Front Street Wealth Management

Fee Only, Proactive Wealth Managment

How a Variable Annuity Actually Works

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Variable annuities aren’t simple and they aren’t cheap. I was once again reminded of this after analyzing a couple of policies in recent weeks.

Before I get too deep into variable annuities, I cannot stress enough how much a true financial plan helps to minimize the motivation to purchase a financial product, especially products designed to feed off a sense of insecurity. A deep concern of outliving one’s assets is often the key driver of most annuity purchases. No financial professional should ever dismiss this fear, out of hand. An objective adviser should instead work to understand and address the fear.

So how exactly do variable annuities work? At its simplest level, your money is invested in a basket of mutual funds. Your money then moves in lock-step with the financial markets. That certainly explains the “variable” part!

Now, without yet considering the added bells and whistles that often ride on top of variable annuities, this simple part of your policy represents your “true” account value. The cost of these mutual funds runs about 1% per year.

However, in addition to these mutual fund costs, the insurance company also imposes some other nebulous-sounding charges and fees. One is called the “mortality & expense” charge. Another is the proverbial “administrative” charge. These charges and fees typically add up to another 1.4% per year.

The high cost of about 2.5% per year in fees naturally hobbles the growth potential of your simple mutual fund portfolio. With a balanced portfolio of mutual funds, and barring a rip-roaring and sustained bull market, your variable annuity might be destined to make about 2% per year. You might fairly ask if this doesn’t just sound like a very expensive mutual fund program. I’d agree.

To combat this reality, insurance companies dangle enticing add-ons, called living benefit riders, that work to address the dual pain points of investment volatility and the fear of running out of money in your retirement.

When you add a living benefit rider to the picture, your policy actually has a second “shadow” account value that is wholly-unrelated to your “true” account value. It is typical for your shadow account value to offer a guaranteed annual return of around 6%, promised for about a decade. After that, the shadow account stops growing and can only be accessed if you agree to receive a lifetime of monthly payments. These riders cost yet another 1% per year.

Again, without the help of an extended bull market, it should be clear that the “true” account value – after all those fees are applied – simply cannot compete with the “shadow” account.

So what do you get when you make the rational choice of accepting the lifetime of monthly payments? For the next 12 to 15 years, the insurance company sends you back your own money plus the little bit of growth you got to keep. Only after you’ve been made whole does the insurance company finally start to send you their money.

As you can tell, my quick answer to the variable annuity question is “Just Say No!” As you can no doubt imagine, figuring out what to do, if anything, after you’ve already purchased a variable annuity is more complicated!

Jason P. Tank, CFA is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com

Two Tax Tricks to Remember

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Not long ago, I highlighted two tricks to help lower your tax bill. Since we’ve entered a whole new tax year, I’ll take the risk of sounding like a broken record. It’s worth it to me, if it saves you some money.

Prior to the new tax law, about 30% of all tax filers itemized their deductible expenses. Today, fewer than 10% will itemize. The culprit? The new standard deduction essentially doubled. Your taxes got much, much simpler.

For single filers, the new, bigger standard deduction is about $12,000. For married filers, it jumped all the way up to about $24,000. Think of these as a hurdle.

If the combined total of your property taxes, your state income taxes, your out-of-pocket medical expenses, your mortgage interest, and your charitable donations doesn’t exceed the new, bigger standard deduction, you can now skip the tedious record-keeping.

But, remember, If you are no longer itemizing, your charitable donations won’t be tax deductible either. That is, unless you use one of these two tricks to preserve your deduction!

The first trick only works if you are over age 70 ½ and have an IRA. If you aren’t yet lucky enough to be over age 70 ½, the second trick is made for you.

If you are older than 70.5, you can donate to a charity directly from your IRA. These are known as “qualified charitable distributions” and they work to satisfy, in part or in whole, your annual required minimum distribution (RMD) from your IRA. Even better, the money you give directly to charity from your IRA won’t count as taxable income. Since you are giving away money that’s never been taxed, it’s just like getting a tax deduction.

