The Investment Scientist

images-75Yesterday I received an email from a doctor client of mine telling me how he had a conversation with some fellow doctors, and all of them are pulling their money out of stocks because they feel that with the market breaking new high after new high, a crash is imminent. He wanted my opinion.

First of all, while all of his doctor friends might feel a market crash is imminent and certain, there is simply no such thing as certainty in the stock market. All we can work with are odds. The following are the odds of market corrections:

Magnitude of market decline Frequency of occurrence (out of 64 years from 1950-2013)
>5% Every year (94%)
>10% Every two years (58%)
>20% Every five years (20%)
>30% Every ten years (10%)
>40% Every fifty years (2%)

My study also shows that the market breaking a new high does not substantially change the odds of returns. In other words, the odds of the market dropping over 20% in the next twelve months are still about one in five; the odds of the market dropping over 30% in the next twelve months are still about one in ten.
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EIA Salesman

Typical Salesman’s Chart for EIA

Financial author Allan Roth once wrote an article called “Investment Trick – Annuity Style” where he asks a rhetorical question, “If the S&P 500’s total return is 12% in a given year, what do you think your equity index annuity (that is supposed to track the S&P 500) would return”?

  1. 10%
  2. 8%
  3. 5.4%
  4. 3.4%

Allan Roth goes on to explain why the correct answer is 3.4%. Boy, was he wrong! Read the rest of this entry »

images-65 A client of mine bought a fixed rate annuity a few years ago. She was told by the agent that it’s just like a savings account, only with a higher interest rate of 3%.

Recently, we took the money out in favor of a better investment, and boy was she in for a shock! There was a $17k surrender charge and nearly $3.6k in tax withholdings. All the interest she supposedly earned in the annuity went to the surrender charges, and now she has to pay income taxes on that interest!

Here is why a fixed rate annuity is nothing like a savings account.

1. A savings account is FDIC guaranteed, in other words, it has the full faith and credit of the US government behind it. A fixed rate annuity is NOT FDIC guaranteed, it only has the credit of the issuing company behind it. Think AIG! Read the rest of this entry »

Sunk-shipMany people keep their bad annuity investment because it imposes a stiff surrender charge. This is a stereotypical example of sunk cost fallacy, an academic term which describes people throwing good money after bad.

Why surrender charges are sunk costs?

Imagine you were sold a $100k variable annuity with a ten year surrender period. The agent who sold you the contract collected a 10% commission, or $10,000. Where do you think this money came from?

Bingo! Your pocket. I hate to break it to you, but insurance companies are not in the charity business and they sure as heck aren’t gonna tell you that 10 of the 100Gs you just handed over to them are going to pay the agent’s commission! If they did that you’d pull your money out and rightly avoid them like the plague in the future.

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images-38Recently I was approached by two prospective clients. The husband is a very successful entrepreneur and they are also very frugal. As the result of that, they have accumulated substantial wealth – north of $5mm.

The only problem? all of that money is in about 28 variable annuities they purchased over the years. In examining these variable annuities, I turned up the following problems:

1. Horrible returns

For each variable annuity, I was able to calculate its annualized return.

Out of the 28 variable annuities, only two have annualized returns above 4%. Seven have annualized returns between 3% and 4%. Six have annualized returns between 2% and 3%. The rest (13 of them) have returns less than 2% including a few that have negative returns.  The average annualized return? 2.12%. Not enough to beat inflation!

2. Horrible surrender charges

There is this one annuity they purchased from Jackson National Life in 2007 for $200k; today it has grown to a “value” of $245k, but if they should cash it out, they would only get $221k since there is a surrender charge of $24k. After seven years, there is still a surrender charge of 12%! This is just horrible! Read the rest of this entry »

On March 19th of this year, the Maryland legislature approved a bill that would raise Maryland’s current state estate tax exemption from its current $1 million leve. The Maryland legislation, which is expected to be signed shortly by Governor Martin O’Malley but as of today it is still awaiting his signature would eventually raise the Maryland state exemption level to the federal estate exemption level.

Currently, assets forming part of a Marylander’s estate upon his or her death in excess of the $1 million threshold would be subject to astate-imposed estate tax this year. Unlike the 2014, federal estate tax exemption amount of $5.34 million. The Maryland legislation provides for the estate tax threshold to continue to rise until it is aligned with the federal estate tax exemption in the year 2019. In 2015, the threshold will be $1.5 million; in 2016, $2 million; in 2017, $3 million; in 2018, 4 million; and finally, in 2019, an amount equal to the federal threshold (which is projected to be $5.9 million in that year once it is adjusted for inflation).

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I met a couple today (who could become my clients.) The husband is a medical specialist who has been making close to $1mm a year, the wife is a psychologist who was making peanuts. They are both retired now and planning to claim social security incomes.

To maximize their incomes, there is a little-know “File and Suspend” strategy they can use. Here is the gist of it according to Kipinger.

Say you are the higher earner and want to delay until 70. If your wife is 62 or older, she could collect her own benefit — but perhaps she’d get more money with a spousal benefit. One catch: She can’t collect a spousal benefit until you file for your own.

 

As long as you’re full retirement age, you file for your benefit and your wife applies for a spousal benefit. You ask Social Security to suspend your benefits. Your wife will still receive a spousal benefit, and you can continue to accrue delayed retirement credits until you reapply for benefits, presumably at age 70. Because you’re increasing the value of the survivor benefit, this “file and suspend” maneuver supercharges the survivor benefit for your wife if you die first.

 

Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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