Friday, December 14, 2012

Questions to ask BEFORE investing in a Variable Annuity

Questions to ask BEFORE investing in a Variable Annuity

Financial professionals who sell variable annuities ("VA") have a duty to advise you as to whether the product they are trying to sell is suitable to your particular investment needs. Don't be afraid to ask them questions. And write down their answers, so there won't be any confusion later as to what was said.

VA contracts typically have a "free look" period of ten or more days, during which you can terminate the contract without paying any surrender charges and get back your purchase payments (which may be adjusted to reflect charges and the performance of your investment).  You can continue to ask questions in this period to make sure you understand your VA before the "free look" period ends.

Before you decide to buy a VA, consider the following questions:

·       Will you use the VA primarily to save for retirement or a similar long-term goal?
·       Are you investing in the VA through a retirement plan or IRA (which would mean that you are not receiving any additional tax-deferral benefit from the VA)?
·       Are you willing to take the risk that your account value may decrease if the underlying mutual fund investment options perform badly?
·       Do you understand the features of the VA?
·       Do you understand all of the fees and expenses that the VA charges?
·       Do you intend to remain in the VA long enough to avoid paying any surrender charges if you have to withdraw money?
·       If a VA offers a bonus credit, will the bonus outweigh any higher fees and charges that the product may charge?
·       Are there features of the VA, such as long-term care insurance, that you could purchase more cheaply separately?
·       Have you consulted with a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?
·       If you are exchanging one annuity for another one, do the benefits of the exchange outweigh the costs, such as any surrender charges you will have to pay if you withdraw your money before the end of the surrender charge period for the new annuity? 


Before purchasing a variable annuity, you owe it to yourself to learn as much as possible about how they work, the benefits they provide, and the charges you will pay.

How much does a Variable Annuity cost?

How much does a Variable Annuity cost?

You will pay several charges when you invest in a Variable Annuity (“VA”).

Often, they will include the following:
·       Surrender charges – If you withdraw money from a VA within a certain period after a purchase payment (typically within six to eight years, but sometimes as long as ten years), the insurance company will usually assess a surrender charge, which is a type of “sales charge”.  This charge is used to pay your financial professional a commission for selling the VA to you.  Generally, the surrender charge is a percentage of the amount withdrawn, and declines gradually over a period of several years, known as the "surrender period."  For example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the eighth year, when the surrender charge no longer applies.  Often, contracts will allow you to withdraw part of your account value each year – 10% or 15% of your account value, for example – without paying a surrender charge.
For example: You purchase a VA contract with a $10,000 purchase payment. The contract has a schedule of surrender charges, beginning with a 7% charge in the first year, and declining by 1% each year.  In addition, you are allowed to withdraw 10% of your contract value each year free of surrender charges. In the first year, you decide to withdraw $5,000, or one-half of your contract value of $10,000 (assuming that your contract value has not increased or decreased because of investment performance).  In this case, you could withdraw $1,000 (10% of contract value) free of surrender charges, but you would pay a surrender charge of 7%, or $280, on the other $4,000 withdrawn.

·       Mortality and expense risk charge – This charge is equal to a certain percentage of your account value, typically in the range of 1.25% per year.  This charge compensates the insurance company for insurance risks it assumes under the annuity contract.  Profit from the mortality and expense risk charge is sometimes used to pay the insurer's costs of selling the VA, such as a commission paid to your financial professional for selling the VA to you.
For example: Your VA has a mortality and expense risk charge at an annual rate of 1.25% of account value.  Your average account value during the year is $20,000, so you will pay $250 in mortality and expense risk charges that year.

·       Administrative fees – The insurer may deduct charges to cover record-keeping and other administrative expenses.  This may be charged as a flat account maintenance fee (perhaps $25 or $30 per year) or as a percentage of your account value (typically in the range of 0.15% per year).
For example: Your VA charges administrative fees at an annual rate of 0.15% of account value.  Your average account value during the year is $50,000. You will pay $75 in administrative fees.

