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This is lengthy, but one of the best articles you'll ever see on the use of mutual funds, annuities and life insurance for various needs. The comments do not address plans that are taxed deferred- 403(b), 501(c)3, employer plans and so on. (This was written well before the nex tax laws allowing substantial monies to pass upon death)

Let me first preface my comments with an overview of a regular annuity. You can buy one almost anywhere (best to use an independent agent) and either put in monthly amounts or a lump sum to grow towards retirement or a lump sum to take out payments immediately. Annuities provide tax deferred growth which is their key marketing element. Most annuities pay (essentially) current interest rates and are known as fixed annuities.

If you are willing to take a risk with an annuity, you can buy a variable annuity and use mutual funds as the investment vehicle. As stated, all growth is tax deferred, but there is one major caveat. Any gain is taxed as ordinary income on removal. That's bad because, irrespective of the internal compounding, you are apt to lose 30%+ upon removal of funds due to ordinary income tax. Remember this foremost when investing in these. Anything else you can do that might be better? Well, if you bought mutual funds, all gain is taxed at capital gains and that rate may be considerably lower than the ordinary income rate. (Another point- if you are buying a variable annuity, you must/should have exhausted all other investment plans available to you at work- 401(k) for example. It's only after that- where you have more discretionary income that is geared for long term investments- that you would use a variable annuity. Further, I make the assumption that many of these people would be in the higher tax brackets.) Additionally with mutual funds, you don't have to bother with annuity surrender charges, a 10% penalty for withdrawal before 59  1/2, the assets are easier to gift in pieces, the fund expenses are traditionally lower- sometimes much lower- and the selection of funds is greater. There is a problem, however, in that any dividends distributed yearly, as well as any capital gain distributions (made annually), are currently taxable annually. That's bad since regular funds have up to 100% (and more) turnover rates per year and a lot of gains might be distributed and taxed. But you can still avoid most of this problem with a simple investment strategy.


Index funds, whether the S&P 500, Small Cap, International, etc., all normally have a very low turnover (7%+-) and a very low (0%- 2%) dividend rate. Therefore, you get almost all tax deferred growth, long term capital gains and good asset allocation. On the negative side, if a downturn happens and you do sell a fund, any gains are taxable that year and this will reduce the overall long term return. (Think about what you should have done in the mid 70's. If you aren't familiar with the market in the 70's, you need to do some more homework before investing. The same scenario is true for our existing economy. Yes, it is absolutely true capital gains would have had to been applied to any funds that made gains in the 90's. But better to take such taxes than to watch your assets drop 50% in the last couple years. And you can only argue against this element of indexing IF you also adjusted your funds within a variable annuity when returns plummeted. If not, then you certainly not only did not use a variable annuity properly, you did not recognize what happens with economics.) Anyway, while the comparison is not exactly direct, I think it is close enough to warrant the consideration of indexing a portion of your taxable assets.

And here I go again with basis. If you don't understand this, you can never do effective retirement or estate planning. The bottom line is that while there are certain issues to view with variable annuities and mutual funds, they almost solely apply while you are ALIVE. And that's because, if you die with an annuity- fixed or variable-, there will be NO STEP UP IN BASIS versus a FULL STEP UP IN BASIS with the mutual funds. If you bought an annuity with $25,000 and it had grown to $100,000 at your death, your beneficiaries will get the $100,000 but $75,000 will be taxed as ordinary income. Use the same numbers on a mutual fund and your beneficiaries get the full $100,000 with NO tax. It basically means that if you have various assets, strip the annuity clean during retirement and leave the other assets to grow. Don't understand that? Well you or your advisor must get this down cold before investments are made.


As regards variable annuities versus variable life insurance: Both give you tax deferred buildup in the policy, but since you have to pay for life insurance in the variable life, you have less growing in the variable life policy. But go back to basic tax planning again. Even if you do have more money in the variable annuity, you are going to be subject to probably a 30%+ federal and state income tax when the money comes out. You WILL lose part of the return anyway, so you need to adjust the overall returns for taxes. That's because life insurance gives you a significant opportunity since you can get most of the cash buildup WITH NO TAXES AT ALL. Simply take out a loan. These are not taxable (some caveats apply) and the resulting sum can equal or better what was growing in the annuity MINUS the 30% tax. And during the same period of time, one has the extra life insurance, even though it may be minimum.

