eAC Sales Idea:
Sequence Risk

Arithmetic v. Geometric Averages

This article series is supplied specifically for securities-licensed individuals. In many states, discussing sequence risk and how it may apply to a particular client’s portfolio could be considered investment advice. For a non-registered individual, it is generally better to avoid the discussion.

If you would like to learn how to become an Investment Advisor Representative, please call any of the Senior Market Sales annuity specialists at 877-888-0095.

The difference between Arithmetic and Geometric Averages

Arithmetic Mean according to investorwords.com: Simple average, equal to the sum of all values divided by the number of values.

Geometric Mean according to investorwords.com: A measure of central tendency calculated by multiplying a series of numbers and taking the nth root of the product, where n is the number of items in the series. The geometric mean is often used when finding an average for numbers presented as percentages

Why is this an important distinction?

Here is a real world example – I would contend that your clients generally think in terms of Arithmetic averages, not geometric averages. If your client were to look at the following table of returns, and calculate the average return, they would most likely give you the arithmetic average, which is 8%. Not too bad . . .

Return

-11%

25%

10%

Arithmetic Average

8%

Now let’s look at that same table of returns, but apply those returns to an initial investment of $100. If you were to look at that same table of returns, to determine the client’s effective annual rate of return over the period, your calculation would be based not on the arithmetic average, but on the geometric average – which looks a bit different.

Beginning Value	Return	Ending Value
100	-11%	89
89	25%	111.25
111.25	10%	122.38

Arithmetic Average	8%
Actual Annualized Return (geometric average)	6.97%

Helping your clients understand that calculating returns using simple averages is misleading can be a good workshop component. Have a worksheet on each table and door prizes that go to the winning table. When you are saving, your actual rate of return matters, but not nearly as much as in retirement, when you are basing your withdrawal rate and resultant income on these projections.

The example above is a great transition to “Sequence Risk” – the idea that losses early in retirement can have an extremely negative impact on the duration of the retirement portfolio.

The next eAC article will discuss Sequence Risk in-depth and provide a couple of slides that can help you position the principal protection features of indexed annuities as a way to counter Sequence Risk, particularly just prior to, and in the early years of retirement.

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eAC Sales Idea:
Becoming an RIA

If you are like most indexed annuity producers, you’ve probably gotten at least one e-mail, postcard, or seminar invitation aimed at scaring you into becoming a Registered Investment Advisor (RIA).  The purpose of this article is not to scare, but to inform.  Should you be concerned about the NASDs stance on indexed annuities?  How can securities regulators get involved in your insurance practice?  What are the advantages and disadvantages to becoming an RIA? 

Because of the buzz surrounding indexed annuities, these are important questions to have considered.  Whether you choose to become an RIA, or choose not to, you will want to make a conscious decision for the course you choose.

Background:

Since the NASD issued notice 05-50, the indexed annuity community has been on high alert, with senses awakened and watching for the slightest move from the NASD or the SEC.  In the two years since notice 05-50 was issued, there has been no such move from either body. 

In the absence of action on the federal level, there has been action on the state level.  Several states have issued some form of warning regarding non-registered producers giving investment advice.  In the past, in order to be considered investment advice, the adviser would need to have charged a fee.  These states have broadened their interpretation to include any non-registered individual who earns a commission by selling a product that replaces a product that would have required registration to sell in the first place, including mutual funds and variable annuities.  

Massachusetts issued a 50 page cease and desist order to an insurance producer who had been selling Indexed Annuities.  The order charged the producer as giving investment advice. 

Iowa sent a letter to all licensed producers highlighting a section that states that fixed only producers may not replace variable annuities or  mutual fund money with fixed annuities. 

Other states including Nebraska, Minnesota and Kentucky have taken similar steps.  These states are part of a trend that is spreading. 