The mechanics are extremely easy. Many brokerage firms will simply issue you a checkbook for your IRA. All you have to do is keep a record of the donations you make from that dedicated checkbook. Just be sure to report your gifts to your tax preparer or else you’ll end up paying tax on those charitable distributions anyway!

If you are under 70.5, you get to use a different trick to claw back your tax break for your charitable giving. In order to deliberately push up your itemized deductions above the new, bigger standard deduction, consider “bunching up” years worth of your charitable donations into a single year.

A great way to bunch up your donations without having to give it all away in one fell swoop is to open up a donor-advised fund. Just like that IRA checkbook for those over 70 ½, your donor-advised fund creates a dedicated pot of money for your future donations.

As I write this, I suspect that too many people are dutifully tallying up all their charitable donations made last year only to find that none are actually tax deductible. Well, as the old saying goes, “Only two things in life are certain; death and taxes.” If you didn’t use either of these tricks last year, there’s always this year.

The Market’s Bounce and Your Cash Holdings

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Q: It’s been quite a rebound since Christmas Eve, so what’s going on with the stock market, lately?

A: You are very right. The market’s bounce back over the last six weeks has been both sudden and strong. It hasn’t quite clawed back all of the big decline that began last September. But, generally-speaking, it’s more than halfway there.

I’d chalk up the rebound to four factors. First, when the mood gets as dark as it was, you can usually expect a bounce back. It’s pretty typical when markets get so “oversold.” Second, the fear of a looming recession has somewhat faded. Recent economic data have been better than expected, including yet another strong jobs report in January. Third, the potentially damaging trade war with Trump and China appears to have cooled off. Continued spasms should be expected until that issue is resolved, however. Finally, the Fed blinked as Wall Street’s loud whining got their attention.

Of course, none of these factors are irreversible and the concerns of the recent past were not entirely invalid. Given this, my suggestion is to take this rebound as an opportunity to now evaluate your overall portfolio risk. After this big rebound, it feels like a second chance.

Q: With the Federal Reserve having raised rates over the last couple years, what return should I expect on my cash?

A: Cash is no longer trash. But, you need to be vigilant to get the return you deserve. Banks and brokerage firms are perfectly happy paying you far too little. It’s not evil; it’s just economics.

For example, the default money market funds at most brokerage firms pay about 0.25% to 0.5% today. You can easily get more than 2% on your cash, even if it comes with some very minor inconveniences. This difference can add up.

My suggestion is to first review your cash holdings as a percent of your portfolio. If your portfolio has much more than 5% sitting in cash, talk to your adviser about shifting it into a “position-traded” money market fund rather than the default, “sweep” money market fund. Yes, when you need access to your cash, you’ll need to sell (for free) your money market fund, like you do with a normal mutual fund. But, it takes just one day of planning ahead in exchange for getting an extra 2% return on your cash. It’s an easy move!

Join us for our next Money Series presentation this upcoming Wednesday at 6:30pm in the McGuire Room of the Traverse Area District Library. This month’s talk is based on a thought-provoking academic study on the power of working longer to boost your retirement planning. To register, please visit MoneySeries.org or simply call (231) 668-6894. Front Street Foundation, through its commercial-free Money Series programs, is a non-profit committed to providing open-access to financial education, for all.

Year-End Letter to Investors

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Financial markets were not friendly in 2018. Over the last few months, the markets were actually just plain mean.

For my clients, I’ve been sticking to a more conservative approach that helped to somewhat lessen the blow. That basically means I chose to invest less-heavily in stocks than I could have been. However, in all honesty, I didn’t position things conservatively enough. Hindsight always appears crystal clear!

I’ve been asked lately if we’re heading into a recession. Here’s why I feel it’s too early to tell.

There are two major types of recession indicators. The first is made up of “betting” indicators. They are a reflection of the shoot-first, question-later collective guesses made by the markets. The second type is comprised of “fundamental” indicators. These include both business and consumer surveys as well as economic releases.

The market-based indicators are often way out in front of the economy’s fundamentals; zigging and zagging and garnering alarming media headlines. Today, the financial markets are currently flashing red.

