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Eyes wide shut II: good mutual funds vs. investment annuities.

Years ago--I think it was 1993, in the late summer, after the first World Trade Center bombing--I attended a due-diligence meeting at the Marriott Hotel near the Twin Towers.

The meeting was hosted by a then-subset of Oppenheimer called Quest for Value. QFV seems to have morphed into a regular Oppenheimer mutual fund (Quest Opportunity Value?), but back then, it was separate and special, marketed mostly to individuals who were looking for reliable income for rollover and other IRAs. In fact, QFV was, as I remember, marketed separately from all other Oppenheimer funds. QFV used computer illustrations extensively. It even provided a compelling historic snapshot of what the past would have looked like with a Quest IRA, showing withdrawals at perhaps 5% for years and years.

At one dinner, during the two-day due-diligence meeting, I got to sit at a table with the Clintons' financial advisor, who was visiting from Arkansas. He was the most popular rep at the meeting, since everyone assumed he knew all there was to know about the then-new president.

QFV was good stuff. I'm not sure why it moved back to being a member of the regular Oppenheimer stable of funds, but it did. The QFV illustrations were great. This was all, of course, before variable annuities offered living (income) benefits. In the dark age of 1993, variable annuities had lower expenses. The big selling points were diversity (a number of sub-account funds from different top-drawer investment companies) and the idea that, when retired, you would be able to keep up with inflation by retiring on a combination of variable and fixed units. The variable units were invested in the stock market (underlying sub-accounts), and the fixed ones were tied to bond accounts or the insurance company's general fund. The idea, again, was to be able to manage inflation during retirement. In a sense, in the early 1990s, variable annuities and Quest for Value were competitors for the same dollar.

In last month's annuity treatment, I gave short shrift to mutual funds and stocks. Now, it's their turn.

Mutual fund results

The mantra of the annuity income benefit is that income is guaranteed for life. It may be a surprise to learn that mutual funds can do a good job of providing life-time income, too.

If I run, for example, American Fund's Capital Income Builder for 20 years, the income at 5% (with slices taken monthly, from a mostly increasing pie) mostly increases each year, and at the end, one is left with a larger amount than he or she started with. I'm sure readers will write to me, saying something like, "Gee, sure, that period included the bubbling 1990s. Of course the results were good." So, I've decided to show 10 on-average rotten years of the 2000s.

Test No. 1: American Fund's Capital Income Builder

I used $500,000 worth of C-shares of this fund, which declined by about 30% in 2008. The result? The guy or gal who retired Sept. 30, 2001, would have received $288,530 over the 10 years (an average of $28,853 yearly) and, at the end, Sept. 30, 2011, would own shares worth $521,555. And that's over a non-performing, flat and horrible decade. Your broker-dealer might not let you sell $500,000 of C-shares, but I was trying to use a compensation level that was roughly the same as a variable annuity. (Note: the C-share concession would be 1% yearly, while the VA C-share would typically have a 2% concession in the first year, followed by a 1% concession.)

Test No. 2: James Balanced: Golden Rainbow

This is a favorite of mine, I confess. Here I used the fund, alone, inside an advisory account. Again, since it is only one fund, I'm sure my RIA would be more than a bit unhappy about me charging a 1.12% advisory fee, but, again, I'm trying to compare similar compensation arrangements.

In this case, the retiree has received, in the same 10 years, $288,502 in income ($28,850, yearly, on average) and has $600,092 at the end.

The truth is, I might use both of the funds, mixed with other investments, in an advisory account. In which case, the Capital Income Builder shares would be load-waived, and the result between the two might even be more similar.

Test No. 3: Ivy Asset Strategy

Another fave fund, Ivy, using the 1.2% fee model (like James) would have provided an income during the 10 years of $331,666, or an average of $33,166 yearly. At the end, the investment would have been worth $688,525.

Test No. 4: Dividends only

A portfolio could be built--no, I won't do all the work, and so no results appear here--using a combination of dividend-paying stocks, ETFs and master limited partnerships (MLPs). In this kind of portfolio, the focus is on dividend income, and all the dividends are taken in cash. Josh Peters, CFA, of Morningstar, builds a pair of nice dividend-paying portfolios, and anyone may subscribe to his monthly newsletter. It would seem reasonable to expect around a 3% yield, and that amount would likely increase yearly.

