Do You Need an Annuity?

Annuities are like religion and politics - which are best when not discussed in polite company. Most financial advisors can be found on one side or another of a wide divide. Some advisors love the annuities and all the complex bells and whistles that add flash to the product (and make them difficult to understand). Other advisors hate annuities for being too expensive, over-hyped products that pay good salesman far too much money to incent them to lock unwary investors into these products (for life). For the record, I'm in the latter camp.

But even in my skeptical view, annuities have their place. (For more about annuities, check out this Morningstar article.)

Annuities will be the solution of choice for many retirees who have saved up some money, but not enough to truly provide them with financial security for life. These folks are at risk of outliving their financial resources, and for them it may make sense to transfer this risk to an insurance company which can afford to spread it around. For these people, an “immediate annuity” is worth considering. This investment will assure a certain amount of money for life. For a couple, a “joint annuity” will pay out until the second spouse dies. If the couple is killed in a car wreck on the way home from buying the annuity, bad news for them (but they won’t be around to complain). However, in the event that they have inherited good genes and live to be 105, it is the insurance company who takes it on the chin. For those with limited retirement funds, outliving your resources can be a sad end to an otherwise noble life. To me, it makes sense to insure against the “risk” of living too long, even if it means that an insurance company will receive a windfall if something happens to you in the near future.

As an example, an internet-based web calculator estimated that a joint life annuity for a 72 year-old male and his 74 year-old spouse will pay a 7.7% yield. This is far above what’s available in the bond market, but you would expect it to be because part of that income stream is return of principal. It’s an apples and oranges comparison to a 10-year bond at 4.87%. On a $200,000 portfolio, that would provide a payout of $15,400 annually. By way of contrast, many financial planners will tell you that tapping your portfolio for more than 4% annually (which provides only $8,000 per year) leaves investors at risk of outliving their resources if markets head south for a protracted period of time.

True, the comparison is patently unfair. At the end of most normal periods, the normal portfolio will still have money in it which can be passed on to the next generation. That’s why, for many, an annuity is inappropriate. But consider the downside in each scenario for a retiree of limited means. With an annuity, the downside is that maybe the kids don’t inherit as much. What did they do to earn it? With a normal portfolio of stocks and bonds, the downside is that the investor lives too long and ends up living with their offspring (providing that’s even an option). For many, the higher current income and worst case scenario with an annuity are preferable to the risk of outliving their resources and being without any resources at the end of life.

The other person who may want to consider an annuity is on the other end of the economic spectrum. If you happen to be one of the lucky few who is young and making more money than you can fit into your retirement plan, annuities provide a tax-deferred saving vehicle. Because they are more expensive than normal mutual funds, the money needs to remain in them for awhile (sometimes nearly 20 years!) before the benefit of tax deferral will offset the high fees of many annuity products. And keep in mind that money comes out as ordinary income instead of capital gains, and currently is taxed at a relatively high rate. But if you’ve maxed out your IRA and your 401(k) and there is still a need to build up the retirement nestegg, then annuities could provide some tax shelter. Take a professional athlete who has high earnings potential while he or she is young, but uncertain earnings power after retirement. They might be an excellent candidate to consider an annuity for all or a portion of their retirement planning needs.

If you don’t fit into either of these categories, feel free to shop for an annuity, but caveat emptor (buyer beware!). I’ve seen IRA’s put into annuities, where the tax deferral is unnecessary (IRA’s are already tax deferred vehicles, and have much lower expense ratios) and it would seem that advisor commissions, rather than common sense, drove the decision.

Also beware of the bells and whistles. Most bells and whistles are like fins on a 1950 Buick. They are there to sell the car, and have little real utility. By offering unique riders and options, annuity salesmen take themselves out of the commodity market – where returns can be compared – and put themselves in the arena where special features make comparison shopping impossible, and the commissions on these products are much higher. Sales commissions on annuities can be as high as 7% - 10% of the face value, and salesmen who have no shame love the complexity of these products.

Most investors ought to avoid the bells and whistles that make the products sound sexy. If you need to transfer the risk of outliving your resources to an insurance company, take a look. If you need a larger tax deferred retirement nestegg than you can stash away in your IRA and 401(k), then consider an annuity. Otherwise, take a look but be skeptical of the promises you hear.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Western CO stocks miss out on Christmas Cheer

The Scout Partners Index of Western Colorado Stocks fell sharply in November, -1.3% versus a +1.3% increase for the widely followed S&P 500 stock index. The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), Startek, CRH (United Companies), and the Union Pacific Railroad.

For the month of December, the strongest performer in the index was Safeway Companies (SWY), which surged 12.2%. The California-based grocer hosted a mid-month analyst meeting in which the company said that 2007 earnings may top current Wall Street expectations for the company. The company showcased its Blackhawk Network subsidiary which sells gift cards for major retailers such as Home Depot and Best Buy, and raised its stock repurchase plans from $400 million to $1 billion.

