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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Employee Stock Options: The Top 5 Mistakes That Leave Money on the Table

Employee stock options can be a wonderful form of compensation. Unfortunately, far too many employees leave money on the table when managing them. Here are the top five mistakes you should strive to avoid:

1) Underappreciating Tax Liabilities

There are two types of company stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs). They differ in structure, who they’re offered to, and how they’re taxed. Here’s a good review of both.

In order to maximize the value of a stock option grant, employees should always try to minimize the resulting tax liabilities. Stock options can be tricky creatures from this perspective since the option grant, exercise, and resulting stock sale can all be taxed differently. Exercising ISOs can even subject employees to the alternative minimum tax (cue shudder). Thus, tax minimization should be a focal point of any long term stock option strategy.

2) Exercising Options and Selling Shares Immediately

Rather than exercising and selling immediately for a profit, it’s almost always better to exercise employee stock options and hold the shares for at least a year. By doing so, the difference between the sale price and strike price is taxed as a long term capital gain instead of ordinary income.

Since long term capital gains are taxed at lower rates than ordinary income, this can be a big tax saving technique. Also, keep in mind that incentive stock options must also be held for two years after the grant date to qualify as long term capital gains.

3) Forgetting About Them Until It’s Too Late

The very worst case scenario is when employees forget about stock option grants and allow them to expire unused. While not nearly as costly, another common mistake is neglecting options until they approach expiration. Allowing the exercise window to close limits your options, thwarting the benefits of a thoughtful long term plan.

Employees should start thinking about their stock option strategy immediately after they’re granted. Starting early leaves you the most flexibility, and the best opportunity to minimize taxes and maximize their value.

4) Neglecting Stock Plan Rules Before Resigning

Most companies force employees to exercise stock options upon termination of employment. Normally they have 90 days to take action, but the window varies from place to place.

This window for stock options will also be different than the windows for severance packages and other benefits, making things a bit confusing. Before tendering resignation, be sure to understand your company’s stock plan and set a strategy accordingly.

5) Failing to Account for a Merger or Acquisition

Mergers and acquisitions affect employee stock options in several different ways. Sometimes vesting schedules accelerate, while in others the existing company’s shares will be phased out and replaced with the new company’s.

When going through a merger, employees should keep abreast of how management is handling their stock plan, and adjust accordingly. If necessary, pester HR for up to date information. The only way to maximize stock option value is to concoct a strategy with up to date data.

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

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:

Never lose money
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

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

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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Buying Bonds vs Buying Bond Funds

Stock markets tend to be pretty good at keeping investors up at night. Peaks, troughs, business cycles, corrections, and crashes are par for the course when investing in stocks. And for many investors this is just a little too much excitement.

For anyone uncomfortable with the risk of investing in stocks, bonds are often the first alternative. They won’t nock knock your socks off with huge returns, but bonds can provide steady income with less risk that your portfolio sours.

But when it comes to buying bonds, investors have a big choice to make: do you buy individual bonds or bond funds.

Unlike stocks, the choice between buying individual securities or a fund that includes individual securities has major implications.

Here’s a quick guide that explains what you need to know.

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4 Telltale Signs You’re in the Wrong Investments

Investing is kind of like buying new shoes.

There are a thousands of options out there: running shoes, hiking shoes, dress shoes, and flip flops just to name a few. The right pair for you will depend on what you need them for, how big your foot is, and how much you want to spend.

There are thousands of options in the investment world too, from individual stocks and bonds, to mutual funds and ETFs, to managed accounts and automated platforms.

One question I hear a fair amount is, “with all the options out there, how do I know if my portfolio is right for me?”

Much like buying a new pair of shoes, the right portfolio for you matches your needs.

If you need new shoes to take your dog for a walk around the block twice a day, you probably won’t go out and buy ski boots. The same idea applies when investing.

4 Telltale Signs You’re in the Wrong Investments:

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What No One Is Telling You About Long Term Disability

When someone mentions the word insurance, most of us think of one of three things:

Aaron Rodgers doing a discount double check
The GEICO Gecko using his British accent
The coverage we carry on our cars, our home, our health, or our life

What most of us don’t think of is our long term disability coverage.

Since tangible assets like our cars and homes are easy to visualize, they’re often top of mind when it comes to insurance protection.

But what about the risk that we get sick or injured, and can’t work?

Long term disability insurance is meant to replace our income if this happens. And coincidentally, our ability to earn a living is probably our biggest and most overlooked asset.

Earnings Capacity

Let’s take a moment to think about your ability to earn a living. Just imagine for a moment what your lifetime earnings will look like.

Your lifetime earnings includes every single paycheck you earn throughout your entire career. It counts every single raise, every single promotion, and every single bonus.

When you add them all together you’ll get a massive number. It will be far bigger than the value of your home, your car, and probably your retirement nest egg.

Your ability to go out into the work force and earn this money is your earnings capacity.

Now Imagine It’s Gone

Many people consider the possibility that they die, and the impact that would have on their family. But what if you were hurt or sick and unable to work?

Your family would be left with monthly expenses like a mortgage, utilities, and grocery bills. They’d also be left without your steady paychecks to afford them.

Plus there’s a chance you might need additional help from a caretaker if you’re permanently disabled. The end result? Higher expenses, lower income.

It’s More Likely Than You Think

If you’re thinking “that’ll never happen to me,” the statistics would disagree with you.

The social security administration says that 1 in 4 of today’s 20 year-old’s will become disabled for some period of time before they retire.

And if you’re under 45, the chances that you become disabled are far, far greater than the chances that you die.

Let’s Think About This

Our earnings capacity is our biggest and most important asset
Becoming disabled is far more likely than we realize
Losing our earnings capacity could cause our family severe hardship

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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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