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Remember: There is no such thing as a free-lunch

Periodically I see financial services companies offering a free financial plan, for example a free retirement analysis or a full blown comprehensive plan. Usually this is to someone that may hold an investment or bank account with the company; sometimes just a general offer to anyone interested in their financial services. All I have to say is buyer beware.

In marketing, this is what you call a loss leader, a pricing strategy where in this case a service is sold below cost in an effort to stimulate sales in another profitable item that the vendor provides. It’s a marketing ploy.

The big problem with the free financial plan is that the actions prescribed in the plan will have far more influence on your probability of achieving your goals than the financial products, usually investment and/or insurance products sold to implement the plan. Your actions concerning savings, spending and the timing of these actions will be the dominant determinant of your success. The products bought to implement the strategy is always secondary, or a sub-set of a financial plan.

If the provider of this advice is discounting the value of this advice, how good is this advice to begin with? Or if they are giving away the advice, isn’t this an indicator that they don’t provide enough value in this advice to be profitable at it (and successful at what they do)? Or are they masquerading as a financial planner when they really are pushing product? If they are only getting paid when they make the sale, don’t you think there is a bit of a conflict here? Over the past few years, I’ve taken advantage of these “free” offers to see what they are all about. In the end, what you get is a cookie cutter analysis lacking in depth; leading to the push to buy something, usually a proprietary product. Isn’t discounting what’s most important and instead just charging more for the purchase of the less important aspect, the product a little backward?

In the end, it’s like what my mother always said: “You get what you pay for.”

Tax Reform in Maine? What a Joke

With the threat of TABOR back in November and the savings estimated by the state’s school consolidation plan, where has this gotten us in terms of tax reform: Nowhere.

The big problem with this tax proposal is that this is a gimmick. In return for the favor of relief in the highly visible income and property tax, were going to end up paying it in all sorts of silly, complicated and less visible ways (I guess I’ll stop eating my fritos) where it’s making business do it’s dirty work. Anybody ever look at a gas pump just to see how much you pay the state for pumping a gallon of gas? That’s the road were heading down.

The bottom line is that the state pulled the old revenue neutrality game, replacing one tax with another and hiding behind the excuse of fiscal discipline. The problem isn’t on the revenue side, it’s simply because Augusta can’t control their spending habits. When one can’t control their spending, they go bankrupt. When a company can’t control their spending, they go bankrupt or get bought out. The problem is that when the state can’t control their spending, they ask their constituents to pay. A constitutional amendment was dropped that would have made it more difficult to raise taxes; although I thought this was a little extreme, it may have been the leash for the state’s denial that they have a serious spending problem.

I’m sure the status quo is chuckling all about this, but the bottom line to Augusta is that this is the taxpayer’s money, not yours. And it’s your duty to spend it wisely and efficiently, not on some pie in the sky ideas with the grandiose idea that you can influence society with your actions. It may create many difficult decisions, but nobody put a gun to your head and forced you to run for office. You volunteered for the job.

For the taxpayer: if you aren’t happy, you have two powerful tools: Money and Votes. That’s the only thing that the politician will respond to. And in the meantime, let’s hope that a leader will emerge from one of us; because from what I’ve seen, there is not an awful lot of it up in Augusta.

One Lousy Retirement Account: The Variable Annuity

In the past, I’ve discussed the merits of Immediate Annuities and I’ve also told you to avoid Equity Indexed Annuities. Now it’s time to discuss Variable Annuities as it is long past due.

For those who do not know what a variable annuity (VA) is, in a nutshell it is an investment vehicle wrapped within an insurance contract. Premiums with the VA are invested in mutual fund like investments. The investment in a VA grows tax-deferred and is taxable as ordinary income (with a 10% penalty if withdrawn before age 59 ½) when withdrawn. VA’s usually come with a death benefit that insures that your beneficiaries get at least your investment in the contract if you pass away if the value of the VA is below the amount that you invested in the account at that time. Also, many VA contracts are now available with life or living benefits that guarantee that you get at least your original investment usually compounded with a certain interest rate when withdrawn at retirement.

