To make a case for annuities, advisors often compare the most expensive, tax-inefficient mutual funds to the most inexpensive variable annuities.  However, an objective analysis, will find that annuities appear to be poor choices in most (but not all) cases.

To fairly compare the two (and remove compensation considerations), I used a 0.30% marginal cost gleaned from the cost of a Vanguard “no load” annuity.  The 30 basis points are in addition to the underlying cost of the funds – vastly lower than the additional costs of most annuities that are sold.

Annuities made a lot more sense when the ordinary income and capital gains rates were the same.  Now, annuities have to overcome both higher rates (ordinary income vs. capital gains) and higher expenses.  Given a long enough time horizon, the 100% tax-deferral theoretically may overcome these disadvantages.  Seeing if that is true is the point of this exercise.

Six factors impact the decision:

1. Rate of return – higher returns favor annuities; lower returns favor taxable accounts.
2. Ordinary income tax bracket – lower ordinary income tax brackets favor annuities; higher ones favor taxable accounts.
3. Capital gains tax bracket – higher capital gains rates favor annuities; lower ones favor taxable accounts.
4. Tax efficiency of taxable alternative – tax-inefficient, high-turnover investments favor annuities; low-turnover approaches favor taxable accounts.
5. Time horizon – long time horizons favor annuities; short horizons favor taxable accounts.
6. Annuity cost – the lower the marginal cost of the annuity over the comparable mutual fund investment, the better it will compare (obviously).

Also note that I am not talking about immediate annuities which can have a place in a portfolio as insurance against the additional costs of a long life.

Here is one example:

1. Investment rate of return – assume 10%, the long-term stock market average.  (In reality, it would be somewhat lower due to the expense ratio of the subaccount/fund, ad due to lower expected returns currently but using this relatively high number should favor the annuity.)

2. Tax bracket – assume the most favorable case for an annuity, 25% ordinary income and 15% capital gains. (This is most favorable because the spread between the rates is lowest.)

3. Tax efficiency – assume a 50% portfolio turnover.  This is extremely inefficient and would favor the annuity.  I have assumed that all gains are long-term, however.  This implies an advisor would not be foolish enough to select funds for a taxable account that throw off short-term gains.  (In reality, I think a 10% turnover in a taxable account is more reasonable for a competent advisor.)

4. Annuity cost – as mentioned earlier, I used a 30 bps marginal cost to the annuity.  This attempts to remove compensation confusion from the analysis.  In other words, if the total expenses are 1.15% for a fund, the annuity would be 1.45%.  In this example, the net return ends up being 10.0% for the fund and 9.7% for the annuity.

In short, I have tried to use reasonable factors that would favor the annuity.  Using the numbers above, we solve (using my spreadsheet calculator here) for the time horizon necessary to make the annuity a better investment than the taxable alternative.  In this case the breakeven is 26 years.  In other words, a rational investor should not place in an annuity any funds he or she will need within the next 26 years.  If we change any one assumption, it just gets worse.  For example:

1. If the portfolio turnover is 10%, a 49-year time horizon is required to favor the annuity.
2. If the net investment is 8% instead of 10%, the breakeven becomes 34 years.
3. If the ordinary income tax bracket is 35%, the breakeven is 42 years.
4. If the ordinary income tax bracket is 15% or lower, the breakeven is never (because of a 0% capital gains tax rate).
5. If we make a conservative assumption that the market will return 8%, and our alternative is a passively managed investment with a 10% turnover (in essence combining 1 & 2 above), the breakeven is 62 years.

Some other factors:

1. In the case of death, the heirs are vastly better off with a taxable investment because of the step-up in basis.  The odds of dying in the early years (when the investor would be likely to have losses) are trivial vs. the odds of dying in much later years (when the odds are in favor of large embedded gains).  Remember, if there aren’t big gains, the taxable investment will be better; it is therefore irrational to use an annuity for “protection” for the very small chance that someone will die when it will be worse if they live.

2. Taxable accounts allow tax loss harvesting much more easily and efficiently.  Annuity losses have to exceed the 2% of AGI threshold, and the taxpayer must itemize.

3. If the investor needed the money early, he or she could be vastly worse off in three potential ways:  1) surrender charges, 2) the time period was too short to favor the annuity alternative, 3) early withdrawal penalties for pre-59½ distributions.