·       Underlying Fund Expenses – You will also indirectly pay the fees and expenses imposed by the mutual funds that are the underlying investment options for your VA.

·       Fees and Charges for Other Features – Special features offered by some variable annuities, such as a stepped-up death benefit, a guaranteed minimum income benefit, or long-term care insurance, often carry additional fees and charges.

Other charges, such as initial sales loads, or fees for transferring part of your account from one investment option to another, may also apply. You should ask your financial professional to explain to you all charges that may apply. You can also find a description of the charges in the prospectus for any VA that you are considering.

Be sure you understand all the charges before you invest.  These charges will reduce the value of your account and the return on your investment.

Tuesday, December 11, 2012

Should your kid go to college (part 2)?


But only when your child reaches a certain level of maturity and when tertiary education can be funded WITHOUT ANY DEBT.  Maturity will obviously differ from child to child, in terms of age, life experience, etc.  Very few seventeen year olds have the ability to think and plan ahead for the rest of their lives.  Heck, some adults are still deciding!

A professional degree, e.g. law, medicine, accounting, etc., requires a college education.  Almost any other degree offers little or no value beyond the personal and life experience value derived, and perhaps especially later in one’s career.

Refer back to part 1.  The answer was no.  It assumed to be talking to parents of high school children, from middle class families.  In other words, people who would typically require debt financing in order to pay for college.  The answer is absolutely “no”!

The opening paragraph above is not a contradiction to the previous no.  Deb and I have two sons, neither of them schooled in the traditions of middle class America (or Canada, where they were raised).

Our older son finished high school in Canada and left promptly thereafter to teach English in Muikamachi, Japan for a year.  The cost of this life education was minimal, at only a few thousand dollars in travel costs and pocket money.  In order to qualify for his teaching post at a kindergarten school, he had completed a TEFL certificate on weekends during his senior year at high school.

When he returned from Japan to Toronto, he enrolled for a general business diploma, part-time at a local college, and worked regular, low-paying retail jobs (just like other students) to help fund his tuition.  Occasionally we helped him with some of the tuition and general cost of living expenses.  With the $150,000 we saved on full time college tuition, we bought an apartment, which he lived in, that we later sold.  We reinvested some of the proceeds into our family property management business, which he co-owns.

He also has a real day job now, working as a Solutions Specialist for a technology company; helping clients with implementations, consulting and service issues.

Our younger son is 19.  He attends Brighton College (UK), studying online, part-time.  He also works 6 days a week as a driver for a car dealership.  It happens to be a Mercedes Benz dealership, which means he also gets to drive some of the finest cars on the planet.  This infers that he likes his part-time, low-paying job… he does, while he completes his studies.  He pays his own tuition and we help with some of the cost of living expenses. 

He lives on his own in West Palm Beach FL, in a property owned by the property management company mentioned above, which he co-owns with his parents and brother.  Total student debt = $0.  Total current personal savings = $ 5-figure cash + an equity portfolio of Dow stocks.

Total tuition costs referenced above = less than $10,000 (each).  Total student debt = $0.

Sound doable for you? Probably also "yes".

Should your kid go to college (part 1)?

Rand University, Johannesburg, South Africa - my college after high school

No. First read "8 Alternatives to College" on the blog - The Altucher Confidential - and then bookmark the blog so that you will be able to enjoy sound advice, shared with common sense and logic derived from experience, as often as you'd like.

Now… here’s my take on a U.S. (insert your country here) college education:

1.     Colleges feature resort-style facilities at prices similar to luxury beach resorts – send your kid to a beach resort in Dominican Republic; it will cost the same, but she will have more fun, and it will be more educational
2.     The college experience is mostly ‘party-time’ for young kids, depriving them of quality learning, independent thinking and general life experience
3.     The lost ‘opportunity cost’ of attending college can be measured in more than just money (see # 2 above, and # 4 below)
4.     The product does not match either the aspirational value, usefulness, or cost of the goods sold, especially when measured in $ return on investment, or ROI
5.     In the past students were at least taught a sense of entitlement based on learning, future earnings, etc.  Today, that value proposition is also gone
6.     Colleges stifle young creativity (at a peak during early years). Innovation and new ideas – during a time of abundant availability – are sacrificed, focusing instead on ‘book knowledge’ about historical events, thoughts and philosophies
7.   Colleges support the teaching of risk avoidance and mitigation (“you need to graduate to get a good job”).  Young people have greater risk tolerance.  The older we get, the more risk averse we become

Let’s revisit point # 4 above:

Q: What can one buy for $150,000 (i.e. the average cost of a 4-year degree in the US)? 