So what’s not to like about VA’s? Plenty:

Tax Erosion: In most cases, if you are investing in equities you would be better off owning an index or tax efficient mutual funds rather than a VA. VA’s are taxable as ordinary income, with rates ranging from 10% to 35% while long-term capital gains taxes are taxed at either 5% or 15%.

Surrender Fees: VA's are subject to surrender charges if you withdraw a certain amount of your balance, usually in excess of 10% within the initial years of the contract. Surrender charges atypically start at 7% of your investment and decline over a certain amount over time; on average around 7 years. The term of the surrender period and the penalty percentage can well exceed the averages. If an investment was so wonderful, why do they have to “hold you hostage” for such a long period of time? It is a sneaky little trick. Since most people are loss averse, they stick within these accounts because they want to avoid paying the fee to exit the account; and if you stay in the account, they “gotcha” with the………..

Excessive Costs: According to Morningstar, at the end of 2005 the average insurance cost of a VA is 1.35%. Add this to the expense ratio of the mutual fund and you can run well north of 2% in annual expenses. Doesn’t seem like an awful lot, but see what costs can do after a long period of time:

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In many cases, the death benefit rarely pays out in a VA because over the long-haul, the odds that you will die with your portfolio “under-water” from the amount invested will be quite low. And what if your VA is above the original investment? The VA will still continue to assess its death benefit premium; and as the portfolio grows the dollar cost will increase exponentially. What about the living or life benefits? Usually the holding period of these benefits are 10 years. How many times has the S&P 500 lost money over a ten year period? Of the rolling ten year periods from 1926 to 2006 it has happened only twice in seventy-two periods. And this happened back in the great depression. Is the life or living benefit that tacks on usually .5% in additional costs to the income base really worth it? And in addition, this doesn't prevent the insurer from using its own conservative annuitization rate to stealthy deplete the guaranteed growth rate. The bottom line is minimal guarantees in light of the risk you are taking and paying excessive costs for that protection.

Your Heirs won’t be Happy: Most assets receive a step-up in cost basis when they are inherited, lowering the tax significantly or totally from the gain when heirs sell the asset. Not the case with a VA. VA’s are subject to income in respect of a decedent, which means that the earnings from the VA will be subject to income taxes when withdrawn from the account. Imagine if you are subject to estate taxes? The combined tax can take a significant amount away from the total estate.

When does a VA make sense? If a person is in a high current tax bracket and expected to be in a very low tax bracket when they withdraw the funds, has a time horizon in excess of ten years, doesn’t have a concern about the income tax implications to their heirs and exhausted their available contributions to their 401(k), IRA or other annual retirement savings vehicles for the year, it may make sense if you choose an annuity provider with low costs. But to be honest with you, I’ve been a fee-only, independent financial planner for over nine years now where I have an endless amount of options and not restricted to proprietary or “in-house” products like some other advisors. And I’m still haven’t found that person yet where this would be a prudent alterative.

What are the red flags? One is when someone tries to sell you a VA in an IRA; the tax-deferral is redundant, comes at a higher cost with only the death benefit is the plus (and I’ve talked about how diluted this benefit really is). Also is selling these things to the elderly; when you have a surrender charge that may outlive the individual, that’s a sham. Finally someone selling you on flipping one VA for another; the person advising this better have a compelling argument that the benefit of this will exceed the cost. If not, you just have a new surrender period and the person selling this enjoys a wonderful commission for their effort. But these are things to watch out for, and the regulators would certainly like to know those salespeople who are engaging in these practices.

In the end, these products are often part of abusive sales practices; usually attracting the fear based investor that doesn’t understand the true risks involved and the hidden costs. And there has been some positive innovations to this type of account; recently one provider has provided a death benefit fee that is a flat amount over time (certainly better than paying a certain percentage over time, with that percentage increasing along with the asset level for a benefit that is probably not going to pay out). But in the end, buyer beware because these vehicles are usually a rip-off.