1996 level of 28% in 2013.  If this occurs, the total federal taxes that could be owed on the sale of a $1 million business interest would rise to $318K, leaving only $682K remaining after federal taxes.  If this scenario occurs, postponing the sell of a business could more than double the amount of federal income taxes that must be paid.

Thanks to the recent extension of current tax rates, there is a two year window of tax certainty.  Based on previous government actions, it seems reasonable to expect that nothing further will be done regarding taxes until the end of 2012, at the earliest.  If you are considering the sale of a substantial business interest in the near future, it might be wise to begin this process now, so it can be completed before the end of 2012.

As with all investments, you should never let the “tax tail” wag the investment dog.  If you are enjoying your business and expect it to keep growing in value over the years to come, short term tax consequences will be diminished by the increase in total value that you will receive by selling your business in the future.

However, if your business is not growing rapidly and you are not enjoying it like you once did, it may be time to sell.  As the economy continues to improve and banks begin to offer business loans, preparing your business for a sale by the end of 2012 could maximize your after tax business returns.

In the fourth quarter of 2010, much of the US economy showed signs of revival from the 2008 to 2009 recession.  Consumer spending is once again edging toward 70% of GDP and many manufacturing and services businesses are starting to hire and make new capital investments.  This “positive economy” continues to grow and could provide buoyancy for the stock market in 2011.

As the “positive economy” expands, there will likely be inflationary pressures seen with any expanding economy.  In 2010, the price of certain commodities rose, especially in the areas of food and energy. These prices will likely continue to rise in 2011.  Investors will also expect higher returns on their risk capital, putting upward pressure on longer term interest rates and stock dividends.  If not for the “negative economy,” the US could be well on the way to a bullish recovery.

The “negative economy” is mainly represented by the banking and housing industries.   Since 2009, approximately 300 banks have failed and most of our largest banks maintain a significant amount of “toxic assets” on their balance sheets.  The Fed’s free money policy has kept large banks afloat and continues to be a major contributor to their earnings.  At the same time, the housing industry continues to be moribund with nationwide housing prices expected to drop another 5% to 15% in 2011.

Because of the “negative economy,” core inflation rates (of which over 40% is represented by housing costs) continue to stay near zero and many economists maintain concerns that our economy could suffer from the effects of deflation.  Banks, remaining in a precarious financial position, continue to provide only “risk free” loans, while “safe” investments such as CDs yield less than 1%.

The Fed appears to believe that it must support the banks, Wall Street and other contributors to the “negative economy,” even when these actions adversely impact the “positive economy.”  This was recently confirmed in the Fed’s decision to implement Quantitative Easing 2 (QE2).

Thanks to the stronger than anticipated “positive economy” and the Fed’s continued support (enabling?) of the “negative economy,” the S&P 500 was up almost 13% in 2010.  However, it should also be noted that gold was up over 25%, a barrel of oil was up 17% and the Australian currency was up over 11% in 2010.

What do these two divergent economies portend for your investments in 2011?  Knowing this answer would lead to untold wealth.  Since my crystal ball is no better than yours, let’s consider what might occur.

1) The “positive economy” will likely continue to strengthen in 2011.  This could be very positive for stock valuations, especially those of large multinationals with rising dividend payouts.

2) Commercial real estate, supported by REITs, will likely strengthen as the “positive economy” improves.

3) The lack of bank lending will likely increase mergers and acquisitions of some solid small and mid cap companies.

4) The Fed will likely continue to support the financial markets in ways that will further devalue the dollar.

5) Fed actions will likely keep short term interest rates low, while longer term rates may rise as the value of the dollar decreases.

6) A weakening US dollar will likely cause commodity prices (food, energy, gold) to continue to rise in 2011.

Successful investing in 2011 will require correctly anticipating how the events occurring in the the forthcoming year will affect both economies.  Since it appears that we have two divergent economies and a Fed that is determined to protect and defend the big money interests of large banks and Wall Street, investment decisions for 2011 will remain as challenging as they were in 2010.

While there is no such thing as a completely safe investment, by paying attention to macro-economic events in the US and abroad, we can make educated decisions on the types of investments that will likely provide the best returns for our portfolios.  In this article we will look at alternative investments that could enhance your portfolio.

On the domestic front, it appears that the Treasury and the Fed are determined to create two outcomes that they hope will help revive our economy.  It is their desire to reduce the value of the dollar and increase inflation, while keeping short term interest rates near zero for as long as possible.

If our government is successful in producing these outcomes, it will be important to own investments that appreciate when the dollar is devalued as well as investments that provide total returns that exceed the rate of inflation.