The downside of the variable life is, obviously, the extra cost of initial purchase, extensive internal annual fees, whether or not you will be accepted for life insurance (means you will be poked and prodded by a nurse or physician) and the fact that you effectively will need to keep the policy for life or taxes WILL occur. But it certainly suggests a detailed review before any purchase takes place. I will caution you with this however. This is not the vehicle to buy if you really need a life insurance. It is very, very expensive as compared to policies designed primarily for insurance coverage and you don't get much coverage for each $1 of premium. You've got to do a lot of homework before you buy a variable life policy.


Usually boils down to whether or not you need life insurance. If you don't need insurance, you're still better off to use the index mutual funds approach above. And if you do need insurance, it provides so little coverage for the dollar invested that you would invariably need to buy more anyway. Admittedly the gains may be taken out as a tax free loan with the insurance, but you lost money in the extra costs for the insurance. I have analyzed variable life policies against index mutual funds and I can assure you that in every one that I have looked at, you will end up with FAR more money from the (index) funds than you will with the variable life. Further, you must maintain the policy for life.

And here is another real "gem" regarding any cash value insurance. Assume you did buy variable life in order to use it for retirement. Say you were 35 years of age. Well, by the time you are 65, you better start taking out the money and spending it, gifting it, etc. Why? Because if you leave the money there to grow and then you die, you defeated the whole reason for buying the thing in the first place- retirement income. I bet that anyone who could afford a variable policy now will undoubtedly have over a $1,000,000 estate upon death. All the money made in the policy will be taxed in the estate- up to as high as 55%. There is no sense in having cash left in a policy and subject it to estate taxes.

Here's the next gem. Assume you did take a bunch of money out but you also realized your estate will still be too big with the inclusion of the life insurance and that it will be taxed at least at 45%+. (Assume you had a $1,000,000 estate PLUS a $300,000 insurance policy (any type). Now you got a $1,300,000 estate and the $300,000 of insurance will incur an estate tax of roughly $120,000.) Unfortunately, you won't be able to get the policy out of your estate since you have incidences of ownership (the loan). In other words, any attempt to put it into an irrevocable trust won't work. Yes, you could gift it away, but you'll undoubtedly have gift tax problems, it will cost you a lot and the new owner will have the loan for the money you got. In review of this issue, it would appear that it would have been preferable to buy mutual funds under the indexing parameters and, should you have needed insurance, buy the cheapest standard policy available (some policies are designed to provide almost solely insurance- not cash value- and they therefore can be put into an irrevocable trust or gifted away with far less gift tax problems.) In the latter cases, the beneficiaries would have received the funds without tax and the estate might have avoided tax as well.

Additionally, with the mutual fund, you can gift the money away to others and possibly not have anything taxed in the estate. There are caveats in doing this as well. If you had simply left the funds in your estate, they get a full step up in basis at the date of death versus the existing basis with a gift. (If you or your advisor don't understand basis, you're screwed.)

VARIABLE LIFE VERSUS CHEAP LIFE INSURANCE: Ben Baldwin's book on Life Insurance, The New Life Insurance Investment Adviser, has some very valid points about the use of life insurance. He, however, is a major proponent of variable life, particularly variable universal, since the owners can do all sorts of things with the policy. This not only includes the ability to pick various mutual funds, but to vary the amount put into the policy at any time so that the cash value can increase for more protection or to keep it at a lower rate. That is a viable consideration save for one major issue. COST. Life Insurance Selling recently had a study of different types of insurance and the costs of a $1,000,000 policy. The cheapest variable life was about $7,250 annually. The cheapest whole life was $4,400. True, you could do more with the variable, but my question is, why would you want to? It'd cost (roughly) an additional $3,000 a year to gain a $2,000 cash flexibility in the policy and doesn't make sense. Of course, Ben Baldwin's study did NOT include the whole life policy I repeatedly discuss. It is unfortunate that these studies exclude the (probably) cheapest life insurance policy in the United states and as a result, other options can look good. (But not to me). (Note 2000. The policies now to address would be no lapse.)

Here is another reason for looking at pure insurance (essentially nil cash value buildup). There are such things called irrevocable life insurance trusts that are used to make estate tax payments with discounted dollars. In their simplistic format, parents would gift money to such trust and the trustee would buy the life insurance. But in order to use the annual gifting allowance of $10,000 per person per year- or for man and wife of $20,000- you have to use Crummey power provisions to make it a current gift. Well, assume you had one child but the policy cost $40,000 for a $5,000,000 second to die. In such a case, the $40,000 payment is $20,000 over the joint gift and would have to be used against the parent's lifetime gift exclusion of $675,000. Over a period of just 10 years therefore, $200,000 of lifetime exclusion is LOST. This is not good financial planning particularly where you look at the cost of really cheap insurance (A+ Best rated for 18 years, etc.) at $10,500 per year. Why the big difference? The latter policy is NOT designed for cash value- in fact, anything but. It's like a long term term policy guaranteed till age 100. It's well under the $10,000 gift provisions per year.

