InvestSense Challenge

  

The InvestSense Challenge

James W. Watkins, III, J.D., CFP®, AWMA®

CEO/Managing Member
InvestSense, LLC

Investors often suffer unnecessary investment losses due to lack of accurate information and/or misperceptions about investment markets, investment products and investment professionals. The InvestSense Challenge was created to increase investor awareness of some of the leading reasons that investors suffer such losses and to suggest steps that investors can use to protect against such losses.

1. True or false?

Stockbrokers, investment advisers and other financial consultants are required to always put their customers’ interests ahead of their own and to disclose fully and completely any actual or potential conflicts of interest.

2. Which of the following statements is true about variable annuities?

A. If you annuitize a variable annuity in order to receive a lifetime stream of income, you must give up control of the money in the annuity and, upon your death, the insurance company that issued the variable annuity, not your heirs, receives the balance in the annuity.

B. Variable annuity issuers often base their annual fee for the guaranteed death benefit on the accumulated value of the variable annuity, even though the guaranteed death benefit in most variable annuities only obligates the issuer to repay the annuity owner’s designated beneficiaries an amount equal to the owner’s actual capital contributions.

A. Only Statement A
B. Only Statement B
C. Both Statements A & B

3. The projected return/risk profile of your actual investment portfolio is

A. annual return less than 12%, annual standard deviation greater than 12%.
B. annual return greater than 12%, annual standard deviation less than 12%.
C. annual return and annual standard deviation both greater than 12%.
D. not known.

4. From December 1,1988 to November 30, 2008, the annual compounded “real” return of the stock market, as measured by the S&P 500 Index, was

A. 3.13%
B. 6.11%
C. 14.27%

5. True or false?

Asset allocation explains 93.6% of the investment returns of an investment portfolio.

6. A ‘break-even” analysis allows an investor to compare the effect of fees and taxes on available investments. Assume that we have two investments, each with an annual return of 10%, one being a mutual fund (annual expense ratio of 0.20%) and the other being a variable annuity (annual expense ratio of 2.4%). The break-even point for the annuity, the point at which the annuity provides a greater after-tax, after-fees return than the mutual fund, would be approximately

A. 12 years
B. 25 years
C. 34 years
D. 50 years

Answers 

1. True or false?

Stockbrokers, investment advisers and other financial consultants are required to always put their customers’ interests ahead of their own and to disclose fully and completely any actual or potential conflicts of interest.

Investment advisors, including financial planners, are, by law, fiduciaries. As fiduciaries, they are held to the highest standards in connection with their dealings with the public. Fiduciaries are required to always put their clients’ interests first and to disclose any actual or potential conflicts of interest.

Stockbrokers, on the other hand, are generally not considered to be fiduciaries. Consequently, they are not required to put their clients’ interests first or to disclose all information regarding actual or potential conflicts of interest. While fiduciaries are required to only recommend investments that are in a client’s best interests, stockbrokers are only required to recommend investments that are “suitable.”

Fortunately, anyone providing financial advice to the public may soon be required to put the client’s interests first as a result of the recent Dodd-Frank law.  Congress and the SEC still have to finalize the new fiduciary standard, so hopefully common sense and the need to protect the public will result in one uniform fiduciary standard.

For more information on these and other related issues, please see “Everyone Is Not Losing Money – Investment Myths and the Unnecessary Investment Losses They Create” on our web site.

                                                                                                                                                                        2. Which of the following statements is true about variable annuities?

A. If an annuity owner annuitizes a variable annuity in order to receive a lifetime stream of income, the owner must give up control of the money in the annuity and, upon the owner’s death, the insurance company that issued the variable annuity, not the owner’s heirs, receives the balance in the annuity.

B. Variable annuity issuers often base their annual fee for the guaranteed death benefit on the accumulated value of the variable annuity, even though the guaranteed death benefit in most variable annuities only obligates the issuer to repay the annuity owner’s designated beneficiaries an amount equal to the owner’s actual capital contributions.A. Only Statement A
B. Only Statement B
C. Both Statements A & B

Assuming that an annuity owner annuitizes the variable annuity and the “single life” option is chosen, upon the owner’s death, the life insurance company that issued the variable annuity, not the owner’s designated beneficiaries, will receive the balance remaining in your annuity. If the “joint survivor” option or the “last to die option” is chosen, the insurance company will receive the balance remaining in the annuity, if any, upon the second person’s death. This inability to pass one’s life savings on to their heirs is one of the primary reasons that many financial advisors caution their clients not to purchase variable annuities.

