Surgeon's Bulletin Board

October 22, 2007
Surgical Rounds®, October 2007, Volume 0, Issue 0

Bulletin Board topics cover equity-indexed annuities, mutual funds, and more

•Think twice before investing in an EIA

At first, equity-indexed annuities (EIAs) seem to be a great deal, because they offer a guaranteed return if held to maturity. These annuities appeal to investors who want the possibility of growth, but seek downside protection. While this investment option seems to be a win-win proposition, surgeon investors should carefully consider whether this option is right for them.

Scratching the surface of an EIA

An EIA is a special type of fixed-rate annuity. It pays a lower guaranteed rate than an ordinary fixed annuity (about 1.5% to 3% annually), and pays a higher rate if a stock-market index performs well in a particular year. Furthermore, if the market falls during the year, nothing is lost, but the return will be zero for that year. Like all annuities, EIA earnings are tax-deferred, so the money is not taxed until it is withdrawn.

EIAs have various crediting methods. For instance, a contract may call for crediting 50% of the market's profits. So, if the S&P 500 is up 15% for the year, you'll be credited with a 7.5% rate. Since many EIAs have rate caps, you will not earn more than a certain amount; for example, even if the index is up 30%, you may only earn 9%. While EIAs sound appealing, there are some downsides, including their complexity, money access issues, withdrawal penalties, and large commissions that chip away at returns.

Complexity

Every EIA has a different crediting method, and those fine details can make a big difference in your return. Even the simplest EIA is complex, but some are so complicated that they make your head spin. It is challenging to understand how EIAs work and even harder to compare them, making it almost impossible to know if an EIA you are considering is one of the best ones.

Money access issues and withdrawal penalties

The big "if" with EIAs is that the minimum return is guaranteed only if you hold the EIA to maturity. If you do not, all bets are off and withdrawal penalties can last up to 10 years. If you need your money before the surrender period is up, you will have to pay a stiff withdrawal fee, and you may not get the guaranteed minimum rate.

Big commissions and fees eat up returns

Whether you invest a little or a lot in an EIA, the agent earns the same commission, with up to 15% being typical. You do not pay a sales charge, but the money has to come from somewhere, and it is ultimately deducted from your return. The same is true of the insurer's hefty management fees and profits. While EIAs do provide some advantages, surgeon investors planning for retirement may be better off pursuing other options.

EIA alternatives

You can achieve the same goals as an EIA, but much more cost-effectively and without tying up your money, by pursuing the following three EIA alternatives: 50/50 stock/treasury mix, variable annuities, and fixed-rate annuities.

50/50 stock/treasury mix

Consider putting 50% of your nest egg in treasuries and 50% in conservative stock mutual funds. You will have a guaranteed return on half of your money and growth potential with the other half—and it is all 100% liquid. Another advantage is that a portion of mutual-fund dividends (ie, the portion generated by qualified stock dividends) are taxed at a maximum 15% rate, as are long-term capital gains distributions.

Variable annuities

Most variable annuities now offer guaranteed lifetime income options or withdrawal options that help cushion against market risk. While a variable annuity may produce a negative return during any given year, you get the full benefit when the market is up, instead of just a portion. The best variable annuities have reasonable management fees. Some that are sold by financial advisors have no mortality and expense fees—just an asset-management fee, making them as cost-effective as mutual funds.

Fixed-rate annuities

Fixed annuities provide a guaranteed tax-deferred yield without gimmicks. If you want to guarantee some of your principal, you can, of course, put part of your money in variable annuities and part in fixed annuities.

Before you put your money into an EIA, consider the alternatives carefully. The more you look under the hood, the less attractive EIAs will be.

— Frank Congemi

Frank Congemi is a Registered Financial Gerontologist (RFG) and financial advisor who works with many physicians in several states. He practices in Deerfield Beach, Fla, and Forest Hills, NY, and can be reached at or (800) 228-2309.

•Understanding the three faces of mutual funds

From the questions I get asked, it seems that many investors do not fully understand mutual funds, especially the differences among the three major categories they come in: open-end, closed-end, and exchange-traded funds (ETFs). Because most people invest in both stocks and bonds almost exclusively through mutual funds, it is important to understand the characteristics of all the three types.

The mutual fund concept

Aside from the legal structure and other complexities, a mutual fund is a pool of investors' money managed by professional money managers following defined investment objectives and strategies. Beyond the advantages of professional management and the pooling of investments, there are two key factors that have made mutual funds the preferred investment vehicle.

First, mutual funds do not have to pay any income or capital gains taxes on their returns. Instead, they are required to distribute all their interest and dividend income and realized capital gains to their shareholders in the same year. Investors pay the taxes on those through their own tax returns, so there is no double taxation involved. Mutual funds would not have flourished without this tax treatment.

