How to Analyze a Variable Annuity(2)

How to Analyze a Variable Annuity

Ever had a variable annuity pitched to you?  Maybe you own one.  They’re a popular way for many people to mix guaranteed retirement income with the growth potential of equities.

But I’m guessing even if you hold a variable annuity, you’re not 100% sure how it works.

“What are the annual fees again?”

“How does that bonus period work?”

These were a few of the questions a client asked me recently when he was considering a variable annuity.

**Full disclosure – I do not sell variable annuities** 

This client just wanted a second opinion. He’d recently met with an advisor who pitched him a variable annuity, and wanted input from an objective source.

My client was in a tough position.  He’d just lost his father, and was about to receive a sizable inheritance.  He wanted to use this inheritance to produce income throughout retirement, since he was about to turn 60.

He was skeptical about investing in the markets, fearing that another financial crisis would destroy his nest egg.  At the same time, he struggled with the idea of buying an annuity.  He was attached emotionally to the money since it was coming from his father’s estate, and he didn’t want to fork it over to an insurance company.  On top of that, the annuity he was considering was complicated and confusing, and he was feeling a little lost.

After walking through everything together, my client decided to use some of his inheritance to purchase an annuity – but not the one he was being pitched.  He opted for a fixed rather than a variable annuity, which he bought with a small portion of the money from his father.  He decided to invest the majority of the money in a diversified portfolio geared to produce income.

My client isn’t alone, and I get a lot of questions about variable annuities.  Since they have so many moving parts, I wanted to share exactly how I analyze variable annuities using my client’s contract as an example.

There’s a lot of nonsense floating around the internet when it comes to annuities.  Hopefully this framework is useful to you if you’re considering buying one.

 

American Legacy Annuity Analysis

In this video, I’ll analyze the American Legacy variable annuity offered by Lincoln Financial Group, which my client was considering.  This specific contract is the American Legacy Shareholder’s Advantage annuity, with the i4LIFE Advantage Guaranteed Income Benefit.  I’ll also assume that the Enhanced Guaranteed Minimum Death Benefit (EGMDB) is chosen.

Framework: How a Variable Annuity Works

Before we discuss how to analyze a variable annuity, let’s take a step back and review how they work & where they came from.

Variable annuities have become very popular in the retirement planning industry over the last 25 years.  Essentially, they’re a contract between you and an insurance company that guarantee you a series of payments at some point in the future.

There are two phases in a variable annuity: the accumulation phase and the payout phase.  What’s unique about a variable annuity is that you invest your contributions during accumulation phase – hence the term “variable.”  These investments are known as sub accounts and behave a lot like mutual funds.  They are professionally managed and will follow a specific investment strategy described in a prospectus.

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The Ultimate Guide to Early Retirement with Rule 72t Distributions

72t Distributions: The Ultimate Guide to Early Retirement

What’s the most common piece of retirement advice you’ve ever heard?

I bet it has something to do with tax advantaged retirement savings.  Most people are inundated with voices telling them to start saving early and take advantage of tax deferrals.  It’s solid advice.  Saving tax deferred money through IRAs, 401(k) plans, and other retirement vehicles is a wonderful way to grow your wealth over time.  The downside?  Those pesky withdrawal penalties.  The IRS will typically ding you 10% if you withdraw from these accounts before turning 59 1/2.  And if you’re considering an early retirement, this can pose a problem.  Fortunately there are loopholes, including taking 72t distributions in substantially equal periodic payments.

 

Tax Advantaged Savings

 

The IRS wants us to save for retirement.  By allowing us to defer taxes in retirement accounts like IRAs, Roth IRAs, and 401(k)s, the government is essentially begging us to improve our own financial futures.

The catch is that we have to keep our money in these accounts until we reach 59 1/2.  Otherwise we’re hit with a 10% penalty, in addition to income tax.

The IRS does provide 9 ways for us to take withdrawals without incurring the penalty:

  • Take withdrawals after 59 1/2
  • Roll withdrawals into another IRA or qualified account within 60 days
  • Use withdrawals to pay qualified higher education expenses
  • Take withdrawals due to disability
  • Take withdrawals due to death
  • Use withdrawals for a qualified first-time home purchase up to a lifetime max of $10,000
  • Use withdrawals to pay medical expenses in excess of 7.5% of adjusted gross income
  • As an unemployed person, take withdrawals for the payment of health insurance premiums
  • Take substantially equal periodic payments pursuant to rule 72t

But it you’re seeking to retire early, you probably don’t want to wait until 59 1/2. And if this is you, most of the loopholes the IRS provides will not apply.

Except for the final loophole, that is.  Rule 72t allows you to take withdrawals from your qualified retirement accounts and IRAs free of penalty, IF you take them in “substantially equal period payments” over your lifetime.  Here’s how:

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SEC Money Market Reform(2)

SEC Money Market Reform

Since the crisis in 2008, regulators have paid extra attention U.S. financial markets.  Sweeping changes like Dodd-Frank and the Department of Labor fiduciary ruling will change the way Americans save for retirement.  While these two examples have received tremendous media coverage, others haven’t.  SEC money market reform efforts have important implications, but seem to have flown under the radar.  Here’s what you need to know:

 

Background

Money market funds are a type of mutual fund developed in the 70s, which invest in short term fixed income securities. Their objective is two-fold:

  1. Never lose money
  2. Provide a higher yield than interest bearing bank accounts

The money fund market is comprised of three types: government funds, tax exempt funds, and prime funds.  As you can guess, each type describes what securities the fund may invest in.