Even though it is near an all time high, gold will likely continue to rise if the dollar continues its decline.  Gold can be viewed as an alternative currency.  To understand this concept, look at how much less gold has appreciated when priced in Euros or Yen than it has when priced in dollars over the last five years.  A simple and effective way to own gold is through Exchange Traded Funds (ETFs) such a GLD or AIU.

Another way to take advantage of a falling dollar is to invest in the currencies of nations whose currencies could appreciate relative to the dollar.  As an example, in 1973, when the Japanese Yen was allowed to float against the US dollar, it took 271 Yen to buy a dollar.  Today, a dollar can be bought for only 81 Yen.   The Yen has increased 235% against the US dollar since 1973 and 65% since 2002.

Two counties whose currencies could increase with a continuing decline in the US dollar are Australia and China.  Both countries have large amounts of natural resources, which will rise in value as the dollar declines.  This helps make them less dependent upon the US economy in the future.   ETFs are available to allow for the investment in both country’s currencies.  For Australia, the ETF call sign is FXA and for China the call sign is CYB.

As the dollar declines, the price of commodities (priced in US dollars) will increase.  To invest in a broad basket of various commodities, you might consider the ETF with the call sign DBC.  Agricultural products should also increase, as the dollar decreases.  An ETF that provides a broad basket of agricultural commodities has the call sign DBA.

While the above alternative investments may do well if the value of the dollar continues to decline, they are all risky investments.  For most investors, no more than 10% of your total portfolio should be invested in “alternative investments,” with remainder in equities, fixed income and cash equivalents.  Next month, we will explore investments in these categories that will likely do well as the dollar declines and inflation increases.

With so much of this product being sold, it is likely that someone will soon offer you this product with “no downside risk.”  Let’s explore whether this annuity product has any downsides.

All annuity products are sold by insurance companies through licensed insurance agents.  With equity indexed annuities, you are often provided a 10% “signing bonus” and the guarantee that your purchase price (including the bonus amount) will never go down, provided you hold the annuity throughout the surrender period.

Each contract year, you are allowed to pick a specific stock (or sometimes bond) index in which you can participate.  If the chosen index appreciates, your annuity will go up, subject to a predefined “cap” (maximum amount) that is set annually by the insurance company.   If the index goes down, your annuity amount remains the same as in the previous year.

Currently, index caps are between 5% and 8%.  If the market goes up dramatically, as it did in 2009, your upside is limited by the cap.  Most equity indexed annuity products also allow you to choose a guaranteed income option for the year.  With this option, your deferred annuity increases by a set amount for the year.  Currently, income rates are typically between 2% – 4%.

Are their any downsides to guaranteed downside protection?  Consider the following:

1)    Since caps and interest rates are set annually, insurance companies may lower the cap or the guaranteed interest rates each year.  This will likely occur if interest rates remain low.

2)    Surrender charges, as high as 12% of the annuity purchase price, are applied if you need your money before the end of the surrender period.  Until recently, most deferred annuities had surrender periods of 6 to 8 years.  Most equity indexed annuities have surrender periods of 10 to 14 years.  While each year you may withdraw up to 10% of the account value with no penalty, can anyone be certain that they will not need the invested funds for 14 years?

3)    In inflation skyrockets, will the annuities guaranteed interest rates and/or caps exceed the CPI.  If not, equity indexed annuity owners will receive a negative real rate of return, even as the markets may be prospering.

4)    All annuity gains are taxed at ordinary income tax rates when withdrawn.  With investments in stocks and other capital assets, gains are taxed at capital gains tax rates, which usually are significantly lower than ordinary income tax rates.

A conservatively managed portfolio of stock funds/ETFs, bond funds and alternative investments, can usually outperform “safe” deferred annuity products over a period of 10 to 14 years.  Recently we analyzed the performance of two equity indexed annuities, using the S&P 500 as the linked index.  With the current cap rates of 6.25% (for a 10 year surrender period annuity) and 7.65% (for a 14 year surrender period annuity) the equity indexed annuities provided  annualized returns of 3.89% and 4.49% respectively from 2000 until 2010,.

Next, we analyzed the performance of a conservative balance portfolio, consisting of 25% stocks (represented by an S&P 500 ETF), 10% alternatives investments (represented by a gold ETF) and 65% bonds (represented by a Barclays Aggregate Bond Index ETF).  The portfolio, rebalanced yearly, provided an annualized return of 6.49% (2% more annually than the 14 year surrender period deferred annuity) from 2000 until 2010.

For a $100,000 investment, the balanced portfolio provided $35,000 more than the 10 year surrender period annuity and over $27,000 more than the 14 year surrender period annuity.

To quote columnist Jason Zweig in a recent Wall Street Journal article concerning equity indexed annuities,  “If you want only some of the gains from a bull market in stocks and none of the losses from a bear market, I would advise rolling your own.”