4. Using an annuity increases the standard deviation of returns relative to the taxable alternative.  This is contrary to what is desired.  In other words, for any given time horizon there is a rate of return where annuities and the taxable alternative are equivalent.  If the investment experience has been good (i.e. better than breakeven), then the annuity will be the superior choice.  If the investment experience has been bad (i.e. below breakeven), then the taxable alternative would have been better.  In other words, when purchasing an annuity, very good returns get better, and very bad returns get worse.  This is undesirable in most cases.

5. Finally, sometimes an advisor has placed an annuity inside of an account that is already tax advantaged.  The rationale is that the client is risk-averse and wants this “protection” even with the higher costs.  The expected payoff is computed by multiplying the average percentage the account is likely to be down (when it is at a loss), times the probability of being down, times the probability of dying.  This figure would be compared to the marginal cost of the annuity vs. the alternative investment in the account.  My calculations show this to be a bad bet because the probability of dying is too low – unless the annuity owner is in his or her nineties.

Let me dilate further on #1 above.  The death benefit has a computable value that will be greatest the very first year of the annuity because the investment has a positive expected return.  Even if some losses are bigger in years after the first one, the chance of them happening goes down even faster.  Using a mortality table, we can compute what a rational investor should be willing to pay for the insurance.  Still, that isn’t the whole picture because if the annuity has increased in value, the heirs lose on the tax treatment, and the odds of being up are much higher than of being down.

So, no matter what the mortality is, even if the investor dies after the first year, the annuity “protection” is a small net loss unless future investment performance will be dramatically worse than history. And, if that assumption is valid, purchasing an annuity is not optimal because high returns are required for it to make sense if the investor lives.  Note that that is the best year!  After year one, it gets dramatically worse. This means the “protection” is on average worth much less than zero because of the adverse tax treatment.

If the annuity is purchased within an already tax-advantaged account, we can ignore the second part of the analysis above and simply look at the benefit vs. how much the annuity costs (the incremental cost over an alternative mutual fund).  The downside protection is only worth the probability of being down, times the average magnitude, times the probability of death.  There are no annuities inexpensive enough to make sense in a tax-advantaged account, unless life expectancy is less than about 5 years.

Despite what our foregoing analysis, if an investor wants/needs to hold very tax-inefficient investments, and does not have sufficient “room” in tax-advantaged (e.g. retirement) accounts, and does not need the income generated, annuities can be the correct solution to put a tax-efficient “wrapper” around those inherently inefficient vehicles. (Tax inefficiency is a function of both the tax rate and the amount recognized each year.  Treasury bonds in the late 1970’s or early 1980’s for example were very inefficient holdings.)

Finally, annuity salespeople will claim that people don’t buy (i.e. they aren’t sold) the “plain vanilla” annuities I have used in my examples above.  That they are actually buying some sort of market guarantees or protection.  It is hard to debunk this because the products are changed constantly so it is like playing whack-a-mole, but I would simply point out that it is impossible for insurance companies to offer returns without the commensurate risk. They can do this with other types of insurance only because the risks are uncorrelated (all the houses don’t burn down at the same time).  In the market all the investments do tend to decline simultaneously so there is no advantage to risk pooling.

 

Tax loss harvesting is the sale of securities in a taxable account that have declined in value since their purchase in order to recognize the loss for tax purposes.  Most people (including professional financial advisors) do this at the end of the year determining whether the transaction is worthwhile by comparing the immediate tax savings to the transaction cost.  This is not optimal two different ways.

First, positions should be evaluated throughout the year for opportunities to save on taxes; there is no reason to wait until the end of the year.  Because investments tend to go up more than down and there is little serial correlation in the market, taking losses when they are economically meaningful is prudent.

Second, the calculation of tax savings and costs is more complicated than it first appears.  Consider first the standard analysis:

• Assume the original investment was $10,000.
• The investment has declined in value to $9,000.
• The investor is in the 15% tax bracket (i.e. this will offset other long-term capital gains).
• An equally attractive alternative investment that is not a wash sale violation is available.
• The transaction costs are $20 for each trade ($40 total – one sell and one buy).  Transaction costs should include not only the explicit commissions but also bid/ask spread costs and market impact costs.