Becoming an RIA

One of the potential solutions that will allow a producer to discuss mutual funds, variable annuities and other securities products in his or her seminars and client meetings is to become a Registered Investment Advisor, or RIA.  Starting an RIA firm is significantly different from becoming a Registered Representative.  As your own RIA, you does not need to affiliate with a broker-dealer, thus does not have any securities production requirements.  Further, an RIA does not actually sell securities at all, and does not earn commissions.  Instead, an RIA enables one to charge a fee for investment advice, and as a registered entity, it also gives the producer the ability to discuss the clients total portfolio including mutual fund and variable annuity performance.

It is actually relatively easy to become an RIA, requiring completion of the Series 65 examination and several filings with the state securities commissions.   There are services that can do this for you.

An RIA can most effectively be compared to a doctor.  Doctors are paid a fee to diagnose a health problem, not to sell a surgery.  In the diagnosis process, the doctor must evaluate all potential options, including mediations, surgeries, and other potential courses of action.  At the point of diagnosis, the doctor has a primary responsibility to explain the most effective potential option.

This is the same process most insurance planners follow.  An initial interview and research determines what client assets fulfill client needs and identifies any assets that should be repositioned to achieve the client's objectives.  In many cases, a client may be best suited by leaving a portion of long-term assets in the market.  The RIA has the ability to recommend money managers, such as Fidelity, Schwab, and countless boutique firms that can manage this portion of assets for the client's specific objectives.  Further, the RIA is able to collect a management fee for the funds under management.  As an ancillary benefit, the RIA may establish custodial accounts, and can better facilitate transfers from securities products into vehicles that may be more suitable for the conservative client.  When the time comes to select any insurance products, this producer has also placed himself in the best possible position to write any fixed business through his or her insurance practice. 

Starting an RIA firm is not right for every insurance producer.  If you look to a sale as the primary objective, as opposed to the client’s best possible option, the RIA route is not for you.  As an RIA, you will have a legal responsibility as a fiduciary.  Even though your RIA business should be completely separate from your insurance practice, you will expose yourself to a higher standard of suitability.  If you are comfortable in the fact that you hold yourself to the higher standard without the requirement to do so, then you have every reason to become an RIA.  It will help you build your practice. 

A Word of Caution

There are many Independent Marketing Organizations touting the RIA as the absolute solution to indexed annuity compliance.  It is not.  Ethical practices are.  Most of the marketing organizations offering RIA setup services will require that you move all your indexed annuity contracts there.  It resembles a broker-dealer requirement.  You do not need a marketing organization to do become an RIA, or to function as an RIA.  In fact, maintaining your independence is one of the greatest reasons to begin an RIA, as opposed to becoming a Registered Representative.  You can either complete the filings on your own, or pay a consultant less than you would pay these IMOs for the same result without the requirement to move contracts. 

We recommend Zachary Gronich of RIA in a Box (www.riainabox.com/gold).  He is a CPA and has been set up RIA firms for CPAs for the last five years.  He functions on a fee only basis and is competitive with the fees marketing companies are charging, without the requirement to move contracts.   He has no affiliation to eAnnuityCoach.com or Senior Market Sales, and we have no financial incentive for this recommendation other than helping our producers become more successful. 
 

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eAC Sales Idea:
Four-Stage Roth Conversion

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I’ve scanned my brain for hours and I can’t think of a single person I know who likes paying taxes. Even though we all know that taxes are a certainty, the idea of paying taxes earlier rather than later is still pretty repulsive to most people.

The anti-tax mentality is probably the number one hindrance to people who can benefit most from converting a portion of their retirement saving into a Roth.

What is a Roth IRA?

A Roth IRA is an after tax retirement account that allows funds inside it to grow tax free. Funds are taxed before they enter the Roth and any growth on those funds is distributed tax free.

