Breaking The Rules

Art McPherson | July 16, 2014 | Annuity Basics

To start, let me tell you a secret that many banks, stockbrokers and insurance agents won’t tell you. All three want you to give them your hard-earned money, and all three make money off of your money being invested with their financial institutions.

The banks make money when you keep your money in their branches, and they use your money as reserves, making loans to others and using your money as collateral. Because they are using your money, they will usually pay you an interest rate for the use of your funds. It’s hard to think 0.002% is interest, but in today’s market, it is.

The brokerage firms invest your money as you specify, and they make money on the transactions. They make money on the bids and ask prices they set for each invested security, or they can charge a percentage fee based on assets under management, and then all bids and ask prices are done with no fees.

Insurance companies make money by investing your money in longer-term interest-bearing debt securities like treasuries and corporate bonds. They make an interest rate on that portfolio, and after taking out a percentage fee for expenses, the balance is passed to the investors.

All three financial institutions can be heard saying many times why they are the best and how the other financial institutions are not any good. But in “Realville,” they all have their place and each financial institution has a very valuable role to play.

Now, let’s break some rules. Right now you may be reading this article because you are fed up with the low interest rates your bank is currently paying you. You want better interest, but you have read that annuities are not that good. Or maybe you have had your money in the stock market for the last few years, and you love the good interest you have been receiving lately, but you’re scared to death that the stock market is going to crash like in 2008. Well, let’s break some rules!

Rule 1: CDs are the only fixed interest vehicle that guarantee principal.

Incorrect. CDs do protect principal, but so do fixed annuities. “But my CD is FDIC insured,” you say. That’s true – if your bank goes out of business and your money is in that bank, then the FDIC will guarantee your deposit. But an annuity has guarantees too. Each insurance company is part of a guarantee association that guarantees your annuity principal if the insurance company should go bankrupt too.

Rule 2: I can’t expect to do much better than 1% on my safe money right now.

True, CDs and short-term treasuries are extremely low right now. If you break some rules, however, you can currently get 2 to 4 percent on fixed annuities depending on the term (anywhere from two years to 10 years). Another fixed annuity called an indexed annuity can consistently produce interest in the 4 to 7 percent range right now. Money is still 100% guaranteed, but you may get a much higher payout! Let’s look at what breaking the rules could create in interest or income.

Let’s use $100,000 as an example. In a five-year CD, you would be lucky to get 2% right now, which would pay $2,000 a year in interest or income. The same money in a fixed annuity would pay 3%, or $3,000 a year in interest or income. That’s 50% more income than the bank rate. Not only that, but the annuity will allow you to withdraw your interest and up to 10% of your principal each year with no charge or penalty. The bank CD will not allow you to do that; all principal in a five-year CD has to stay in the CD or you will be penalized. So, by breaking the rules, you get $1,000 more a year in income, or $5,000 more over the next five years.

Rule 3: If I invest my money in the stock market, the more risk I take, the better the return, and the less risk I take, the lower my return.

True, if you invest only in stocks, bonds and cash, but what if you used indexed annuities as a bond alternative? Remember, indexed annuities guarantee your principal, but you still have your interest based on market indexes.

Let’s look at the above example again. You have $100,000 in the market in a balanced portfolio. You’re age 60 and you have five years until retirement. You have a balanced portfolio, and 60% of your investments are in bonds, while 40% of your investments are in the stock market. When doing an efficient frontier analysis, your residual wealth equals $89,802.87, using just stocks and bonds. This is a measure of the likelihood that your invested money will have the desired performance. Let’s see what happens if we add indexed annuities to the portfolio, with 36% stocks, 24% bonds, and 40% indexed annuities. When doing an efficient frontier analysis on this mix, we now have residual wealth of $156,081.33. That’s a 74% increase in residual wealth and a 59% decrease in investment risk. We just broke our rule and increased our return, all while reducing our risk.

If you’re willing to break some rules, you may be much happier with your investment returns and your desired income. We have found with many of our clients that breaking the rules has given them a new peace of mind that their goals and objectives can be met, even though we may have reduced risk to their investments or portfolios.

 

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