SUMMARY: Totally risk adverse investors (a misnomer right there- someone who is totally risk adverse is NEVER an investor) might use a fixed annuity to defer monies, but primarily where there is no other choice- say a TSA or a employer plan. Otherwise, annuities don't work that well due to the probable high income tax upon payout and no step up in basis. (You rarely want to leave an annuity to beneficiaries if you have other assets instead.) Further, on the way out, annuitization means loss of access to the funds (normally) and loss due to inflation. And most times the returns during annuitization are dismal unless you plan on living till around 90+. (If your or your advisor cannot use an HP12C or similar, you're screwed again.)

If you need insurance, just buy insurance. If you want growth and are outside of your 401(k) plan or an IRA (even with an IRA), consider the use of index portfolios since the turnover rate per year may only be 7%+-. But even these are not perfect since, if the market starts to slide, you may want to sell the funds (consider annual rebalancing) and that capital gains taxes will occur on any gains. Some of that may be avoided by leaving certain amounts in certain portfolios to grow for life- or to pull out at a later point when the monies are needed. I would suggest that readers buy the book, What Works on Wall Street, by James O'Shaughnessy, McGraw Hill, 1996. You'll understand a lot about investments from his research. Note I did not say you had to agree with him (or me for that matter). But the information is invaluable for proper analysis.

Regardless, you don't do any of the above in a vacuum. You need to review your entire portfolio, risk profile, estate plan, taxation, basis, retirement income needs and all investment opportunities before selecting one way unilaterally. And considering the topics I just mentioned, you may need to seek a competent adviser (See Who Can You Trust) Problem is, I don't know of any that could adequately address the issues I just mentioned. But try anyway. Be sure you understand basis, be sure you have an HP12C, be sure the agents are competent. Do NOT just get a referral to just anyone without doing your homework.

1997 COMMENTARY ON VARIABLE LIFE: Here is another real life example of why variable life is a bad thing to do. The figures on the policies came from an article in California Broker- an insurance trade magazine. The article did point out the inconsistencies between various products, but did not go into why you would use them in the first place. I'll use the two that showed the highest values at 20 years. Male age 45, 1,000,000 death benefit, policy endows at age 95, premiums paid for 20 years and a gross investment return of 9%. The policy was designed for maximum income, NOT insurance coverage. For other alternatives, get the April 1997 edition of California Broker.

Carrier Net Return Cash Value in Years 1 10 20 Income Year 21- 40

A 7.44% 9,472 132,785 393,493 33,243

B 8.3% 9,085 127,017 396,361 34,257

Carrier Death Benefit 1 10 20 40 Guaranteed death benefit

A 127,442 350,735 611,493 71,785 24 years

B 216,485 334,417 603,761 85,733 20 years

So what's the deal?

These policies cost $10,000 a year. Carrier A provides $127,500 insurance to start- carrier B provides $216,000. If I bought the cheapest insurance for life, it would be about $1,000 a year for life. That means that $9,000 would be left over to grow in a separate investment fund. Now in order for my comparison to work, I am going to put the entire amount in index funds that have low turnover- about 5%+ per year. I also assume the same return as the variable life- 9%- I must also adjust for the capital gains that are thrown off each year from the index funds. At a 30% tax on the gain, it results in net yield of 8.87%. So using that for 20 years, and you have a value of $493,828. Add the $175,000 of insurance that has grown to almost $200,000 and you have a total death benefit of $693,828- far greater than either of the best two policies. Now the best income stream from the insurance is about $34,000 per year. So with my example, I can get $49,000 but have to pay the continuing $1,000 annually for insurance. The remaining $48,000 is taxable whereas the monies from the policy is tax free. After deducting 30% tax and you net approximately the same net $34,000. But I still have $200,000 in net insurance versus the other policies at about $75,000. And my policy now has a cash value of $50,000.