This appears to be the proverbial “no brainer” – spend $40 to save $150 (a $1,000 loss times 15% tax savings).

In fact, given the information above, whether this is a prudent strategy or not is undeterminable.  Three key pieces of information are missing:

• How long does the investor expect to keep the “old” investment in their portfolio if they don’t harvest the loss?
• What will the tax bracket be at that time for that transaction?
• What is the hurdle rate for the return on this strategy?

Let’s assume if the investor doesn’t sell to take the loss it would be sold in 5 years anyway for some reason (perhaps we estimate this by simply knowing the investor has a 20% portfolio turnover rate).  Further, assume the tax bracket at that time will continue to be 15%.  The future transaction costs aren’t relevant since it will be sold at that point anyway – it doesn’t matter which investment it actually is.

At this point, it is simply a time value of money problem.  With tax loss harvesting, the investor saves $150 in taxes now less the $40 for transaction costs for a net of $110.  However, in 5 years the cost basis is $1,000 lower than it would have been had the old investment been kept.  Thus, the tax bill at that time is $150 higher than it would have been.  Essentially the $110 now cost $150 in five years.

Since the rate of return that will grow $110 to $150 in 5 years is 6.40%, this selling is only advisable if the current tax savings can be invested to earn more than 6.40%.  Alternatively, it can be viewed as an opportunity to borrow at 6.40% for 5 years.  That might or might not be attractive depending on the situation.

To recap, tax loss harvesting is more attractive to the extent:

• The loss to be harvested is large.
• The transaction costs are low.
• The alternative investment is attractive.
• Future tax rates will be low.
• The investment will probably be held for a long time.

Conversely, tax loss harvesting is unattractive if:

• The loss to be harvested is small.
• The transaction costs are high.
• The alternative investment is unappealing (such as keeping cash for 30 days to avoid the wash sale rules and then repurchasing the original investment).
• Future tax rates will be high.
• The investment will be sold shortly anyway for unrelated reasons.

Tax gain harvesting is potentially advantageous when a taxpayer finds themselves facing a lower rate in a particular year than they are likely to face in the near future.  The optimal strategy is frequently to harvest those gains and pay the taxes early, but at the lower rate.  For investments that will be held for the long term, but not too long, it may be optimal to sell and lock in the gain at the lower rate and then immediately repurchase the investment.  This would mean that only future gains will be taxed at the higher rate.

To prevent taxpayers from selling investments at a loss to get the tax deduction and then immediately repurchasing the investment (or doing something roughly equivalent economically) there are what are known as “wash sale rules” that disallow taking the deduction until the investment is “really” sold.  These rules do not apply to recognizing capital gains.

Many investors may have large carryforward losses.  The current tax code only allows the recognition of $3,000 per year of capital losses against ordinary income.  The remainder is carried forward to future years where it may be used against subsequent recognized gains.  For taxpayers in this situation, recognizing gains early will not be advantageous as they are not actually being taxed at the long-term gain rate, but rather simply using up some of the accumulated losses.

Assume a stock was bought for $50,000 and is now worth $150,000 and would incur taxes of $15,000 (a 15% rate) if sold this year and that the same sale in the future would incur taxes of $20,000 (a 20% rate).  If it is anticipated that the investment would be sold in ten years but instead is sold now and repurchased, the investor pays $15,000 today to avoid taxes of $20,000 in ten years.  That is a rate of return of just 2.92% (annualized).  It would probably be better to invest the $15,000 instead of paying taxes and earn enough to pay the $20,000 later with money left over.  (This simplistic analysis ignores transaction costs from the “extra” trades and taxes on the alternative investment, so the return is slightly overstated.)  Conversely, if it is anticipated that the investment would be sold in two years rather than ten, the rate of return is 15.47% (annualized).  That is compelling.  To recap, capital gain harvesting is more attractive to the extent:

• There are substantial embedded capital gains on investments in a taxable account
• The investor does not have offsetting recognized losses or loss carryforwards
• The investment will be sold anyway in a relatively short period of time.

