Tips from Donna (November 2013)
by Donna Gordon on November 24th, 2013

Small Numbers Big Picture,Variable Annuities,Risk of Over-Allocated Funds
The Wesban Monthly
November 2013 

Don't Let Small Numbers Distract You From the Big Picture

Even though it's all about dollars and cents, the financial industry runs on percentages; dollar signs are few and far between. The use of percentages is an understandable, and helpful, convention when communicating financial information. After all, a headline saying “Company A’s Net Jumps by 16%" is more helpful than one that reads "Company A’s Net Jumps to $1.02 billion.” Providing percentages rather than dollars also allows investors to compare apples to apples: You can readily discern that an investment that has gained 8% during the past 10 years has been a better bet than one that has gained half as much.
Yet dealing in percentages, especially relatively small ones like inflation rates, expense ratios, and long-term annualized returns, can also distract from important information that factors into your financial plan. Those small and innocuous-looking percentage figures, when translated into dollar terms and compounded over many years, can make a huge difference between success and failure.
How Small Numbers Can Make Your Investment Plan…: Say, for example, that you stick with the 3% 401(k) contribution rate that your company uses as the default, contributing $1,500 of your $50,000 salary for 40 years and earning 5% on your money. You'd have about $190,000 at the end of the period; not too shabby. But bumping up your percentage contribution just 2 percentage points (to 5%) would have a meaningful impact on your bottom line, increasing your nest egg to nearly $320,000.
In a similar vein, you might choose to keep your child's college fund in cash. Assuming cash yields stay as low as they are now (which is, admittedly, a big assumption), a $50,000 investment that earns just 1% for the next 10 years will amount to just $55,000 at the end of the period. But by maintaining a 60% stock/40% bond portfolio and assuming a not unreasonable 4% return, you'd be able to grow your $50,000 investment to $74,000. Neither return rate will allow you to keep up with college inflation, sadly, but at least it's better than putting the money under your mattress. However, keep in mind that the 60/40 portfolio entails market risk.
…or Break It: Just as seemingly small percentage changes (either in contributions or return rates) can provide investors with an enormous helping hand, they can also work in reverse, and this is where many investors run into trouble. They blow off small percentage amounts like expense ratios and inflation rates when making investment decisions.
For example, let’s say an index fund has a fairly low expense ratio of just 0.63%. It's certainly cheaper than most actively managed funds, and it doesn't appear to be that much more expensive than most other S&P 500 index funds, some of which charge as little as 0.06%. If you opted for the expensive fund rather than a cheaper alternative and you held it for a long time, you'd be shortchanging yourself. Assuming a 10% annualized return and a $100,000 initial investment, you'd be leaving a lot of money on the table during a 25-year period by opting for the more expensive fund: nearly $170,000, to be exact. All because your fund charged 0.57% per year more than a comparable option.
Inflation is another factor that investors tend to underestimate, because the average historical inflation rate of roughly 3% looks pretty benign when viewed without any context. Should the fact that bananas that are $0.59 a pound today but might be $0.79 a pound 10 years from now cause a major rethinking of your financial plan? Yes, actually. When you extrapolate inflation across all of the items in your shopping cart and compound it over many years, it can have a hugely corrosive effect on the purchasing power of your savings, meaning you need to save a lot more than you thought you did.

How Are Variable Annuities Different When Held in a Qualified Account?