Variable annuity salesmen also tout the guaranteed death benefit (“GDB”) offered by variable annuities. In most cases, the GDB only guarantees that if the annuity owner dies without annuitizing the annuity and the value of the annuity is less than the owner’s actual capital contributions, the insurance company will pay the variable annuity owner’s designated beneficiaries an amount equal to such capital contributions.

While the actual value of a GDB is questionable for long term investors given the historical performance of the markets, the cost of a GDB is even more questionable given the fact that most insurance companies calculate the cost for the GDB on the accumulated value of the variable annuity rather than on the amount they are legally obligated to pay under the GDB, which is often significantly less the variable annuity’s accumulated value.

For example, if you invest $100,000 in a variable annuity, and the value of the annuity grows to $250,000, the insurance company that issued the annuity may charge you an annual fee for the GDB based on $250,000, even though they are only liable for paying $100,000. When you consider that the fee for the GDB is usually a variable annuity’s largest annual fee, often in the range of 1.5% to 2% of the value of the variable annuity, and multiply that over a number of years, you can understand how abusive this can become.

Variable annuities may make sense for a limited few. However, for many investors, the high fees and expenses, the tax issues, and the potential loss of substantial assets to leave to one’s heirs make a variable annuity an unsuitable investment.

For more information about the various issues regarding variable annuities, please read the article, “Variable Annuities: Both Sides of the Story,” on our web site.

                                                                                                                                                                                 3. The projected return/risk profile of your actual investment portfolio is

A. annual return less than 12%, annual standard deviation greater than 12%.
B. annual return greater than 12%, annual standard deviation less than 12%.
C. annual return and annual standard deviation both greater than 12%.
D. not known.

For most investors the correct answer is “D,” even for those investors who have actually had an asset allocation/portfolio optimization plan prepared.

Financial advisors often prepare asset allocation/portfolio optimization plans for investors. These plans often include recommendations to help the investor “optimize” their investment portfolios to earn greater returns with less risk. Charges for these plans can be substantial, in some cases thousands of dollars.

Unfortunately, the value of such plans is questionable at best. Some of the most common criticisms of such plans are that

• the plans are usually based on the historical performances of various asset classes, even though “past performance does not guarantee future returns;”
• some asset allocation plans are based on “guesstimates” of future performance of the investment markets and the economy;
• the plans and their recommendations are based on broad, generic asset categories rather than an investor’s actual investments;
• the process and the software used to generate such plans are inherently unstable and can be easily manipulated to produce desired results.

The questions surrounding some current asset allocation practices have led Dr. William F. Sharpe, a Nobel laureate for his work in the area of portfolio management, to refer to the current situation as “financial planning in fantasyland.”1 The truth is that in too many cases asset allocation plans are simply a marketing tool to facilitate product sales for financial service companies and financial advisors, with little or no regard for the genuine value provided by such plans. For these reasons, some critics have referred to such asset allocation plans as nothing more than expensive origami and paper airplane kits.

If you have already had an asset allocation/portfolio optimization plan prepared, go back to the financial advisor who prepared the plan and ask them if they ran a similar plan based upon the investments that they recommended or actually sold to you. If they say they did prepare such a plan, ask for a copy of the plan and the return, risk and correlation assumptions that were used to prepare the plan.

1. W. Sharpe, “Financial Planning in Fantasyland,” available on the Internet at www.stanford.edu/ ~wfsharpe/art/ fantasy/ fantasy.htm.

                                                                                                                                                                                  4. From December 1, 1988 to November 30, 2008, the annual compounded “real” return of the stock market, as measured by the S&P 500 Index, was

A. 3.13%
B. 6.11%
C. 14.27%

Often referred to as “Wall Street’s dirty little secret,” real returns arguably provide a more accurate picture of investment returns by factoring in the effect of inflation. During the twenty year period from December 1,1988 to November 30, 2008, the annual compounded “real” return of the Standard and Poor’s 500 Index was approximately 3.13%. The nominal, or non-inflation adjusted, annual compounded return during the same twenty year period was approximately 6.11%, due primarily to the losses incurred during the 2000-2002 and 2007-2008 bear markets. Without said losses, the annual compounded nominal return during the same period would have been approximately 14.27%, or 133% greater.

As a result of the 2000-2002 and 2007-2008 bear markets, investors have experienced significant losses over the past decade. During the ten year period from December 1, 1998 to November 30, 2008, an investor would have suffered a “real” return loss of approximately 40%. An investor would have suffered a nominal return loss of approximately 33% over the same ten year period.