How about a year spent teaching English to kids in Japan, a turnkey retail business (e.g. the entry cost of a Subway franchise is about $100,000), and about $40,000 in cash ‘left over’ to fund the first few months of business expenses, if required.

The difference in ROI is not only significant, but also material in terms of breaking the mold young people are coerced into.  The mantra: “get an education, in order to get a job, in order to qualify for a lifetime of middle-class debt” vs. self-employment and – more importantly – sustainable, debt-free, self-sufficiency!

As a small business owner, you will generate an income for yourself and other people.  You will employ people who graduated with student debt, like an accountant.  You will have equity and you will start creating wealth on day one – creating assets with value.  These assets can be sold, allowing you to buy another business; or leveraged, allowing you to expand your existing business, open a second store, etc.

Some of your kid’s high school friends, who went to college, will likely ask your self-employed child for work.  She will be unlikely to hire these grads, because they are unlikely to offer any value to the business commensurate with their sense of entitlement, drilled into them at home, and at school!

Sunday, December 9, 2012

What are financial instruments?

Examples of financial Instruments
In a previous blog titled "what is an ETF", we had opened a discussion about one particular financial instrument.  In this post, we'll briefly explore some other, relatively common financial instruments.

Financial instruments are, generally speaking, divided into two categories. The value of cash instruments are determined by the market. 

This grey, amorphous mass referred to as the market, is governed by supply and demand, as people buy and sell (or trade) various financial instruments.  

Cash instruments can further be divided into securities and other securities, like loans and deposits.

Derivative instruments simply imply that that value of the instrument is derived from something else. Most commonly, the value of the derivative is derived from the value and characteristics of another entity, like an asset, interest rate or index.  Derivatives can further be divided into exchange-traded derivatives and over-the-counter (OTC) derivatives, describing how they are traded.

The descriptions above may sound overly complicated, but are not really that complex.  However, trading in many of these different instruments are often very complex, especially for a novice investor!

If you don't fully understand what you may be wanting to trade or invest in, please be sure to contact a professional financial advisor!

Let's explore a few simple, and relatively common examples of the 4 financial instruments described above:
  1. Securities include bonds, stocks and T-Bills (or Treasury Bills). Securities can also include commercial paper, also called promissory notes. Bonds, much like T-Bills and commercial paper, are instrument of indebtedness by the bond issuer to the bond holders. These are therefore called debt securities.  Stock on an incorporated business, on the other hand, constitutes an equity stake.
  2. Other securities are generally limited to loans, deposits, certificates of deposit, and FX-spot (foreign exchange) rates. Although the latter may be a term people are least familiar with, the Triennial Central Bank reported (in 2011) that as of 2010, the average daily turnover of global FX spot transactions reached nearly US$1.5 trillion!
  3. Exchange-traded securities include bond, stock, equity and currency futures.  Futures simply imply that parties agree to buy or sell a specified asset for a price agreed upon today (the strike price) with delivery & payment occurring at a future date (the delivery date).
  4. OTC derivatives are similar to exchange-traded securities, but also include interest rate and currency swaps, caps & floors and options.
You may have heard of a call and put:  This is financial jargon for a buy or a sell.  A simple way to help you remember that call = buy and put = sale, is to think: "I will call my broker to buy something, but I will put something up for sale".

I will offer some more discussion on stock options (and similar/other exchange-traded securities as our readership grows, and based on reader requests for more information.  Some derivatives, like stock option and restricted stock awards, are commonly used as an integral part of executive compensation plans, and we'll discuss these instruments in later postings as well.