Here are a few common investment mistakes (in no particular order):

Selecting investments without an overall plan. Many people have accumulated a hodge-podge of funds and individual securities without considering how they fit together.  They have a collection rather than a portfolio.  The individual investment selection (within the same asset class) is one of the least important parts of the process.  This is confusing because it looks very important.  It is true that selecting superior investments would make a huge difference to your results, but research shows that to be nearly impossible.  Because the market is a fantastic clearinghouse of information, securities are generally priced “correctly” leaving no opportunities to profit from superior investment selection.  In other words, markets work.  The following factors, even though they may seem extraneous, are just a few of those that should be considered in structuring a portfolio:

• Projected cash flows (when money will flow into or out of the portfolio)
• Capital markets assumptions (the expected return, risk, and correlations of the investments available in the market)
• Tax possibilities and probabilities
• Human capital (the value of future labor income, and the level of certainty)
• Debt (ceteris paribus more debt should be balanced by a more conservative portfolio)
• Pensions, including Social Security (the funding/risk level, the survivor benefits, whether there are COLAs, etc.)
• Inflation possibilities and probabilities

Not being properly diversified. In general, you are rewarded for taking risk with higher returns.  However, this does not apply to diversifiable risk.  In other words, stocks are riskier than cash, and one stock is more risky than owning a portfolio of many stocks.  However, you get rewarded (with higher expected return) for owning stocks over cash but not for only owning one stock.  Why?  Because you can easily mitigate that risk by owning many stocks.  The worst form of this mistake is also the most typical.  People frequently accumulate large amounts of their employer’s stock.  This is a very risky strategy, not only from an investment portfolio perspective, but also because in the event of a problem in their company or industry, they could find themselves both without a job and with a diminished investment portfolio simultaneously.  It is almost impossible to have a properly diversified portfolio (technically defined as eliminating non-systematic risk) using individual securities.  Mutual funds or exchange-traded funds are the appropriate vehicle for building a diversified portfolio for the typical investor.

Not staying with the plan. Consider a simple situation where you have determined having 60% of your investments in stocks and 40% in bonds is optimal.  Suppose the stock market then goes up dramatically so the allocation is no longer 60/40.  What should you do?  Many people, happy to see their stocks soaring, plow more into those investments (remember the late 90’s in stocks? 2006 in real estate?).  Conversely, suppose that stocks plummet (as in 2008).  Many people want to move money from stocks to something safer.  Both of these reactions are wrong, but not for the reason most people think.

Academic research has shown there is little serial correlation in the capital markets in the short run (either positive or negative).  In non-technical language, that means what has happened has little or no short-term predictive power over what will happen (again despite what you hear in the media).  The fact that stocks go down does not indicate they will continue down or that they “must” come back.  If stocks (or any other asset classes) go up, that does not mean they will come down.

The reason to rebalance the portfolio (keeping transaction costs and taxes in mind) is that the 60/40 allocation has the risk/return profile with the highest probability of meeting your long-term financial goals.  The losses incurred from missed opportunities or increased risks from trying to outsmart the market can be significant.

Ignoring costs. Many people focus on obvious costs like commissions and fees (which average about one percent of your investments annually for professional help), but completely ignore hidden costs.  For example, most people (and advisors) overtrade because they feel a high need to “do something” even if it is wrong.  The advisor frequently does this not out of malice but due to overconfidence in trading ability or to justify his or her existence.  It is difficult to charge fees for inactivity; however, inactivity is generally called for.  Making a change is not free.  Transaction costs, ranging from the bid/ask spread to commissions to market impact costs, must be overcome before making a profit on each trade.  Insurance products (for investing), separately managed accounts, hedge funds, etc. are all products that tend to have excessive costs.

Another cost is taxes.  Reducing turnover, actively harvesting tax losses from a taxable account, and paying attention to asset location (locating tax-inefficient holdings in tax-sheltered accounts and tax-efficient holdings in taxable accounts) may add from one-half up to one percent to the annual return.  Obviously, individual situations can vary a great deal.  Many advisors and investors do not harvest tax losses effectively because they believe in negative serial correlation (because it went down it must “come back” – see number three above) and because it is difficult emotionally to admit being wrong (though investing shouldn’t be about emotion), and selling something that has declined seems like admitting error.