Roth IRAs have 3 primary benefits over traditional IRAs:

1. Tax Free, Compound Growth
2. Post 70 ½ deferral – Not Subject to Required Minimum Distributions
3. After death tax free growth – Efficient Asset Transfer

For many people, converting traditional IRA assets into a Roth IRA makes sense for the above reasons. The purpose of this article is not to help you to determine whether or not a conversion best suits your client as it is to show you a way to convert to a Roth in an efficient manner.

The Roth Conversion Process

When an individual makes the election to convert IRA assets into Roth IRA assets, they are electing to pay the tax on the converted portion of the IRA today, in exchange for future tax-free growth.

In order to convert to a Roth IRA, an individual simply makes an election on their IRA to convert to a Roth. Brokerages, Banks, and Insurance companies all have procedures and/or paperwork for completing the conversion.

In the year of the conversion, tax will be due on the converted amount. For someone who is in the 25% tax bracket, $59,000 taxable income a year and wants to convert $200,000 into a Roth, the conversion would propel them into the 33% tax bracket and have them owing $61,000 in additional federal taxes plus state taxes, if they were a married couple with taxable income of $59,000 they would also end up in the 33% tax bracket owing $58,000 in federal taxes plus state taxes. That’s a tough pill to swallow, even if the future benefit is clear.

The Four-Stage Roth Conversion

For one year, in 1998, the IRS allowed people who wanted to convert IRA assets to a Roth to spread their tax liability out over the following four years. Individuals who would like to convert today do not have that option within the tax code…

However – there is a way to achieve the same end. If $200,000 were to be converted, an individual could purchase 4 indexed annuities, for $50,000 each that are based on a 4 year term. For the next 4 years, one $50,000 annuity would be converted each year. Because of the four year term of the annuity, no interest will have been credited within the annuity until after the date of the 4th and final Roth conversion. Because no interest will have been credited, the tax amount due will be the tax amount on only the $50,000, not the hypothetical value of what it could be worth on the day of the conversion. The end result for the client is that the income tax due on the Roth conversions would be spread out over a four year period plus you would save a single client $7000 and a married couple $8000 in federal tax.

A few items that need to be taken into account is the effect that the 4 year versus the 1 year conversion on the taxation on the Social Security income and the tax deduction thresholds will be raised causing more income to be taxed for a longer period of time.

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eAC Sales Idea:
Charitable Planning

Blacks Law Dictionary:
Annuity: A yearly payment of money for life or years.

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Insurance agents should be advised that the word “annuity” does not always refer to an insurance company product.  It is simply a legal term used to designate a period certain or lifetime income stream.  Too often, insurance agents hear annuity and assume a simple product sale.  With Charitable Remainder Annuity Trusts (CRATs) or Charitable Gift Annuities (CGAs) the term annuity simply refers to the income stream.  Are there ways that insurance agents can use these techniques to assist their clients?  Certainly.  It is necessary to remember though, that there is much more involved than simply selling a shelf product. 

An effective charitable strategy allows clients to fund a charity of their choice with funds they would have otherwise paid in taxes.  At the end of the day, the winners are the charity and the client.  This article will discuss two popular charitable techniques, the Charitable Remainder Annuity Trust (CRAT) and the Charitable Gift Annuity (CGA). 

In order to illustrate the differences between the techniques, we’ll take the Case of Mr. and Mrs. Brown.  Both are 70 years old and they are considering selling some appreciated land.  The land has an original basis of $500,000 and a fair market value of $2,000,000.  If they sold the land outright, they would face roughly $207,000 in Federal Capital gains taxes, plus state Capital gains tax of $128,340 (assuming CA tax rates).  After a 6% realty fee deduction and taxes paid, they would have $1,544,660 in hand.
What are their options?

The CGA – Charitable Gift Annuity

The Browns enter into a CGA contract with their favorite charity and transfer the land to it.  The Browns would receive a lifetime income stream of $118,000 as long as either lives.  They receive an income tax deduction of $1,242,693 (which can be used to up to 50% of their annual AGI or for the first five consecutive tax years after the annuity begins.  Of the income stream for the first 20.5 years (their life expectancy) approximately $57,831 is taxed as ordinary income.  After 20.5 years, the income is fully taxed as ordinary income.