Second, with some minor exceptions and restrictions, investors can add money to or withdraw money from mutual funds at least once a day. Without this feature, mutual funds would not be as popular or convenient.

The three types

How do the three major types of mutual funds differ from one another? Answer: Primarily in the way they handle money additions and withdrawals.

Open-end mutual funds—In open-end mutual funds—by far the most popular variety—all new money goes directly into the fund and all withdrawals come directly out of the fund. Your money goes in or comes out at the end-of-day net asset value, which, stripped of all technicalities, means you buy into the existing holdings of the fund at their fair market value at the end of the day and cash out at the same price; however, you can buy or sell only once a day.

Close-end mutual funds—In closed-end mutual funds, individual investors do not deal directly with the fund. They buy shares from and sell them to other investors in the market at prices determined by supply and demand. They can buy or sell fund shares anytime during the trading hours, but the price may differ significantly from the value of the securities in the fund itself. Therefore, an investor may suffer a loss on a sale even if the value of the stocks and bonds in the fund have gone up.

ETFs—In some ways, ETFs represent the best of both worlds. They are similar to closed-end funds in that individual investors can buy or sell shares anytime during the trading hours because they have to buy or sell shares from other investors in the market. But what sets them apart from closed-end funds is that ETFs have a built-in arbitrage mechanism that generally keeps the share price in the market close to the value of the securities in the fund. In this important aspect, ETFs are similar to open-end funds, because investors are likely to get a fair price for shares at all times, except during a market crisis.

Which fund is right for you?

Because of the uncertainty about price, you should generally stay away from closed-end funds unless you are very knowledgeable. This is one place where truly knowledgeable investors may find great bargains.

As for choosing between ETFs and open-end funds, keep in mind that, at least for now, all ETFs are index funds. For index funds, it is often a toss up between an ETF and a similar open-end index fund. But remember, on Wall Street success always begets excess, and ETFs have fallen victim to this phenomenon. ETFs based on designer indexes are springing up like wild flowers. Make sure you understand fully the underlying index before buying an ETF based on it.

The bottom line is this: for actively managed funds, open-end funds are still the only game in town. For index funds, ETFs offer a wider variety in terms of underlying indexes, but buy an exotic variety only if you fully understand it.

—Chandan Sengupta

• Did you know. . . .

MSNBC

25%—Percentage of income Americans have left for discretionary spending after paying for essentials. (, 2006)

US Census Bureau

14%—Percentage of Americans who spend at least half of their income on housing. (, 2006)

Associated Press

$800,000—Minimum amount Sotheby's expects Orson Welles' Academy Award for Best Screenplay for Citizen Kane to fetch at auction. (, 2007)

Time

500,000—Shortage of employees India expects to have in the information technology sector by 2010. (, 2007)

Wall Street Journal

118—Number of countries with a McDonald's. (, 2007)

Hastings Center Report

18%—Percentage of all Americans who have living wills. (, 2004)

Hastings Center Report

35%—Percentage of nursing home residents who have living wills. (, 2004)

Social Security Administration

51%—Percentage of calls to local Social Security Administration offices that receive a busy signal. (, 2007)

Norwegian Nobel Institute

$750,000—Al Gore Jr.'s share of the Nobel Peace Prize, which he received jointly with the UN Intergovernmental Panel on Climate Change. (, 2007)

Associated Press

120,000—Cans of Silly String one soldier's mother has shipped to Iraq to aid in tripwire detection. (, 2007)

Fantasy Sports Trade Association

$1.5 billion—Revenue generated by the Fantasy Football industry. (, 2007)

Chandan Sengupta is the author of two books, The Only Proven Road to Investment Success (John Wiley; 2001) and Financial Modeling Using Excel and VBA (Wiley; 2004). He currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at .

•Decipher risk in tempting emerging markets

An emerging market can either be a gold mine or a money pit, but that roller coaster has not stopped investors from throwing billions of dollars over the past few years into countries like Pakistan and Peru. According to Time, the iShares MSCI Emerging Markets Index exchange-traded fund, which tracks stocks from countries including Taiwan, South Africa, Turkey, and Poland, is up 89% over the past 2 years—a tremendous rise compared with the S&P 500's 18% gain. Drops that have occurred in countries like India (29%) and Egypt (37%) haven't dulled investors' interest. Time says that when it comes to emerging markets, as the economies of countries like China and India take off, countries rich in natural resources—like Brazil and Chile—get pulled along when commodity prices peak. While such an assumption can lead to a lucrative venture, financial planners recommend allocating no more than 5% of your portfolio to emerging markets because of unpredictable risk.