An opposite error is occasionally made by focusing excessively on taxes.  The objective is to maximize after-tax return not to reduce taxes.  An example of this mistake would be holding municipal bonds when your tax bracket is too low for that to make sense.  Generally, the best way to reduce costs is to use index funds or exchange-traded funds and a “tax aware” advisor.

Ignoring conflicts of interest. The financial media, while not wishing you ill, have a primary goal of attracting an audience.  “10 Stocks to Buy Now!!!” does just that.  A discussion of buying and holding boring index funds and treasury bonds does not.  Stockbrokers charging commissions have an incentive to overtrade.  Investment advisors charging fees (e.g. us) have incentives to keep you leveraged to increase assets under management (i.e. don’t pay off the mortgage).

Also, many advisors get higher pay (directly or indirectly) for selling “in-house” products, though they generally have poor relative performance and higher costs.  Some firms have fee schedules that give the advisor huge incentives to tilt an asset allocation toward more risk.  (One of the largest firms, at least the last time I saw the fee schedule, was paying its advisors as much as 60% more for using stocks over bonds).  I believe most advisors do have good intentions, but often compensation issues can cloud judgment.

There are obviously many other mistakes people can make in their investments, but in my view, these are the main ones.

I thought I would quantify the returns for delaying Social Security retirement benefits.  A retiree with a FRA (Full Retirement Age) of 66 could claim 75% of their benefit at age 62.  Using mortality tables (RP-2014) we can compute the return for waiting:

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
3.8%	4.4%	3.4%	4.2%	4.3%	4.7%	3.3%	4.3%	4.4%	4.7%

Important notes:

1. Because SS benefits are adjusted for inflation, these are real rates of return on government-guaranteed, creditor-protected, payments.  Thus these returns should be compared with real returns on government bonds (TIPs) which currently range from -0.23% on a 5-year to 0.90% for a 30-year.
2. For married couples the return is even greater for the higher benefit spouse to delay, regardless of the relative ages.  (Because there is some chance, however tiny, that the lower benefit spouse will live longer, a married couple will always have a higher expected return from the higher benefit spouse delaying than that same individual would if they were single.)  If the lower benefit spouse is female and significantly younger, the expected returns from delay can be very significant.
3. Most folks reading this (and their clients) will tend to be the white collar or top quartile folks.
4. Taxes should be considered in the decision as well.  A higher SS benefit might cause higher SS taxation later, but it also provides an excellent opportunity for partial Roth conversions, etc. in the years before the benefits are begun. On balance I would expect waiting will be even more advantageous for the typical client when these other opportunities for exploiting the low income years are included in the analysis.
5. The main financial planning risk for most people is outliving their resources (a combination of a long life and low investment returns) so increasing a government-guaranteed life-long income stream is more valuable than the rates of return indicate because it is most helpful in the worst situations.

Here are the figures for continuing to delay from 66 to 70 (an increase from a full benefit to 132% of it):

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
2.2%	3.0%	1.7%	2.8%	2.8%	3.4%	1.6%	2.8%	3.0%	3.4%

Again we see that the worst case scenario for delaying is still significantly higher than an equivalent investment.

Here are the full returns for waiting from 62 all the way to 70 (from 75% of the full benefit to 132% of it):

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
3.0%	3.7%	2.6%	3.5%	3.6%	4.0%	2.5%	3.5%	3.7%	4.0%

For those born after 1959 FRA is 67 rather than 66. Here is the return for that cohort for waiting from 62 to 70 (from 70% of the full benefit to 124% of it):

Total Dataset		Blue Collar		White Collar		Bottom Quartile		Top Quartile
M	F	M	F	M	F	M	F	M	F
3.5%	4.2%	3.1%	4.0%	4.1%	4.5%	3.0%	4.1%	4.2%	4.5%

 

There are a number of things that need to be addressed in financial planning, including, but not limited to:

• Insurance & risk management
• Employee benefits
• Estate planning
• Retirement planning
• Portfolio allocation

Those items generally can be taken care of and forgotten about until you experience a life change of some sort (retirement or job change, marriage or divorce, new child, etc.) but there are a few maintenance items that are also important, but perhaps overlooked.  It is a best practice to do these things annually.  To remember, many people tie it to either their birthday, the new year, or when they file their taxes.

