A Moment To Focus On The Good

One of my favorite economists, Jeff Thredgold, pointed out in his recent newsletter that society tends to focus on negative information. Consequently, he dedicated some time to focusing on the positive developments within the U.S. Here is a sampling of the information he mentioned:

• The 0.9% decline in the nation’s unemployment rate during the past three months was the sharpest three-month fall in 28 years.
• U.S. economic growth has now been positive for seven consecutive quarters.
• Productivity of U.S. workers rose an average of 2.6% annually during the past 10 years, the largest gain in 40 years. Rising productivity is a long-term key to higher standards of living.
• The number of people who have quit smoking (46 million) now exceeds the number who still smoke (45 million). Less than 21% of adults smoke today, versus nearly half in the early 1950s.
• Substantiated cases of childhood sexual abuse have fallen 49% since 1990. Physical abuse of children is down 43%.
• Economic output of the average American worker is 10-12 times that in China. Americans won 30 Nobel prizes in science and economics during the past five years. China? Just one.
• A record 30% of men have earned a bachelor's degree or higher, versus 29% of women, also a record. This compares to a combined 7.7% in 1960. A record 85% of adults over age 25 now have at least a high school diploma, versus 24% in 1940.

To view Jeff's entire newsletter, visit www.thredgold.com/tea-leaf.

Should We Fear Global Uncertainty?

Recent “cataclysmic” events will be approximately the fifteenth time the world was supposed to end since 1981, when some individuals at Net Worth Advisory Group began their careers as financial advisors. Think about all the crises that have happened and been predicted over the years. Thirty years ago, a Utah man became popular by predicting an earthquake that would devastate the entire earth. He had it nailed down to the very year. Hundreds of his followers in Utah added earthquake coverage to their homeowner’s policies. The earthquake never came. At least insurance companies did well.

With the one-day decline in the stock market on October 19, 1987, again, the world was coming to an end. Three months later it had totally recovered. Other crises occurred in 1982 (global credit crunch), 1989 (junk bond collapse), 1994 (bond market massacre), 1998 (Russian currency crisis), 2000 (Y2K), 2001 (tech bubble), 2008 (sub-prime loan crisis), and 2010 (foreign debt crisis), just to name a few. During the last thirty years, many Cassandras have regularly issued their dismal prognostications. Sometimes an event occurred that temporarily fulfilled their dire predictions. Yet, the economy and market always recovered. The world continues to turn and function. It can be very dangerous to follow the advice of doomsayers. If you had been out of the stock market the last 30 years, you would have paid a very high price. The S&P 500 closed at 122.55 on December 31, 1981. It’s now above 1300.

If we have learned anything about the stock market during the last thirty years, it is that the greatest risk doesn’t occur when fear is rampant. The most dangerous environment is exactly the opposite: when people are wildly optimistic and buying any investment in sight. Those are the times when risk is the greatest. The building of the tech bubble in 1998 and 1999 is a prime example of this infectious group mentality.

The challenge for investors is to step aside and develop the ability to view world events and market activity apart from the crowd of human sheep. Granted, this is easily said but very difficult to do. Remember that your feelings are most likely the same as everyone else’s. Unless you develop the skill of isolating your emotions from those of the vast majority, you will become a market timer who buys high and sells low – not a good strategy for making money.

The recent events in the Middle East and the earthquake in Japan may have triggered a “correction” in the market that was long overdue. A correction always has a triggering event, but we should remember that the “event” is an excuse, not a cause. What was the market psychology that existed when Middle East tensions erupted? Were investors buying any and every stock with reckless abandon? Was the market greatly overvalued? No -- none of these conditions existed. By answering these simple questions, we can conclude that recent events didn’t signal the emergence of the bear from his hibernation. Last year, we had the “PIIGS” European debt crisis. Despite that event, the market did very well in 2010.

History has shown that human beings have remarkable resilience and an amazing ability to overcome catastrophe. People pull together and solve problems. The Chinese character for crisis contains two parts: one is danger, the other is opportunity. People deal very well with poverty and trials. What they can’t handle well is success and wealth. A patient, long-term view is the price investors must pay to profit from the stock market’s attractive returns.

At Net Worth Advisory Group, we believe that our clients should accumulate a reasonable supply of resources, including cash, to prepare for a disaster -- be it natural, man-made, or personal. But anyone who sincerely believes that capitalism is dead and that all human creativity and technological advances have come to an end should sell all his/her financial assets. Then go buy farmland, weapons, ammunition, gas masks, and all the other survivalist paraphernalia. Sit on the porch of your farmhouse in a rocking chair, shotgun cradled in your arms, and wait for the end. It may be a long time coming -- and that will take a lot of patience as well.

How Do Equity Indexed Annuities Stack Up?

Sales of equity indexed annuities (EIAs) have grown considerably in recent years. These products are positioned as simple investment vehicles that enable the investor to participate in market gains but offer protection from market losses. In reality, these are complex investments and because salespeople are paid large commissions for promoting these products, it’s difficult to get an objective opinion on whether they are right for you.