"When (Wall Street commentator) Jim Cramer started talking up Blackhawk," said Doug May, President of Scout Partners. "the stock shot up about 3 points in two days. The analyst meeting seemed to confirm what Cramer was saying about the stock, and it all happened during a week where investors seemed to be deciding that the housing sector wasn’t going to drag us into a recession after all. Blackhawk might indeed be a jewel in Safeway’s arsenal,” May said, “but I’m not convinced that we’re headed for a soft landing."

Arch Coal (ACI) was the index laggard, falling 16.4% during the month of December. In spite of recent upgrades from brokers HSBC Securities and Bank of America, the stock declined steadily throughout the month. May noted that “natural gas prices plunged during the month, and coal competes with gas on the electrical generation side so natural gas prices falling 30% creates some worries about future coal prices.”

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. In the month of November, the index’s concentration in energy stocks boosted index returns. Local stocks rose 2.3% last month while the overall market climbed 1.7%, but December’s weakness in the energy sector caused the situation to reverse while the rest of the market enjoyed a holiday surge.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Who Ya Gonna Trust?

Leveraged buyouts are back in vogue. This is typically smart money – insiders and institutional investors, reminiscent of the leveraged buyout trend that launched a new bull market in the early 1980’s, when the “smart money” recognized great value in stocks coming out of the 1970-1982 bear market.

As a result of this deal-making, the Wall Street Journal reported that the top 5 investment banks bestowed year-end bonuses of $36 billion this holiday season. At Goldman Sachs, the payout equals roughly $750,000 for each of its 22,000 employees. Goldman’s new CEO, Lloyd Blankfein, “earned” (I use the term loosely) a bonus of $27 million, while his total compensation package topped $53 million for about a half a year’s work.Deal making, not money management, drives these bonuses, and bonuses drive Wall Street. Moneyscience.org reports that Goldman’s flagship Global Alpha hedge fund is -12% going into December.

Perhaps to turn around its flagging asset management returns, Goldman reportedly hired 17 traders from Amaranth Advisors, the hedge fund manager whose energy-bet-gone-awry cost investors more than $6 billion when it blew up last Summer.There is a disconnect between Wall Street compensation and investor returns that brings to mind the title of Fred Schwed’s classic book, “Where Are the Customer’s Yachts?”

A lot of assets are being managed by folks whose primary aim is to separate investors from their money. Big, leveraged bets are placed. Some cost investors billions, and the managers simply close down the shop and move across the street. In 2005, more than 1 in 10 hedgers had to liquidate their funds. Some bets work out well for investors, and even better for managers, who can sell that track record to pension funds across the nation who pay 2% on assets under management and 20% of profits to the managers, who can quickly attract billions in assets with the track record. As a result, hedge funds and “private equity” funds are attracting Wall Street money and talent, and investors ought not lose sight of Schwed’s perceptive observation.

The nature of leverage buy-out funds has also changed. There is less emphasis on running companies, and more people acting like “flippers” (to borrow a term from real estate speculation). Though not all hedge fund managers are cut from the same cloth as Enron’s former CEO, Jeff Skilling (who, on a happier note, finally vacated his luxurious River Oaks mansion for more appropriate living quarters in a converted college dorm room at a federal facility in Waseca, MN), Eugene Lockhart, the former CEO of New Power Holdings (an Enron spin-off caught in the midst of the deception at Enron), joined the private equity world as Chairman of New York’s Diamond Castle Holdings.

Another hedge fund recently raised $2 billion in the bond market. The fund already manages about $12-$13 billion in investor funds, and these funds are levered 7-8X, for a total of $90-$150 billion in current leverage, borrowed from major banks, that is probably senior to the bonds recently issued. Bond investors received roughly 6.5% return on their investment, as well as a return of their investment, assuming all goes well. If not, no worries, the manager is getting paid about $350 million a year in the interim. Helped by leverage and a strong market, top hedge fund managers are taking home more than $1 billion a year based on their asymmetrical payout arrangement with pension fund fiduciaries.

Why the rant? Because few would characterize this equity market as speculative, yet the sheer volume of leveraged private equity deals is a classic sign of speculation. Wall Street is not making these deals to capture gains for investors, but rather to pad their own bonus pool. Hedge fund managers live in a world of “heads I win, tails you lose” and they have been entrusted with billions of dollars of pension fund money. And the bond market and the stock market continue to disagree on where this economy is headed, with the bond market still forecasting a slowdown while the stock action over on the New York Stock Exchange is at least invigorating, and possibly exuberant. Who you gonna trust?

The bulls have the momentum. We are back to a fully invested position. But investors need to remain flexible. Though the market is not overvalued, per se, it is highly dependent on an unproven soft landing scenario. The Wall Street marketing machine says things are great, and things are great – on Wall Street.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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