Credit Reports

We encourage our clients to request a copy of their credit reports for two reasons.  First, many people find inaccuracies on their reports.  While most of these are minor, occasionally there might be something significant enough to impair your credit.  The ideal time to discover this is not when you are trying to secure a new home or job.  Second, it will give you early warning of identity theft or fraud.  While many people are concerned with computer hackers stealing their identity, the more mundane methods are still the most prevalent.  A salesclerk stealing a credit card number or a relative stealing a check and forging the signature may not make headlines, but they are still classified as “identity theft.”  Periodically checking your credit report will ensure that you quickly become aware of irregularities in your accounts.

There are a few ways to monitor and protect your credit.  First, a number of services have sprung up that will notify you immediately if something looks suspicious.  While these may give some peace of mind, they probably are not worth the fees for most people since you can get copies of your credit report for free and monitor it yourself.  Similarly, you have no doubt seen many offers for credit protection insurance.  Many people don’t realize that consumers are only liable for the first $50 of fraudulent charges on their credit (not debit) cards (more details here).  Thus, if you are being charged five dollars per month for the insurance, there would have to be fraudulent charges more often than every ten months for this to make sense.

As an aside, many experts also recommend not putting outgoing mail (such as bills) containing checks in your mailbox.  Criminals do sometimes steal the checks and “wash” (using chemicals) the writing (except the signature) off of the check giving them a signed blank check.  It is recommended that outgoing mail with checks be placed in a mailbox that is only accessible with a key.

The easiest way to request your credit report is to go to annualcreditreport.com and follow the steps.  Be aware that you will have to get the report from each of the three services separately.  Also, to verify your identity, each of the services may ask you various questions (“What was your address in 1998?”, “Into which range does your current mortgage payment with ABC Bank fall?”).  If you do not have internet access, you may also request the reports by calling toll-free 1-877-322-8228.

Because there are three main credit reporting agencies and you can request one free report annually some overachievers request one every four months from a different agency.

If you want more information about your credit score (as opposed to your credit report), see here.

Social Security Statements

If you are still working, it is recommended that you get a copy of your Social Security statement each year.  (You may have noticed that as of 2011 you no longer automatically get these in the mail each year, but they were partially reinstated in 2014 so workers get one at ages 25, 30, 35, 40, 45, 50, 55 and 60.)  By reviewing your statement you can see estimates of your disability, future retirement, and survivors benefits (it assumes your current earnings level continues, which is probably correct for most people).  More importantly, since those estimates will change little from year to year, you can verify your earnings and Social Security and Medicare taxes were reported accurately.  This will let you know if someone else is using your Social Security number to report wages, if your employer hasn’t forwarded on the payroll taxes that were withheld, or if there is some other snafu.

To create an account, go to, www.ssa.gov/myaccount. To verify your identity you will have to answer some questions (just like with requesting your credit report) that only you are likely to know the answer to.

Statement of Net Worth

Arguably the best single metric of financial prudence and progress is tracking change in net worth over time.  If housing or investment values collapse (e.g. 2008) net worth will obviously decline, but in general, an increase in net worth year-over-year is a great measure of, as Ed Koch used to ask, “How’m I doin’?”

Net worth is simply adding up the fair market value of what you own (what everything would sell for currently) and subtracting what you owe.  For example, suppose in the last year you had the following changes:

• You contributed $18,000 to your 401(k)
• The principal on your mortgage was paid down (through regular monthly payments even) by $10,000
• You sold a car you no longer needed for $20,000
• Your portfolio declined by $15,000
• Your house appreciated by $10,000

Then your change in net worth is $23,000 for the year ($18,000 + $10,000 – $15,000 + $10,000 = $23,000).  The third item, the car, is irrelevant as one asset (the car) was merely swapped for another (cash) and didn’t change your net worth this year.  The sale of the car may improve it in subsequent years if the $20,000 is placed in something that increases in value rather than a depreciating vehicle.

Rather than the way I did it thought, you should actually make a list of all assets and liabilities and the dollar values each year and compare them to the previous years.

Conclusion

Each year I encourage you to practice good financial hygiene by checking your credit report, obtaining your Social Security Statement, and computing your net worth and comparing it to last year.