Should they die prior to their life expectancy the income stream ends.  The funds remaining stay with the charity.  None goes to the heirs.  Under  IRC section 501(m) charitable entities generally can not use an annuity from an insurance company.  There are exceptions to this rule, but those exceptions are beyond the scope of this article.  CGAs are difficult for insurance agents to become involved with because of these limitations. 

The Charitable Remainder Annuity Trust

Although there are several versions of the Charitable Remainder Trust, the CRAT is the simplest version because the income stream is a set percentage of the original gift, thus income stream will be constant from year to year.  In this scenario, the Browns would transfer the their land to the trustee of the CRAT who sells it, free of capital gains taxes, and invests the proceeds.  If the income stream were established in August of 2006, it would be 7% of the value of the original asset, or $140,000 per year.  The Browns would be allowed a charitable deduction of $463,708 which could be used in the same manner as the CGA deduction. 

The taxation of the income stream depends on how it is invested by the Trustee.  If no investment income is earned then the income stream is return of principal and is tax-free.  If earnings are long term capital gains, then those rates would apply, and if it is other, it would be taxed at ordinary income rates.  If there are mixed investments, then a combination of rates would apply.

At the death of the Browns, the funds remaining in the CRAT pass to the charity, or several, of their appointment.  The CRAT can do some things the CGA can not do:

1. It can have multiple charitable beneficiaries.
2. It can have continuing income to the heirs of Mr. and Mrs. Brown
3. It can be created for a specific number of years (1-20)
4. It can have as many as 6 income beneficiaries.

The Trustee is reasonably free to invest trust assets where they please.  Investment of CGA funds is quite restrictive.  This is the opportunity for insurance agents.  A wise investment structure is to invest about 2/3 of the funds into secured mortgages (usually interest only or 240 month amortized) and 1/3 into a single premium deferred annuity.  The facts and circumstances of each individual case will determine the mix, but this structure allows the agent to make a solid annuity sale while helping a client save taxes and a charity receive funding.

Comparison: $2 million transfer - $500,000 Basis – Both age 70 – AFMR 6.27

	CRAT	CGA
Annual Income	$140,000	$118,000
Charitable Intent	Yes	Yes
Income Taxation	Depends on Investments; Cap Gains, Ord Income or mixture	Combination of Cap. Gains and Ordinary Income
Capital Gains Tax	None	Paid over statistical lifetime of owners
Income stream for heirs	Up to lifetime income	Not possible
Max Number of Income Beneficiaries	Up to 6	Up to 2
Remainderman Value Staying with Estate	$463, 708	$1,242,693
Charitable Deduction	$463,708	$1,242,693

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eAC Sales Idea:
Social Security Tax Deferral or Avoidance

Social Security was passed in 1935 as part of FDR’s New Deal with the goal of providing income for retirees age 65 and over. In 1984, with Social Security payments ballooning and experts predicting its collapse, the federal government made Social Security income taxable to individuals with income exceeding certain thresholds, in the hopes of helping to shore up the program.

A second tier of taxation on Social Security benefits was introduced in 1993, at which point the maximum amount of benefits that could be taxable was increased to 85%, again based on income thresholds.

The thresholds are as follows:

50% of Benefits Taxable 85% of Benefits Taxable Married $32,000 $44,000 Single $25,000 $34,000

The key is to bring the client’s adjusted gross income below the threshold by using a combination of tax deferral and tax-advantaged income streams.

Example:

Ron and Doty Wilson are 67 year-old retirees. They currently have income of $30,000 per year from Ron’s pension, $12,000 from Social Security and $10,000 of interest income from $250,000 in CDs they’ve accumulated over the years. Their adjusted gross income is currently $46,000, making 85% of their Social Security benefit taxable as ordinary income.

