Investing Pitfalls

While fixed lifetime annuities can be a helpful part of a portfolio (during retirement), variable annuities are usually quite the opposite. More often than not, they’re loaded with very high fees and are only purchased as a result of a slick sales presentation.

Unfortunately, once you’ve purchased a variable annuity, it can be quite costly to get your money out of it. The insurance company will often require you to pay a surrender charge. And, if the variable annuity was a deferred variable annuity, there will be tax costs as well:

• Distributions prior to age 59.5 would be subject to a 10% penalty (unless you’re disabled or you have started taking distributions in the form of a “series of substantially equal periodic payments” designed to distribute the entire balance over the course of your life expectancy), and
• The gains would be taxed as ordinary income.

Note #1: These tax costs only apply if the annuity is in a taxable account. If the annuity is in a tax-sheltered account (such as a 401(k) or IRA), you can sell it and move to a different investment within that tax-sheltered account.

Note #2: If the annuity is in a taxable account, but it currently has an unrealized loss (rather than a gain) it might actually be beneficial to liquidate it rather than do the 1035 exchange described below, due to the fact that the tax only applies to gains, not to the entire amount of the annuity.

Tax-Free 1035 Exchange

Fortunately, there’s a way to get around the tax costs. Section 1035 of the Internal Revenue Code allows you to make an exchange from one annuity contract to another, without paying any taxes as a result of the transaction — thereby allowing you to switch to an annuity from a low-cost provider like Vanguard or Fidelity.

Update: A reader (correctly) points out that section 1035 also allows for the tax-free exchange of an annuity to a long-term care insurance contract, which in some cases may be more beneficial.

It’s analogous to rolling a 401(k) into an IRA: The money goes from one place to another, but (when done properly) it’s not a taxable transaction.

Should You Do a 1035 Exchange?

The fact that you can make an exchange without paying taxes doesn’t necessarily mean it’s a good idea.

To see whether or not an exchange makes sense, you’ll first want to find out how much you’d be saving per year (in the form of reduced expenses) if you did make the switch. Against that, you’ll want to compare:

• Any applicable surrender fee, and
• The value of any insurance benefit you’d be giving up (if, for example, the policy has a death benefit that’s far higher than the annuity’s current market value).

With that information, you can see how many years it would take before the annual savings from switching would surpass the one-time costs you’d have to pay to switch.

How to Do a 1035 Exchange

The most important thing to know about executing a 1035 exchange is this: Do not liquidate your existing annuity with the intent of using the money to buy another. That would not be a tax-free exchange. That would be a taxable transaction.

Instead, the exchange must occur directly between the two insurance companies.

To get the process started, just call the annuity provider you’re planning to switch to and give them your information. They’ll pre-fill the necessary paperwork and send it to you for your signature.

Once you send that back in, the transfer will take place entirely between the two annuity providers.

As far as tax reporting goes, you shouldn’t have to do anything. You’ll receive a Form 1099-R that reports the distribution as a tax-free 1035 exchange, but you don’t have to do anything with that form other than keep it for your records.

October 10, 2011 5 comments

Have you ever read The Millionaire Next Door? It’s an insightful book that looks for common traits among people who have been particularly successful at accumulating wealth.

For example, one trait that’s common among “prodigious accumulators of wealth” is that they’re frequently self-employed. From this, we can conclude that self-employment is likely to increase one’s wealth. Right?

Well, no, we can’t.

What if self-employment simply increases the likelihood of extreme outcomes at both ends of the spectrum? That is, what if self-employment increases not only the likelihood of becoming very wealthy but also the likelihood of going bankrupt? If we only look at the success stories, we have no way to know whether or not that’s the case.

In order to determine whether or not self-employment, on average, increases one’s wealth, we need to do a survey of self-employed people–and not just those who are wealthy.

Same Thing Goes for Picking Mutual Funds.

One approach many investors take to picking mutual funds is to find several funds that have been successful and see what they have in common. For example (and I’m completely making this up), if the top 5 international stock funds over the last 5 years all had the following characteristics at the beginning of that period:

• Expense ratios between 1% and 2%,
• Fund managers with 3-7 years of experience, and
• Less than $1 billion in assets.