There are some basic differences when a VA is held inside a qualified account, meaning an IRA (traditional or Roth) or employer plan.
Contract Titling Difference: A non-qualified contract can be held by two owners or a trust, whereas a VA held in a qualified account must have an individual owner who is also named as the annuitant. (Note that on the Lifetime GMWB, joint spousal coverage can be achieved on an individual retirement account.)
Product Differences: Often, a VA contract or benefit held in a qualified account has a different issue age. For example, one lifetime income rider must be purchased by age 77 when held in a qualified account, versus age 80 in a non-qualified account. In a few cases, fees and expenses are different. One variable annuity contract charges an extra 20 basis points when held in a qualified account. One carrier waives the annual account fee for qualified accounts with a minimum balance of $20,000. In one case, the VA product itself was designed exclusively as a qualified contract. For one carrier, an owner of a qualified contract has the option to terminate a living benefit, whereas non-qualified contracts cannot terminate a benefit once elected. Select carriers increase the withdrawal percentage to equal the RMD. Other living benefits treat RMDs favorably.
Tax Treatment—Different IRS limits on contributions: Non-qualified VAs do not have IRS restrictions on annual contributions, while qualified VAs are limited by the $5,000 annual contribution ceiling. 1) RMD requirements: Qualified VAs need to start required minimum withdrawals at age 70 ½ (except if the VA is held in a Roth IRA). Non-qualified contracts do not have RMD requirements. 2) RMD calculation is different: When calculating the RMD, the carrier factors in the present value of any enhanced death benefit and living benefit. As a result, RMDs can seriously erode account value. 3) Treatment of annuity payments: There is no exclusion ratio on payouts from a qualified VA, since no taxes have been paid on any of the investment principal. So 100% of the withdrawals are taxed as ordinary income. 4) Acceptance of rollovers: Proceeds from a qualified plan rollover are eligible to be rolled over directly to a qualified VA without taxation. Conversely, qualified plan rollovers cannot be placed in a non-qualified VA contract without taxes being owed.
Advisor Tips: When a variable annuity is held in a qualified account, name the owner and the annuitant as the same person. Once the owner passes away, the death benefit will pay to the primary beneficiary. When a living benefit is held inside a qualified account, an RMD may erode the account value quicker unless the rider is “RMD friendly,” meaning an RMD above the allowable withdrawal percentage is not considered an excess withdrawal. Be aware of how an RMD affects the benefit base, especially when using a GMIB rider, most of which have no special treatment of RMD withdrawals. Look for “RMD friendly” living benefits.
The examples presented herein are for informational purposes only. They are not representative of any specific annuity and do not constitute investment advice. Annuities are suitable for long-term investing, particularly retirement savings. Withdrawal of earnings will be subject to ordinary income tax and, if taken prior to age 59½, may be subject to a 10% federal tax penalty. Investing in a variable annuity within a tax-deferred account will provide no additional tax savings and, therefore, should be considered only for other benefits that may be provided by the annuity or associated riders. Additional fees apply for living-benefit options. Investment restrictions may also apply for all living-benefit options. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract. It is also recommended that you consult with a financial advisor and tax advisor before purchasing an annuity.
The Risk of Over-Allocated Funds
Exposure to concentrated investments may increase the overall risk of a portfolio. As a rule of thumb, if a fund holds more than 30% of assets in one sector, you may be putting all those eggs in one basket. Take, for example, the dot-com bubble. Investors who loaded up on rapidly growing Internet investments probably lost a considerable amount of money when the bubble burst.
It is also important to consider the extent a fund is vested in its top investments. For example, if 25% of its assets are in the top three holdings, or a fund consists of 40 or fewer holdings, the fund could be a higher risk. Funds with investments concentrated in one country can be a risky proposition as well. A fund manager not only must pick good investments but also runs the risk of a souring economy. Country-specific risks become even more prominent when a fund involves investments in emerging markets. These economies are generally subject to a variety of risks that can drive holdings southbound.
Concentrated investing is not for the casual or risk-averse. You can be exposed to substantially greater losses than those in the overall market, so be sure to evaluate a fund’s holdings to determine the level of risk inherent when investing.
Keep in mind that diversification does not eliminate the risk of experiencing investment losses. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, and differences in accounting and financial standards. Keep in mind that concentrated investments are narrowly focused investments that typically exhibit higher volatility than the market in general. These investments will fluctuate with current market conditions and may be worth more or less than the original cost upon liquidation.

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