Their goal is to leave much of the $250,000 to their children while maintaining their present standard of living throughout retirement.

One way to minimize the tax on their Social Security benefit is to use the money currently in CDs to buy an annuity. Interest is deferred rather than paying tax on 85% of the Social Security benefit. They would pay tax on only 50%.

Another remedy to this tax issue is to use money currently in CDs to fund a split annuity concept and roll the pension funds into a Single Premium Deferred Annuity. The split annuity provides the income stream necessary to maintain the lifestyle Ron and Doty are accustomed to enjoying. And, because it is subject to an exclusion ratio, only a minuscule amount of the income stream is actually subject to income tax. In doing this, Ron and Doty now determine how much of their taxable (IRA) money they want to take out each year to maximize their tax bracket without paying tax on their Social Security benefit.

For this particular sales concept, it may be useful to partner with an accountant who is experienced as a tax planner. You benefit through increased sales; he benefits through client introductions; and your client benefits by reducing tax liability and ensuring a stable retirement.

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eAC Sales Idea:
The Simple Split Annuity

At its most basic level, the split annuity concept is a way for seniors to guarantee a tax advantaged income stream while keeping their options open on a portion of their savings. The split annuity concept has been around for many years, but the introduction of new products has created the opportunity for advisors to provide more effective, albeit more complex, split annuity concepts. This sales idea will explain a basic split annuity. For some, it will be review. For others, it will provide the foundation for more complex split annuity concepts that will be discussed in future articles in the series.

The split annuity is for the person who desires a guaranteed income stream with the option to re-evaluate their circumstances at certain points in the future. There are two annuities involved in the sale, a single premium immediate annuity (SPIA) and a single premium deferred annuity (SPDA).

For example, Don is a 67 year old retiree with $250,000 of nonqualified savings currently in mutual funds. He has been relatively happy with his returns over time, but is frustrated that he pays income tax each year because fund managers sell stock holdings within the funds or he is taxed when personally liquidating funds to generate income stream. Further, he is concerned about market downswings and that his funds may not be enough to carry him through retirement.

Some advisors might suggest he put his $250,000 into a SPIA. The result of this strategy is an absolute guarantee of a monthly income at approximately $1,900 per month, or $22,800 annually for as long as he lives. The advantage of the SPIA is that his income stream is subject to an exclusion ratio making only a portion of his income stream taxable. In Don’s case, 59.6% of Don’s portion is not subject to income tax. Because Don used a SPIA, his taxable income is $9,211.20 per year. Rarely do people have a single goal of maximizing their income stream. More often, people have a dual goal of creating income and leaving something to their children or grandchildren. The immediate annuity alone does not satisfy the dual goal.

The split annuity can do just that – guarantee an income stream for a period of time and provide an option to reevaluate financial circumstances at a later date.

Don may choose to put $125,000 into a 10-year period certain SPIA. For the next ten years, the SPIA could generate about $1,300 dollars per month with 79.9% nontaxable due to the exclusion ratio. Don would pay taxes on only $3,291 while still receiving $15,600 over the course of the year.

In conjunction with the SPIA, Don could also purchase a 10-year (or shorter) deferred annuity. Depending on Don’s expectation on returns, an indexed annuity product or a multi-year guarantee product would fit the bill well. Assuming a 7% rate of return, his $125,000 should be about equal to his original principal when his SPIA expires.

The split annuity strategy appeals to Don because if he were to die within the 10 years, his beneficiary would receive the remainder of the 10-year period certain annuity and would also receive the then-present value of the $125,000 deferred annuity.

If Don were to live past ten years, he could simply repeat the strategy, taking half of his deferred annuity and purchasing another 10-year SPIA (this is why the benefit period of the SPIA should match the surrender period of the SPDA).

The basic split annuity strategy would allow Don to guarantee a tax-advantaged income stream, while leaving money in reserve for heirs or for unforeseen circumstances.

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