…then it would make sense to look for funds that have those characteristics today, right?

Again, no, not necessarily. Because that’s only half the picture.

Going Back in Time

To test whether or not such a fund selection strategy might be successful, we have to go back in time. We have to go back to the beginning of the period in question, look to see what other funds also had the same characteristics, and evaluate their performance as well.*

If all (or nearly all) of the funds with those characteristics performed well, then we might be on to something. (Though even then, it requires a great leap of faith–one I’m personally not comfortable making–to assume that the same pattern will hold true in the future.)

But if half of the funds with those characteristics performed very well and half performed very poorly, then this probably isn’t a great strategy.

In other words, even if all of the top-performing mutual funds share a few characteristics, that doesn’t necessarily mean a darned thing. We also need to check to make sure that those characteristics are underrepresented among poorly-performing funds in order to conclude that they might be useful as predictors of success.

*It’s probably worth pointing out that most of us individual investors don’t even have the resources to do this kind of research. In fact, I’m only aware of two products that make such research possible: CRSP’s Survivorship-Bias-Free US Mutual Fund Database and Morningstar Direct, neither of which is exactly intended for individual investor use.

February 28, 2011 3 comments

Tracking error is the extent to which a portfolio’s performance differs from the performance of the benchmark to which it’s being compared.

For example, if you own an index fund (or ETF) and you find that it’s not tracking its index very closely, then the fund is exhibiting tracking error. And, yes, you should be concerned. It’s likely an indication that something is going wrong.

Tracking Error for a Portfolio

Tracking error can be said to exist at the portfolio level as well. For example, if the stock portion of your portfolio performs significantly differently in any given year than the performance of the U.S. stock market, that’s a form of tracking error (if you compare your portfolio’s performance to the market’s performance, that is).

As such, whenever you include things in your portfolio other than a typical total stock market fund, you increase tracking error. An allocation to REITs, international stocks, or a small-cap value fund, for example, would have that effect.

Of course, with each of those investments, the entire point is that they’ll perform differently from the overall U.S. market. (The idea being that their less-than-perfect correlation will result in lower overall portfolio volatility.)

So Who Cares About Tracking Error?

Perhaps you do.

Imagine this scenario: The market is up 10% for the year, but the stock portion of your portfolio is flat. And some of your holdings have lost 10% or more. Would that bother you? Would you be tempted to sell the investments that haven’t performed well recently?

Or what if the period of underperformance lasted for several years? Would you start to worry that your choice of investments was a mistake? If so, then you care about tracking error. And it might make sense for you to avoid it, because periods of underperformance will happen if you own anything other than a total stock market fund.

In and of itself, portfolio tracking error is not a problem. But it’s important to know yourself and your limitations. If periods of underperformance would bother you and potentially cause you to give up on a particular investment at exactly the wrong time, then perhaps you should stick with plain vanilla total market funds for the equity portion of your portfolio.

January 3, 2011 2 comments

J.D. of Get Rich Slowly recently wrote an article about three personal finance posters that he likes. On the list was a chart typical of the kind that you’d see in a financial advisor’s office or a mutual fund’s sales literature. I’ve always called these “mountain charts” because they show a line of historical stock market returns that climbs upward like a mountain.

You can see the poster I’m talking about here.

I have nothing against these charts themselves, but I think they’re often used to give an entirely-too-comforting view of investing in the stock market.

Visual Tricks

Mountain charts typically use a logarithmic scale, meaning that the y-axis shows exponential growth rather than arithmetic growth. So, for example, the tick marks along the y-axis might be at $10, $100, $1,000, and $10,000 rather than at $1,000, $2,000, $3,000, and $4,000.

One result of using this scale is that it makes bear markets look like no big deal. Click on the link above and look at 2008 in the poster. It’s just a tiny dip. Same goes for 2000-2002.

