When recently reviewing afriend's investment portfolio,I found that he hadseveral variable annuities. Theircumulative current market value wasapproximately $800,000. Some ofthe annuities had been purchased asrecently as 3 years ago, while otherswere purchased several years ago.
Like most investments, their performanceover the past 3 years hasbeen relatively poor, as my friend'soverall investment strategy was arather aggressive one. This wasn'tvery surprising; the majority of aggressiveportfolios have faltered inthe past 3 years due to the markets'poor growth. In short, my friend'sannuities have declined in valuenearly 50% over the past 3 years andtheir current value is not much morethan the cost basis.
Not unlike most investors, myfriend is concerned. He and his wifeare seeking to retire from active practicewithin the next 3 to 5 years. Willthese annuities recoup their lossesprior to their retiring? Unfortunately,the answer to this question is, in alllikelihood, probably not.
There's a long list of variableannuities' pros and cons. Yes, theyoffer creditor protection in somestates. In all cases, the monies accumulatetax-deferred. Additionally,the beneficiary of the proceeds froman annuity may never receive lessthan the cost basis of the annuity.But, within the past 2 years, a newgeneration of annuities has emerged.Some insurance companies nowoffer variable annuities that havewhat is called a "guaranteed minimumincome benefit" rider. What,precisely, does this new rider mean tophysician-investors like my friend?
THE OLD GENERATION
Let's look at an example. Suppose10 years ago Dr. John Smith, age 50,deposited $100,000 of after-tax, non-qualifiedmonies into a variable annuitywith the XYZ Insurance Co. Assumethat he deposited the amountinto a fund subaccount whose performancemirrored that of the S&P 500.Let's further assume that the mortality,insurance, and subaccountexpenses totaled 2% annually.
Over this 10-year time period, his$100,000 deposit would have grownto about $180,000 as of March 31,2003. However, during that sametime period, the value of that annuityon its 7-year anniversary date onMarch 31, 2000, would have beenapproximately $320,000. From thenon, the value would have declined toapproximately $180,000 today.
At this juncture in time, Dr.Smith would have a variety of optionsavailable to him. For instance,he could choose the following:
Also, if Dr. Smith had died atany time during this 10-year period,his beneficiary would havebeen guaranteed to receive no lessthan the current market value ofthat annuity, and in no case wouldthey receive less than $100,000.
THE NEW GENERATION
With the new generation of annuitiesavailable, for a nominal internalfee assessed to the contract on anannual basis, some annuity contractsoffer living benefit riders that havecertain contractual guarantees toprotect against the downside risk ofmarket declines such as we have beenexperiencing for the past 3 years.
The best way to illustrate thisconcept would be to refer back to Dr.Smith. You will notice that in theexample, the $100,000 would currentlybe worth about $180,000.However, had he purchased a livingbenefit rider that promises to protecthis principal, earnings, and compoundsat a guaranteed annual rateof 6%, the chart below shows whatwould have occurred.
So, what are Dr. Smith's optionsat the end of the 10-year period?Obviously, he could withdraw as littleor as much of the $180,351 as hedesires and pay the applicable taxesdue. Another option would be toannuitize the $319,702 (highestcontract value on the contractanniversary date). At this time,because interest rates are so low, theannuitization rates are extremelylow. However, I would rather annuitize$319,702 than just take the$180,351, pay my taxes, and walk.
Also, notice that if the value ofthe annuity was only $120,000 atthe end of 10 years, the contractowner would still receive no lessthan the $180,351 contract value atthe end of the 10th year, but wouldhave to annuitize that amount.
What are the implications?Physician-investors should be moderatelyconservative with their pensionand retirement plan money,given the current market conditions.With regard to monies theyplace into these kinds of annuitycontracts, they should be moderatelyaggressive, because no matterhow bad the market does, their contractis guaranteed to be worth noless than the 6% compoundedannual rate of return (ie, $179,084)over a 10-year period.
Therefore, if an investor knowsthat the floor on the annuity is noless than the 6% guaranteed, theyreally have nothing at risk exceptthe upside potential (ie, opportunitycost) if they are too conservativewith their investment strategy. Whosays having an aggressive portfoliois overly risky in the currentvolatile market environment? Witha guaranteed minimum incomebenefit rider on your annuity,aggressive investing can be lucrativeand safe. With nothing to lose,why not be aggressive?
Thomas R. Kosky and hispartner, Harris L. Kerker, areprincipals of the Asset PlanningGroup in Miami, Fla.Mr. Kosky teaches corporatefinance in the Saturday Executiveand Health Care Executive MBAPrograms at the University of Miami andwelcomes questions or comments at 800-953-5508. For more information, visitwww.assetplanning.net.