Test No. 5: Mixed portfolio

I built a mixed portfolio consisting of six funds (American's Capital Income Builder, Ivy Asset Strategy, Templeton Global Bond, Pimco Total Return, Pimco Real Return, James Balanced: Golden Rainbow) that were all load-waived and added one stock, Berkshire Hathaway B. With no great forethought, I put 16% in Berkshire and 14% each in the others. The added advisory fee was 1.2%, and there was no rebalancing. I withdrew only from the funds. (Berkshire does not pay a dividend, and I used it for capital appreciation.) At the end, the individual, over the last 10 (arguably, lousy) years, the retiree would have received $250,020, or about $25,000 yearly. And the market value of the portfolio on Sept. 30, 2011, would have been $643,000, or $143,000 more than was originally contributed. What was the most successful investment in the seven-investment mixed portfolio? It was Templeton Global Bonds. However, as we all know, that may not be true for the next 10 years, which gets us back to the argument for diversity, doesn't it? The 10-year beta, according to the Morningstar Advisor Workstation, is 0.33, and the standard deviation is less than half that of the benchmark S&P 500.

Aside from Morningstar's dividend portfolios, the American Association of Investors offers a number of portfolios and methods for long-term investment success.

And there are other choices: First Trust's Target Global Dividend Leaders Portfolio has returned (assuming reloading every 15 months) a yearly average of 15.16% for the 10 years ending Sept. 30, 2011. ("Reloading" means rolling funds into each new unit investment trust, or UIT, offering. Old ones expire after 15 months, and new ones are immediately issued.) And what's wrong with a mix of MLPs? They all seem to offer excellent dividend rates. I ran three combined (Magellan, OneOk and Kinder Morgan) on the Morningstar Advisor Workstation, and the 10year average was something like 17%. Good grief!

Where's the beef?--Part II

The point of this exercise is to illustrate--during a really, really tough decade of flatness and volatility--that it is possible to easily construct portfolios or to use funds that will exceed the performance of variable annuities. But the question always looms: what is, in the mutual fund and stock investment world, guaranteed? And none of the portfolios or funds discussed here have any guarantees, even though they were more than adequate for returning excellent income and building value during a tough, tough time. Imagine what they might be like in a non-flat and non-volatile environment. No, not something bubblicious like the 1990s; instead, something approaching normal.

The rest of the story

Yes, some of these funds are available in investment annuities. But there is that pesky trade-off. If you use the fund as a sub-account in an investment annuity, the all-in expenses--assuming you use an income benefit--can be 4% or more (assuming maximum charges; not current charges). Even at 3.25%, based on current charges, that's a steep hill to climb.

The annuity company is willing to promise income for two lifetimes, maybe at 5% or a bit more, depending on age. But it makes big profits on expenses--and sometimes even additional profits from pay-to-play concessions from the investment sub-account managers. Why? Because of those expenses. Figure 3% or more on billions or more of AUM; we're talking serious money.

Put another way, the choice for your customer (and for you) is whether you want most of that 3%-plus to go to the annuity company or to the customer. I'm not saying there's one answer for everyone; that's not true. There are customers who would go nuts, literally, with a 30% drop in 2008 (as with Capital Income Builder). And yet ... are we paid for hand-holding, or what? Could you advise someone to be patient with a 30% loss? Could you do so while the media is screaming that the end of the world is coming and that this time (2008) is worse than the Great Depression? And while every neighbor and co-worker is shrieking: "Get out, for God's sake, get out of the market before you lose it all!"?

If we say that an annuity could have "current" charges of 3.5% (recognizing that the insurer may increase those charges) and an all-in investment advisory account might have 1.5%, the extra 2% has be a conscious choice. Vanguard's founder, John Bogle, is right about one thing, 2% over time is a helluva lot of money. Get out your financial calculator and the digits show that 2% of $100,000 for 20 years is $48,594.74, a not insignificant sum.

Despite the expense, the antidote for the ultra-nervous may be the investment annuity--for that kind of customer, the black-and-white illustration, showing the income benefit, which shines no matter what, may be worth the thousands that may be lost to rider premiums and insurance company profit. In a sense, many of us around the world are ill-suited for investing--the human mind, unless trained to do so, doesn't see the long-term. Instead of focusing on a time horizon, it causes us to run for the exits.

This information is intended for financial professionals only, not the general public. This is not a solicitation to buy or sell any specific security. Mr. Hoe may have positions in the securities or other investments discussed. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions, and when sold or redeemed, one may receive more or less than originally invested.

A Richard Hoe, ChFC, CLU, AEP, has been an investment professional for 42 years and is a member of Prosperity Network's five-person investment team, as well as an investment advisor representative and registered representative. Paul Ewing's Kansas City-based Prosperity Advisory Group has over $2 billion in AUM. Mr. Hoe has been writing professionally for more than 50 years and is a member of the adjunct faculty at the California Institute of Finance, a graduate school at California Lutheran University that offers an M.B.A. in financial planning. He is a member of both the Society of Financial Service Professionals and the Financial Planning Association. He helps edit each edition of Andy Kilpatrick's "Of Permanent Value," a book about Warren Buffett and Berkshire Hathaway published yearly in advance of each shareholder meeting. Readers may e-mail Richard Hoe at
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Author:Hoe, Richard
Publication:Life Insurance Selling
Date:Jan 1, 2012
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