But for an investor who started investing in Vanguard’s Total Stock Market Index Fund 5 years before the market bottom in early 2009, this is the chart he’d be looking at if he signed into his account on 2/28/2009:

That’s not a tiny dip! For many investors, that kind of thing is terrifying. (Full disclosure: I’m inadvertently engaging in visual trickery of my own here. I don’t have control over the axes Morningstar uses for its graphs, so it’s important to note that the Y-axis doesn’t start at zero.)

Charts that give an overly-smooth appearance of market returns can trick investors into dismissing market volatility as no big deal. Result: They create portfolios with far more risk/volatility than they’re actually comfortable with, and they bail out when the market experiences its next decline.

Does History Repeat Itself?

In the long-run, stock market returns are driven by the output of a country’s economy. For the last 85 years or so — the period typically shown by stock market mountain charts — things have been (relatively) peachy for the United States.

But what would a similar chart look like for Germany? Or Brazil? Losing a world war or experiencing annual inflation in excess of 2,000% sends the value of stock investments rapidly toward zero. And those investments don’t necessarily come shooting back upward.

A chart showing U.S. stock market returns over the last 85 years is only valuable as a predictor of returns to the extent that the economies in which you’re invested experience economic growth similar to that of the U.S. economy over the last 85 years. That’s not exactly a sure thing.

How Long Is Your Investment Time Frame?

Finally, for most investors, what happens over an 8-decade time frame isn’t terribly relevant. For most investors, success is determined largely by the returns received during the period in which they have the largest amount of money in the market (i.e., the last decade or so of working years and the first decade or so of retirement).

Are Stocks a Bad Bet?

I believe wholeheartedly that a portfolio of index funds diversified across several countries is a good bet over a period of several decades. But there’s no guarantee that you’ll end up fabulously wealthy, standing atop a mountain of money. And whatever happens, it’s sure to be anything but a smooth journey.

December 15, 2010 6 comments

In a recent article about conflicts of interest and financial advice, I wrote the following:

We [bloggers] make money recommending companies that have affiliate programs. For example, I earn a commission if you open an account at Scottrade through one of my links. I earn nothing if you open an account at Vanguard. Similarly, it’s more profitable for me to recommend Ally Bank than Bank of America.

Apparently Ally Bank didn’t like that.

Within just a few hours of publishing that post, I received the following email from my account manager with the affiliate network that manages Ally Bank’s affiliate program:

[Ally Bank is] not pleased with the insinuation that they “payoff” affiliates for recommendations on publishers sites. They want you to modify the language to make it clear that they do not pay affiliates to recommend Ally Bank, however Ally Bank pays affiliates to place their ads on their sites. Ally Bank is concerned that this language may come off wrong to customers.

I don’t have a problem with a company paying salespeople a commission to sell their product. I do have a problem with a company trying to keep that fact a secret.

Ads or Recommendations?

In my opinion, Ally’s position that they pay for advertisements rather than recommendations is nonsense.* The “ads” in question do not pay a flat rate per month. Nor do they pay per pageview or whenever a visitor clicks on the “ad.”

Instead, we’re talking about an arrangement in which Ally Bank pays a commission to a web publisher whenever a visitor clicks a link from the publisher’s site to Ally’s site and opens an account.

When you pay a commission, what do you get? You get people to sell your product. Paying a commission is the very essence of paying people to recommend your product.

Ally Bank pays for recommendations, and that’s exactly what Ally Bank gets. (If you don’t believe me, Google “Ally Bank review” and see if you can find a negative review anywhere in sight.)

Don’t Believe Everything You Read

I bring this up not because I have any ill will toward Ally. In fact, as a customer, I’m quite happy with their services, and I plan to keep my own money market account there.

Rather, I bring it up because I think it’s important to know that what you read online is often influenced by behind-the-scenes payments. Ads don’t stay nicely segregated in the sidebar, header, and footer of a site. Often, they’re the content itself.

*From a legal/regulatory perspective, Ally may be absolutely correct that their affiliate program counts as advertising rather than buying recommendations. I have no idea. But I doubt that’s their concern here. It seems unlikely that the legal nature of the program is affected by how I describe it in my blog posts.

December 8, 2010 28 comments