MONEY Master the Game: 7 Simple Steps to Financial Freedom (27 page)

I flew to Philadelphia to meet with Dr. Babbel for a “one-hour” interview, which turned into four hours. His strategy, which we will highlight in the “Create an Income for Life” chapter, was powerful yet simple. And the “peace of mind” factor really came through, as I could see the freedom his strategy afforded him. I left with a completely different view on annuities! Or at least certain kinds of annuities.

He was very clear that “not all annuities are created equal.” There are many different types, each with its own unique benefits and drawbacks.
There are ones you should indeed “hate,” but to lump all annuities into one category is to thoughtlessly discriminate against the only financial tool that has stood the test of time for over 2,000 years.

THE JULIUS CAESAR INSURANCE COMPANY

The first lifetime income annuities date back 2,000 years to the Roman Empire. Citizens and soldiers would deposit money into a pool. Those who lived longest would get increasing income payments, and those who weren’t so lucky passed on; the government would take a small cut, of course. One must render to Caesar what is Caesar’s!

The Latin word
annua
is where we get our word
annual,
because the original Romans got their income payment annually. And, of course, that’s where the word
annuity
comes from! How’s that for “exciting” water cooler trivia?

In the 1600s, European governments used the same annuity concept (called a tontine), to finance wars and public projects (again keeping a cut of the total deposits). In the modern world, the math and underpinnings of these products are still the same, except governments have been replaced by some of the highest-rated insurance companies, including many that have been in business for well over 100 years; insurance companies that stood the test of time through depressions, recessions, world wars, and the latest credit crisis.

But we must be careful when it comes to the different types of annuities. Annuities were pretty much the same over those last 2,000 years. There was just one version: the Coca-Cola Classic of financial solutions. It was a simple contract between you and an insurance company. You gave them your money, and they promised you a guaranteed income or return on your money. And after you made your contribution, you got to decide when to start receiving income payments. The longer you waited, the higher your income payments. And the day you bought it, you had a schedule that showed the exact payment, so there was no guessing.

IS IT PROGRESS OR JUST CHANGE?

Over the last 50 years, annuities have evolved into many different types compared with the original ones offered by Caesar. Sometimes evolution is a good thing. Other times we end up a mutant!

It’s safe to say that there are more poor products out there than good ones. As Jack Bogle says, “I remain a recommender of the annuity conceptually, but you’d better look at the details before you do anything.” So let’s cut to the chase. Which should you avoid?

VARIABLE ANNUITIES ARE INVARIABLY BAD

In 2012 over $150 billion worth of variable annuities were sold. To put that in perspective, $150 billion is just a hair below Apple’s gross revenue for 2012. Variable annuities have evolved into the commission darling of many large brokerage firms. So what the heck is a variable annuity? In short, it’s an insurance contract where all of the underlying deposits are invested in mutual funds (also known as sub accounts). Yep. The same mutual funds that underperform the market and charge insanely high fees. But this time the investor buys them inside of an annuity “wrapper.” Why would anyone want to invest in mutual funds through an annuity? Because annuity products have special tax benefits, and the money inside can grow tax-deferred, just like a 401(k) or IRA. This arrangement is especially attractive, the pitch goes, if you have already maxed out your 401(k) or IRA limits and have extra capital to invest. But now, instead of just paying excessive fees for underperforming mutual funds, there are
additional
fees for the annuity itself.

FEES ON TOP OF FEES

So what’s the appeal? Why would someone buy mutual funds wrapped inside an annuity just to avoid taxes? Most variable annuities guarantee that even if the account goes down, your beneficiaries will receive at least the total amount you invested originally. So if you put in $100,000, and the mutual funds drop in value to $20,000, your children would still get $100,000 when you die. That doesn’t sound like such a bad deal until you realize that you just bought the most expensive form of life insurance available.

Earlier, in chapter 2.2, we outlined the laundry list of fees you will pay to own an actively managed mutual fund and how these fees can dramatically drag down your performance. To recap, the total of all the fees (expense ratio, transaction costs, soft-dollar costs, cash drag, sales charges) will
average
approximately 3.1% per year, according to
Forbes
(if held in a tax-deferred account such as a 401[k], IRA, or variable annuity).

That’s $3,100 per year for every $100,000.

But we ain’t done yet.

When you buy a variable annuity, not only are you paying the fees listed above but also you have
additional
fees paid to the insurance company. There is a “mortality expense,”
⁷
which according to Morningstar averages 1.35% per year, as well as administrative charges that can run somewhere between 0.10% and 0.50% per year.

Let’s add ’em up:

Average mutual fund costs = 3.1% (according to
Forbes
article),

Mortality and expense = 1.35% (average),

Administrative cost = 0.25% (average).

A grand total of 4.7% per year, or $4,700 for every $100,000 you invest! And this money comes off the top before you make a dime.
Said another way, if the fund returns 4.7%, you didn’t make anything!
All of these additional fees all to avoid tax on the gains? Heck, after all the fees, you probably won’t have much gain, if any, to pay taxes on!

PAINTED INTO A CORNER

Even though most people lose money in these variable annuities, they feel locked in and afraid to pull out their money because of the death benefit guarantee (the guarantee that their heirs will get back the original deposit amount). And there are usually heavy surrender charges, so the insurance company might charge you for leaving the party early.

Are there any exceptions to the rule? Only two that experts tell me are worth considering in so far as one needs the tax efficiency. Vanguard and TIAA-CREF both offer extremely low-cost variable annuities with a list of low-cost index funds to choose from. They do not charge commissions, so there are no surrender charges if you want to cash in.