While totally avoiding the losses of the referenced bear markets is improbable without totally avoiding equity investments, the significant difference in returns clearly illustrates the potential value of an effective, proactive risk management program. If, as many financial professionals believe, we are in the midst of a secular, or long-term, bear market, then risk management will be a critical factor in determining one’s investment success.

The other lessons to take away from the stock market’s historical “real” returns are the impact of inflation and the cyclical nature of the markets. Both can have a significant impact on actual returns realized. Simply put, investment success requires avoidance of significant losses. While “buy and hold” may make sense during bull markets and for some specific investments, the cyclical nature of the broader markets increases the risk of a “buy and hold” strategy for index funds and index-based exchange traded funds.

                                                                                                                                                                         5. True or false?

Asset allocation explains 93.6% of the investment returns of an investment

Many investors have heard or read this statement so many times that they simply believe that it has to be true. Truth is, the statement is a misrepresentation, either intentional or unintentional, of what was actually said.

The statement is based on a 1986 study that concluded that asset allocation “explained, on average, 93.6% of the total variation in actual plan returns.” (emphasis added). The main thing that investors need to know about the study is that it analyzed the determinants of the variation of returns, not the determinants of the total returns themselves. Variability of returns is significantly different from total returns, with no absolute correlation between the two.

The authors of the study never claim to have examined the impact of asset allocation on determining actual portfolio returns, let alone claim that asset allocation explains 93.6% of a portfolio’s actual returns. The investment industry, however, has manipulated the findings of the BHB study and combined it with yet another investment myth to promote perhaps the most devastating investment myth of all, the buy-and-hold investment myth.  The important point for investors to remember is that asset allocation is an important aspect of the wealth management process, although only one aspect of the process.

For more information on these and other related issues, please read the article, “Everyone is Not Losing Money: Investment Myths and the Unnecessary Investment Losses They Create,” on our web site.

                                                                                                                                                                                   6. A ‘break-even” analysis allows an investor to compare the effect of fees and taxes on investments options. Assuming that we have two investments, each with an annual return of 10%, one being a mutual fund (annual expense ratio of 0.20%) and the other being a variable annuity (annual expense ratio of 2.4%). The break-even point for the annuity, the point at which the annuity provides a greater after-fee and after-tax return than the mutual fund, would be approximately

A. 12 years
B. 25 years
C. 34 years
D. 50 years

In choosing between investment options, investors often fail to factor in the impact of taxes and any fees that the investments may assess. A break-even analysis lets an investor know at what point two investments would provide equivalent after-fees, after-tax returns.

In our example, the 0.20% annual expense ratio for our mutual fund is representative of the average annual expense ratio for a no-load index fund. A no-load fund was chosen since studies have consistently shown that no-load funds, with their lower fees, on average generally outperform higher fee-laden actively managed mutual funds by an average of about 2% annually. According to Morningstar, as of July 31, 2009, the average annual expense ratio for variable annuities was 2.4% (a combination of the 1.33% insurance expenses and 1.07 subaccount investment management fees). In both cases, we are assuming a tax rate of 35%.

Assuming that the mutual fund investor has to pay taxes on his gains each year, while the annuity investor only pays taxes when the annuity is surrendered, it would take the annuity owner 34 years to break even. Note that in order to fairly compare the value of the two investments, we are comparing the after-fees, after-tax value of the two investments in each year if both investments were cashed in. If the annuity investor were to purchase one of the popular “living benefit” riders offered with many variable annuities, at an average annual cost of an additional 0.50% fee, the annuity owner’s break-even point would increase to 64 years!

Even these numbers understate the impact of the variable annuity’s fees. Since it is highly unlikely that a mutual fund owner would have 100% turnover each year, the break-even gap would increase even more, especially if any of the mutual fund gains qualified for the much lower capital gains tax rate. If a mutual fund were held in a tax-deferred vehicle such as an IRA, 401(k) or 403(b), any taxes on mutual fund sales or exchanges would be deferred, just as in the variable annuity, and the variable annuity owner would never break-even!

If you have already purchased a variable annuity or are considering purchasing one, the annuity salesperson surely explained the break-even issue with you for your particular purchase or even prepared a break-even analysis for you, so you knew all about the impact of fees and taxes, right? The break-even issue is just one of the reasons for the industry saying that “annuities are sold, not purchased.”

For more information about the various issues regarding variable annuities, please read the article, “Variable Annuities: Both Sides of the Story,” on our web site.

This web site and the information herein is for informational purposes only and is not designed or intended to provide legal, investment or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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