Government money funds invest in government securities only, and as a result are thought to be the safest of the three types.  Tax-exempt funds invest in municipal securities that are exempt from U.S. federal income tax, while prime funds may invest in both corporate and U.S. government debt. So, while government funds may be safer, prime funds normally offer a higher yield in exchange for slightly more risk.

 

Reserve Primary Fund

Many investors have historically viewed all three types of money market funds as safe alternatives to cash. This view changed during the financial crisis in 2008. At the time, the Reserve Primary Fund was the largest money market fund in America, with assets of over $55 billion.

Being a prime fund, the Reserve Primary invested in an array of corporate debt issues. And in 2008, its portfolio included sizable chunk of securities issued by Lehman Brothers – which wasn’t seen as an overly risky proposition at the time.

As you probably know, the Lehman Brothers investment did not turn out well. Lehman Brothers was in far more trouble than its management let on, and the company eventually went bankrupt and could not repay its debts. This meant the Reserve Primary Fund lost its entire investment in the debt securities, striking a blow to its portfolio value.

 

Breaking the Buck

The hit was large enough to cause the fund to lose money, as its net asset value fell from a stable $1.00 to $0.97 per share. Also known as “breaking the buck,” only three other money funds had lost money in the 37 year history of money market mutual funds.

The reaction from the fund’s investors was fierce, as the consensus opinion at the time viewed the Reserve Primary Fund as a safe alternative to cash. Investors ran for the exits and demanded millions in redemptions. The fund lost over 60% of its assets in a mere two days, compromising its ability to meet other redemption requests and further spreading market contagion.

To diffuse the situation, the U.S. Treasury Department stepped in and offered to insure money market funds much like the FDIC insures bank deposits. Investors in funds participating in the Treasury’s program would be guaranteed at least a $1.00 net asset value if their fund broke the buck. This support helped limit liquidation pressure, and helped stabilize money markets until the crisis subsided.

 

SEC Money Market Reform(2)

SEC Money Market Reform

Unsurprisingly, the government does not want to be in the business of insuring money market funds today. So, the SEC has responded with reforms to help avoid this situation in the future. In July of 2013 the SEC amended Rule 2a-7, which will be enacted in October of 2016 and change the market structure of money funds.

The amendment essentially bifurcates money funds into two broad categories: retail and institutional. The previous classifications of government, tax-exempt, and prime will still exist, meaning that each will be further partitioned into retail and institutional classes.

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The 9 Most Common Small Business 401k Mistakes

The 9 Most Common Small Business 401k Mistakes

It’s no secret that small businesses are often short on resources.  And my guess is that keeping close tabs on your 401k plan is not at the top of your to-do list.

As you likely know, sponsoring a 401k plan comes with certain responsibilities, and neglecting them can get you in hot water with the IRS and Department of Labor.

If you’re wondering whether your bases are covered, here are the 9 most common small business 401k issues I see in my practice:

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6 401k Trends for 2016

6 401k Trends for 2016

Now that we’ve turned over the calendar to 2016, I thought it might be helpful to take a look at current 401(k) and 403(b) trends across the country.  The marketplace is continuously changing, and 401(k) and 403(b) sponsors can maintain competitive and low cost plans by keeping current.

Six 401k Trends for 2016:

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How to Calculate Solo 401k Contribution Limits

How To Calculate Solo 401k Contribution Limits

Whatever you want to call it: solo 401k, solo-k, uni-k, or one-participant-k,  the retirement plan is one of my very favorite for small business owners.  Solo 401k plans are easy to set up, low cost, and easy to maintain.  But despite the benefits, solo 401k contribution limits and the plan’s other intricacies can be murky.

 

When Can You Contribute To A Solo-401(k)?

 

The solo 401(k) is just what the name implies – a 401(k) plan for business owners without employees.

While most often utilized by sole proprietors and single member LLCs, solo 401(k)s can also be used in partnerships, multi member LLCs, S-corporations, and C-corporations as long as there are no qualifying employees.

Basically, you can make contributions in any year that you report income from self-employment on your tax return.  This can come in several forms:

  • Schedule C income from a sole proprietorship or single member LLC
  • W-2 compensation from an S-Corp or C-Corp
  • K-1 income attributable to self employment earnings, from a partnership or multi member LLC

 

Solo = No Eligible Employees

 

Not only must you have self employment income, but you can’t have any eligible employees.  This is where many business owners get tripped up, because the definition of an eligible employee can seem a bit murky.

Basically, the solo 401(k) is not much different than the traditional 401(k).  Solo 401(k) plans must have a plan document that describes how the plan is to be operated, just like traditional 401(k) plans.  Additionally, all 401(k) plans must be fair & equitable to all participants, and not discriminate in favor of highly compensated employees (or against non-highly compensated employees).

Solo 401(k) plans are no different.  They all have plan documents that must be followed, but since there are no other participants in a solo 401(k), there is no one to discriminate against.

From an administration standpoint this is great for business owners. Making sure that a traditional 401(k) is compliant requires non-discrimination testing each and every year, which can be onerous and expensive.  No employees = no testing required.
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