NOT YOUR GRANDPA’S ANNUITIES

In chapters 5.3 and 5.4 of this book, “Freedom: Creating Your Lifetime Income Plan” and “Time to Win: Your Income Is the Outcome,” we will clearly examine traditional income annuities as well as a relatively new type of annuity (the
fixed indexed annuity
) that provides some of the highest and most compelling income guarantees of any financial product, while also providing 100% principal protection. By the time you are done with this book, you can have the certainty and peace of mind of knowing that every month when you walk to your mailbox, you will be receiving a paycheck (that you won’t have to work for). And we can accelerate your path to financial freedom if we can eliminate taxes on your lifetime income payments. How, you ask?

By taking a portion of our money and combining the power of a Roth IRA with the power of a lifetime income annuity.
This means that no matter what the government does with tax rates, you can rest assured that the entire amount you receive is spendable income. That’s right: a legal and secure tax-free lifetime income, with no moving parts or worries about market volatility.

The purpose of this chapter is not only to tell you what to avoid but also to warn you about getting sucked into the marketing myth that
all
annuities are bad. The only reason why I’m not going into more detail on the power of annuities is because you first need to understand where to put your money: asset allocation. And understanding asset allocation will help you know when and where annuities make sense for you.

THE SOLUTION

If you have an annuity, regardless of what type, it’s always beneficial to get a review by an annuity specialist. You can reach out to an annuity specialist at Lifetime Income (
www.lifetimeincome.com
), and he or she will perform a complimentary review, which will help you:

• discover the pros and cons of your current annuity,

• 
determine the actual fees you are paying,

• assess whether or not the guarantees are the highest available, and

• decide whether to keep it or get out of your current annuity and “exchange” for a different type of annuity.

If you have an annuity that you find is not great, there is a feature called a
1035 exchange.
It requires some simple paperwork to move a cash balance from one insurance company to another
without being hit with a tax penalty.
But you must be aware that your current annuity might have “surrender charges” if you haven’t owned the annuity for long enough. It may make sense to postpone an exchange until there are low or no surrender charges. Also, you may be forfeiting the death benefit guarantee.

Stick with me here, as there is just one more truth we must uncover! The last and final illusion is one that insiders are most aware of: the myth that you have to take exorbitant risks to make great returns.

Let’s unmask Myth 8. . . .

7
. Fees, included in certain annuity or insurance products, that serve to compensate the insurance company for various risks it assumes under the annuity contract.

CHAPTER 2.8

MYTH 8: “YOU GOTTA TAKE HUGE RISKS TO GET BIG REWARDS!”

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

—BENJAMIN GRAHAM,
The Intelligent Investor

HAVING YOUR CAKE AND EATING IT TOO

Superficially, I think it looks like entrepreneurs have a high tolerance for risk. But one of the most important phrases in my life is “protect the downside.”

—RICHARD BRANSON, founder of Virgin

My friend Richard Branson, the founder of Virgin and its many incredible brands, decided to launch Virgin Airways in 1984. In true David-versus-Goliath fashion, the master of marketing knew that he could “out market” anyone including the behemoth competitor British Airways. To outsiders, it seemed like a huge gamble. But Richard, like most smart investors, was more concerned about hedging his downside than hitting a home run. So in a brilliant move, he bought his first five planes but managed to negotiate the deal of a lifetime: if it didn’t work out, he could give back the planes! A money-back guarantee! If he failed, he didn’t lose. But if he won, he won big. The rest is history.

Not unlike the business world, the investment world will tell you, directly or more subtly, that if you want to win big, you’ve got to take some serious risk. Or more frighteningly, if you ever want financial freedom, you have to risk your freedom to get there.

Nothing could be further from the truth.

If there is one common denominator of successful insiders, it’s that they
don’t speculate with their hard-earned savings, they strategize.
Remember Warren Buffett’s top two rules of investing? Rule 1: don’t lose money! Rule 2: see rule 1.
Whether it’s the world’s top hedge fund traders like Ray Dalio and Paul Tudor Jones or entrepreneurs like Salesforce founder Marc Benioff and Richard Branson of Virgin, without exception, these billionaire insiders look for opportunities that provide asymmetric risk/reward. This is a fancy way of saying that the reward is drastically disproportionate to the risk.

Risk a little, make a lot.

The best example of risking very little to make a lot is the high-frequency traders (HFT) who use the latest technologies (yes, even flying robots and microwave towers that are faster than the speed of light) to save 1/1000 of a second! What would you guess is their risk/reward while generating 70% of all trading volume in the stock market? I will give you a clue. Virtu Financial, one of the largest HFT firms, was about to go public, a process that requires it to disclose its business model and profitability. Over the past five years, Virtu has lost money only one day! That’s right. One single trading day out of thousands! And what is its risk? Investing in faster computers, I suppose.

TWO NICKELS TO RUB TOGETHER

My friend and hedge fund guru J. Kyle Bass is best known for turning a $30 million investment into $2 billion in just two short years. Conventional wisdom would say that he must have taken a big risk for returns of that magnitude. Not so. Kyle made a very calculated bet against the housing bubble that was expanding like the kid in
Willy Wonka & the Chocolate Factory.
It was bound to burst sooner rather than later. Remember those days? When ravenous, unqualified mortgage shoppers were enticed to buy whatever they could get their hands on. And with no money down or so much as any proof they could afford it. Lenders were lining up to provide loans knowing they could package them up and sell them off to investors who really didn’t understand them. This bubble was easy to spot so long as you were on the outside looking in. But Kyle’s brilliance, which he reveals in his interview in section 6, is that he only risked 3 cents for every dollar of upside. How’s that for taking a tiny risk and reaping giant rewards?