With the mutual funds, you have to use index funds all the way due to low turnover. And should you sell one prior to the 20 years, you will incur a taxable gain. Not so within the policy. But the figures for the policies could actually be much lower due to higher commissions charged. And I think that to be the norm. And as it turns out, my way gets more insurance and more money with a lot more flexibility with the funds right from the beginning. Do what you want, but paying a commission for variable life seems to be a waste of money and done primarily because you wanted to use a life insurance agent to do financial planning. That doesn't make sense.

Lastly, in 1996, nearly 1/3 of the $111.4 billion in retail sales of variable annuities were INSIDE IRA's. If you count the other annuities purchased in other retirement accounts, roughly 50% of sales were within existing tax shelters. That doesn't make sense.

VARIABLE ANNUITY VERSUS INDEXING: (1999) Here is a clear example of fraud (yes, I said that) that the NASD and SEC allows to be printed. It's for the use of a variable annuity taken right from my bank's marketing material.

Taxable Tax Deferred
Initial Investment 50,000 50,000
Value in 25 years @ 9% 187,800 431,200
Annual earnings after year 25 16,900 38,800
Taxes @39.6% 6,700 15,400
Net after tax income 10,200 23,400

"The hypothetical assumes a 9% annual return as ordinary income taxed at 39.6%. Illustration does not include any surrender charges OR fund operating expenses OR 1.40% annual insurance charge. If these charges were included, performance would be reduced".

First of all, there are literally no growth funds that pay out 9% as ordinary income that you are using as a long term investment. If there were and you invested in them for growth, you defeated literally every basic tenet of investing. Secondly, you HAVE to include the fund expenses. Thirdly, you should compare against an index fund where you have to recognize the minimal turnover rate- say 5%. That means that only .0045% of the annual earnings will be taxed as ordinary income. That's $90 a year in taxes on earnings of an initial $4,500 long term growth. Index costs at .25% max. So I'll make the index fund's return at 8.6% net. The annuity fund will have standard expense charges of at least .75% PLUS the 1.40% insurance charge for a total of 2.15%. I'll round down to 2% and a net return of 7%.

Taxable Tax Deferred
Initial Investment 50,000 50,000
Value in 25 years @ 8.60% and 7% respectively 393,294 271,371
Annual earnings after year 25 @ 9% 35,396 24,423
Taxes @39.6% 14,016 9,671
Net after tax income 21,379 14,751

Take a look at the real world folks and tell me how many of you fell for the bank's numbers. Sure their numbers were done "correctly"- and according the the SEC- legally. But they weren't the right numbers to put in in the first place. This is, in my mind, unethical and a fraud upon the public who will clearly believe the annuity company numbers. Even if they did suspect something, they still don't know what numbers should be used. And further, they undoubtedly used a broker/agent who couldn't do the numbers anyway.

Are there caveats to my interpretation? Yes- if you ran into a time frame like 1973/1974, you would sell your index fund and go to cash. In such case any gains would be taxable as Long Term Capital Gains. Still, your core investment are sold last so that may be a remote occurrence- though necessary to be recognized.

Look at one more item- if you died with the variable annuity, the gain in the second table of  $271,371 would be taxable at (to keep it consistent) 39.6% to net $163,908. If the index had been left alone, the net would have been $393,294- an advantage of $229,385.

So to all of you who bought variable annuities from a bank, brokerage house, financial planner, insurance agent- don't complain. You used exactly who you wanted without having to do any extra work to find competency. That's easily worth $229,385.

Or you used your next door neighbor or your son in law or someone that had nice legs, was active in your PTA, whatever. Obviously each one of them is also worth $229,385.

You paid your agents huge amounts of money to make commissions or fees that are reprehensible. But you didn't have to think because you trusted them. That's easily worth $229,385.

You are getting screwed.

Grow up and read a book.

2000 Commentary: The elements above effectively have not changed. While the whole life product above is no longer offered, there were many no lapse products during the last few years that accomplished the same thing. You buy insurance- even lasting past age 100- but where any elements of cash increase was totally extraneous to the purchase. You don't even factor growth into the equation. If your estate is going to be too big, you could gift it to a trust with minimal tax repercussions. If you didn't need the insurance later on- simply stop making payments. Again, minimal tax repercussion. Extra funds are invested outside of the insurance envelope (still considering indexing) and might/could be taxable at LTCG rates.  

Don't buy a whole, universal or variable life product from anyone without doing an analysis of No Lapse. But here is a caveat early in 2000. With the new XXX regulations, your agent will have to do a lot of work to determine costs and benefits as the products have invariably changed and now have higher prices. It's going to be a lot more difficult to do.