•Ducking for cover after the subprime implosion

Wall Street Journal

The recent damage to the subprime mortgage market could trickle down and impact your ability to borrow, reports the . A subprime mortgage is granted to those with less-than-perfect credit scores and assigned a higher interest rate to compensate for potential losses from customers who default.

The subprime mortgage market represents only 15% of the total mortgage industry, and it has taken a sizeable dip with implications that reach broadly across Wall Street. Over the past few years, many investors, including insurance companies and Wall Street brokers, have been willing to take on the risk of subprime mortgages. Recently, however, a different type of buyer has surfaced: collateral debt obligations (CDOs). CDOs are a structured financial product that, on one level, can be thought of as a mutual fund, allowing investors to pool money and invest in subprime residential-backed securities, including the lower-rated portions of the subprime market. Now that delinquencies in subprime mortgages have risen faster than forecasted, investors may shy away from CDOs. The Wall Street Journal speculates that if CDOs shrink in volume, the result could be higher interest rates and less credit availability for borrowers.

•Paying for health care after retirement

With the current state of health care, most adults—including surgeons—are concerned about the prospect of not being able to afford it after retirement. The Employee Benefit Research Institute estimates that a 55-year-old couple planning to retire in 2016 will need $560,000 to cover employment-based health insurance premiums, Medicare Part B premiums, and out-of-pocket health care costs. Registered Rep. magazine suggests the number is closer to $1 million.

The Tax Relief and Health Care Act of 2006 features a high-deductible health care plan paired with a Healthcare Savings Account (HSA). An HSA account can provide lower premiums, allows pretax contributions, and tax-free withdrawals. Unused balances can be rolled over for future use or converted into a traditional IRA. Although only 1% of employees currently contribute to an HSA, 40% of employers offer such an account or plan to offer one in the future.

A home equity line of credit (HELOC) can pay for uncovered health costs by tapping into the equity of a retiree's home. The loan can be paid off over a specified period, and the interest may be tax deductible. To best prepare for emergencies, HELOCs should be set up before retirement.

•Simple tips to increase your bottom line

To boost your bottom line, it is important to consider funds with expense ratios in the vicinity of 1% or less, reports a recent article in Motley Fool by Sharon Zimmerman. Keeping the fund's costs down, such as brokerage commissions, is one way to identify a market beater. Funds such as the Vanguard 500 index, which tracks the S&P 500 index, have low expenses of 0.18%. Realized capital gains are also kept to a minimum, saving you tax dollars.

Another method, says Zimmerman, is to select funds invested in by the fund managers. This means that managers' interests are allied with your own. Finally, Zimmerman advises looking for fund managers who buy quality companies during a sell-off period. This happens when price-to-earnings ratios of 10-year market leaders trade below that of the S&P 500 and their market competitors. Funds such as value-slanted Champions Fund have earned returns greater than 460% over a 15-year period ending February 2007.

•Save money on next year's heating bills now

Looking to save money on next year's heating bills? According to an article in Bottom Line, one important step is to lock in a rate with your heating provider when fuel prices are at their lowest relative to recent years. Spring can be a good time to lock in if winter got off to a warm start. Many fuel companies may have excess heating oil and natural gas stored up, allowing them to reduce prices.

Bottom Line also urges you to remember that a lock-in-price is not set in stone; acts of God, hurricanes, or turmoil in the Middle East can disrupt prices. It is also important to find out whether there is a termination fee or an automatic renewal clause, and determine the length of the contract. Natural gas customers can compare prices among gas suppliers, while some heating oil customers in the Northeast can join a heating oil cooperative that, for a fee, negotiates fuel prices for its members.

•Retired couple causes municipal bond revamp

A tax case filed in 2003 by a retired Kentucky couple has big implications for the municipal bond market. The couple challenged Kentucky's policy of taxing out-of-state municipal bonds but not in-state municipal bonds as a violation of the Commerce Clause of the US Constitution that prevents states from discriminating against interstate trade. The Kentucky Court of Appeals sided with the couple, and the state of Kentucky has appealed the verdict to the US Supreme Court.

If the Supreme Court upholds the lower court's decision, 1% to 4% of the value of municipal bonds would be trimmed from California, Missouri, New York, Rhode Island, and other states that have big in-state tax advantages. However, states such as Illinois, Texas, and Washington would be beneficiaries, because they have been required to offer higher yields across the country since they have no in-state tax breaks. If upheld, the case will impact college savings plans in states such as New York by eliminating tax deductions only for residents who use in-state college savings plans.