The stock market recently crossed over the official line that marks a bear market. And, both the yield curve and bond prices for lower-quality companies foreshadow a weakening economy. On the whole, these signs raise concern.

However, financial markets aren’t all-knowing. They often get it wrong. Since 1950, there have been 13 bear markets and nearly half of the time no recession followed. Markets can’t see the future, because (most) people can’t see the future!

The fundamental indicators currently offer a less-concerning picture. Most economist see slower economic and company earnings growth ahead. But, still, positive growth is expected this year. The Fed now appears ready to calm markets by slowing or even pausing its rate hiking plans. And, for different reasons, it’s conceivable that both Trump and China might blink on the trade spat. Overall, the best way to describe the fundamental indicators is they appear to be taking on an unattractive yellow-green tint.

The current split in the indicators forces me to avoid looking to the market to either validate or refute my current game plan.

At the highest level, I rest on the knowledge that my clients’ overall asset allocation is diversified, balanced and appropriate for them. Next, I’m focused on making sure the investments I’ve chosen are both sound and safe. Soundness places a premium on quality investments backed by financial strength. Safety emphasizes value, as measured by price relative to things like earnings or cash flow.

Beyond asset allocation, soundness and safety, the game plan has to remain flexible. To be sure, if the fundamental indicators begin to better align with the market’s signals, taking proactive steps to lower risk is in the cards.

As famed value investor, Ben Graham used to remind his students, including a young Warren Buffett, “Mr. Market” is a fickle man who is prone to bounce between elation and despair. In the face of his emotional roller-coaster, the wisest thing is to be prudent, stay rational, weigh the evidence and think independently. That’s just what I was hired to do!

Your New Year Advisor Checklist

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The turn of a new calendar year holds special appeal. It’s a natural time to reflect. It’s also a moment to set a new course for your personal finances.

For some, seeking the help of a financial pro feels unnecessary. I know people who run circles around some financial advisors! But, most people aren’t comfortable going it alone and do want support.

As I get ready to celebrate my twentieth year in the industry, I’d like to offer up some guidance to help ensure you find a good fit with a financial advisor.

Find a good communicator. Like a good marriage or friendship, communication is number one.

Perhaps using overly-technical terms makes some advisors feel smart or we simply become a bit tone-deaf over the years. The fact is, industry-centric terms hold little meaning for regular people. Help us by asking us to use plain English!

Beyond actually understanding the advice you’re paying for, you should expect to always be kept informed along the way about your money.

Find a seasoned advisor. Like money, knowledge is accumulated over time.

Essentially, a financial advisor’s experience comes from two sources; education and years on the job. The first centers on credentials. And, on behalf of my entire industry, I deeply apologize for the alphabet of letters behind everyone’s names! Even I’ve lost track. To focus you, first look for the letters CFP (financial planning) or CFA (investment management.)

However, a professional designation doesn’t mean much if it’s not backed by years of relevant experience. I used to joke that investment advisors who cut their teeth during the long bull market in the ‘80s and ‘90s accumulated just a few good years of experience – over and over, again. Some stretches are like the movie, Groundhog’s Day. My suggestion is to seek someone who has operated through some market cycles and some volatility.

Find a financially- and ethically-aligned advisor. As the saying goes, form follows function.

Over the years, there’s been a clear movement away from advisors who sell financial products for a commission and toward advisors who provide investment management and planning on a recurring or one-time fee-basis. I feel strongly that a strictly fee-only arrangement ensures advisors will uphold their legal fiduciary duty to place your interests ahead of their own. But, these principles haven’t completely sunk in as evidenced by annuity sales people still offering free dinners just to hear their pitch!

Over the years, I’ve come to recognize that choosing a professional advisor is a daunting task. If the last few months of market turmoil is any indication, ensuring a good fit with your chosen financial advisor may become increasingly important.

Jason P. Tank, CFA is both the owner of Front Street Wealth Management, a purely fee-only advisory firm, and the founder of the Money Series, a program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com