VARIABLE ANNUITIES: (1999) The Variable Annuity Research and Data Service (VARDS) reports that 161 variable annuity contracts offer some type of waiver that triggers payments that are not subject to the usual surrender fees. "Beacon Research, an annuity-tracking service based in Illinois, surveyed 282 fixed annuities and found that 35 percent have a death waiver; 18.5 percent contain nursing home waivers; 7.4 percent have hospital waivers; and a mere 2.3 percent carry disability waivers. VARDS shows the most popular waiver found in variable annuities is the nursing home waiver, with 103 variable annuity contracts containing that provision; 83 provide death waivers; 69 have terminal illness waivers; and 42 carry disability waivers."

MORE VARIABLE LIFE SALES: (2000) Tillinghast reports that the second quarter saw a 17% increase in variable life sales. Let's look at numbers. Assume you bought a $1,000,000 variable life policy and you died shortly thereafter. how much do you get? $1,000,000? Wrong!

$874,700. Now assume you let the policy grow internally to $1,500,000. You die, how much do your beneficiaries get? $1,500,000? Wrong!  $1,164,750. So you take out the $500,000 in fund growth and spend it. Then you try to take the $1,000,000 remaining in the policy and try to get it into an irrevocable trust. Wrong! There remains an incident of interest. No transfer. So your estate (actually your insurance) still  loses at least $135,300 in taxes. Don't understand all that? Not the point. Not one of the purchasers of a variable life policy has the foggiest idea what I am talking about. But they ended up paying a nice commission to someone for a product they universally should not have purchased. I know many agents don't understand the above either.

Variable Annuities (2000) I have an extensive article on the (Mis)use of variable annuities. They still are not valid for investors (investors generally don't buy VA's. People that don't have a clue, market timers (who normally don't have a clue either.) Some caveats are that high income people in certain states can shelter variable annuities from creditors. And people with LOTS of money can shelter bond interest from tax) Anyway the industry is continually coming up with additions to the contract as enticements.

1.Guaranteed minimum income benefit rider. This guarantees that you will receive a minimum monthly payment from your annuity even when your contract's underlying investments perform poorly. This rider requires that you have begun to receive payments from your contract. Example: Your rider says that monthly payments you receive will never fall below 80 percent of your first payment. Thus, if the first monthly payment to you was $800, and your investment performs poorly, the lowest your monthly payment can be is $640.

My comments- are you really sure you want a variable annuity payment? Probably most should consider a fixed payment. Without a financial calculator, annuitants will never figure out how badly they may be getting screwed due to low interest returns. You have to live a LONG time to make out with annuitization.

2. Guaranteed minimum accumulation benefit rider. This guarantees that your contract will be worth a certain amount of money by a certain date, regardless of investment performance. Unlike guaranteed minimum income benefit riders, these riders do not require that you have begun to receive payments from your contract. Example: Your rider says that your investment will earn 10 percent in five years. If at the end of five years, your investment has earned only 7 percent, the insurer will kick in an extra 3 percent.

My comment- 10% over 5 years is simply less than 2% compounded per year. If you are not astute enough to make adjustments in investments for more than 2% annually, you have my condolences.

3. Guaranteed minimum withdrawal rider. This guarantees that you will be able to withdraw a percentage of your original principal annually without penalty, regardless of how your investment performs. You can withdraw up to the amount of your original principal. Example: You invest $50,000 in a VA with this rider. In one year, your investment performs so poorly that it slashes your money in half to $25,000. You can withdraw 7 percent of $50,000 annually without penalty until you reach your original $50,000. The percentage you are allowed to borrow varies by company and by contract.

My comment- this is interesting considering the factors of 1973/74 where investors saw returns drop by 40%. If you are doing an immediate annuity, there maybe value- specifically for small amounts of money. But you need to remember that the costs of a variable annuity are well above 1% and this clause will add more costs. For those  with money, it's better to hire an adviser for 0.5%. You should do better.

4.Guaranteed payout floor rider. This product is for immediate variable annuities, which distribute monthly payments to you as soon as you start investing in the contract. This rider guarantees your payments will never fall below a certain amount. Example: If your immediate VA says that your payment will not fall below $1,000, but your investments perform so poorly that your monthly payment should be only $800, the insurer will kick in $200.

My comments- I won't bore you with the numbers but they don't hold up all that well. And, once again, are you sure you want variable payments on the way out?