How Do Equity Indexed Annuities Work?

EIAs produce an investment return that is tied to a market index, most commonly the S&P 500. Each product has a minimum guaranteed return (currently, 1% is common) and a cap rate, which is the highest annual return the investment can generate (currently, 8% is common).Consequently, an EIA with these common parameters would generate the same return as the S&P 500 of that return was between 1% and 8%. If the S&P 500 produced an annual return of less than 1%, the EIA would guarantee 1%. Similarly, if the index produced a return greater than 8%, the annuity would be capped at an 8% return.

Further, EIAs have participation rates that commonly range from 70% to 100%. For instance, if the index increased in value by 10% during the year, an EIA with an 80% participation rate would produce an 8% return (80% of the index’s 10% return). Also, it is important to note that minimum guarantees, cap rates, and participation rates can change at the whim of the insurance company.

Other Important Factors

As mentioned previously, salespeople are handsomely compensated for selling EIAs. To protect the insurance firm from paying a large commission to a salesperson only to have the investor sell the annuity, these products have a surrender charge if the investors sells within a certain time frame, which can be as long as 10 years. This surrender penalty can be as much as 10%. Thus, liquidity is severely limited with these investments.

EIAs offer tax-deferral, meaning an investor doesn’t pay taxes on investment gains until the annuity is sold. This tax-deferral is similar to the benefit offered by a 401(k) or IRA. However, unlike investments in a 401(k) or IRA, investments in an EIA don’t reduce your current income or tax bill when the investment is made. For this reason, many financial planners encourage their clients to maximize contributions to other tax-deferred vehicles before considering an annuity.

It’s important to note that most EIAs only count equity index gains from market price changes, and exclude any gains from dividends. Since you're not earning dividends, you won't earn as much as if you invested directly in the market. For example, the S&P 500 earned 15.1% in 2010, but 2.3% of that return came from dividends which would not be included in an EIA.

Lastly, the guaranteed return on an EIA is only as good as the insurance company that gives it. While it is not a common occurrence that a life insurance company is unable to meet its obligations, it happens. Information about the financial strength of insurance companies can be found on the SEC's website.

Investment Return

Suppose a 45 year old with a 40 year investment horizon was looking for an investment that offered impressive returns with relative safety. Would an EIA be a good choice? Let’s consider a $10,000 investment in three unique options: an investment in the S&P 500, an investment in a conservative diversified portfolio* consisting of 75% bonds and 25% stocks, and an investment in an equity indexed annuity tied to the S&P 500. For illustration purposes, let’s assume the annuity has extremely favorable conditions: a 100% participation rate, a 3% minimum guarantee, and a 10% cap rate. Further, let’s give the EIA the benefit of the doubt and assume it includes the portion of the S&P 500’s return due to dividends, which few EIAs do. All and all, this annuity is significantly more favorable than any real product you are likely to find. Since the investor intends to live another 40 years, let’s look at what would have happened to these three $10,000 investments during the last 40 years, starting in 1970.

As you would expect, the $10,000 investment in the S&P 500 grew the most over 40 years, to $495,551. However, this investment endured significant volatility, losing as much as -37% in one year. Clearly, this investment is too risky for an investor willing to endure only a small amount of risk. Alternatively, the $10,000 investment in the diversified 75% bond, 25% stock portfolio grew to $433,838 -- still an impressive return. However, the largest loss this portfolio suffered in a calendar year was -6% (1974), which might be tolerable to an investor with a low risk tolerance. Finally, while the equity indexed annuity with unrealistically favorable terms never gained less than 3% per year, our $10,000 investment only grew to $195,479. What if we consider an EIA with more realistic terms: 100% participation rate, 1% guarantee, and an 8% cap rate? Our $10,000 investment would have grown to only $103,767. Clearly, when comparing an EIA to investing in a diversified portfolio with a conservative ratio of bonds to stocks, an investor benefited of accepting a small amount of volatility in their portfolio.

Did you recently purchase an equity indexed annuity without full knowledge of the product? Annuities have a “30-day free look” that enables you to surrender the product free of charge within 30 days of signing the contract. If you recently purchased an EIA, speak to a fee-only financial planner immediately to ensure the product was right for you. If you decide the annuity wasn’t what you thought, a fee-only financial planner can help you exercise your free look provision and find an alternative investment that is more appropriate.

* Model portfolio returns were derived using the following allocation and indexes; STOCKS: 25% DJ Wilshire Large Company Growth Index, 25% DJ Wilshire Large Company Value Index, 10% DJ Wilshire Midcap Growth Index, 10% DJ Wilshire Midcap Value Index, 5% DJ Wilshire Small Company Growth Index, 5% DJ Wilshire Small Company Value Index, 20% Morgan Stanley EAFE Index NR USD; BONDS: 40% Lehman Bros. Long-Credit, 40% Lehman Bros. Long-Term Govt. Bond Index, 20% Citigroup Non-$ World Gov. Bond Index;