In order to make a return higher than the risk-free return of a treasury bill, an investor must take some element of risk. There is nothing wrong with risk. By taking that risk, the investor is offered a potentially higher reward. Some risks are very small and some are very big. It is really up to the investor to understand what exactly the risk is, what the potential losses are, and what the potential rewards are. Once you understand and are willing to accept the given potential for loss, then you can proceed and hopefully reap the benefits of the investment.
It is interesting and even shocking to note that the reason the entire economy almost collapsed in 2008 was because very sophisticated investors did not understand the risks associated with the investments they were buying. Somehow (too many chapters to describe how) those who bought mortgage bond securities that were issued by the government agencies of Fannie Mae and Freddie Mac thought the securities were backed by the U.S. Government. As it turned out, they were not. Pension plans of corporations and countries assumed these were extremely safe investments. When the securities started to fail and everyone realized that what they were holding was junk instead of AAA-rated U.S. Treasury-backed securities, panic ensued. Eventually huge losses and bankruptcies followed because so many of these securities became worthless almost overnight. In essence, the most sophisticated investors made the same mistakes that many average investors can make.
Safe, But Potentially Costly: Annuities
Insurance annuities are one of the most heavily sold types of products that offer a "guarantee." Although these products are good in some situations, I am not a big fan. They are very complex instruments and misunderstood by most investors. The primary reason individuals buy annuities is because of guarantees that appear to reside within the contracts. (These products also pay very nice commissions to the agents selling them.)
An annuity by definition is an "income stream" for some specified period of time. This is where the confusion lies. Did I say lies? Well, let's just say it can be confusing. What is guaranteed
There are so many variations on the annuity theme that it would be impossible to sum all of them up in this space. What needs to be understood is that an annuity is a contract between an insurance company and an annuitant (investor). When you hand over money to an insurance company, you really need to be sure you understand all the ins and outs of the contract you are signing -- especially the "outs." How do you get out? What is the guaranteed cash value if you want all your money at the end of the first year? Or the second year?
Finally, we should mention the taxes and fees associated with annuities. If an annuity is not invested within an IRA, then you have tax issues. If you need cash, interest must come out first and it is 100% taxable. Also, you generally cannot re-register (gift) the asset to, for example, a family member without redeeming the asset and causing a taxable event. Finally annuities can be very expensive contracts. You have to consider: What are the fees to redeem the annuity? What are the annual management fees of the contract? What are the expenses of the underlying investments?
There are some very low cost annuities out there. Vanguard is one. It is a low-cost variable annuity that you could get into and out of at any time with no redemption fees. It even has some guarantees in terms of income that are worth looking at. This is a fine option for people stuck in the annuity world. (Here is what I mean by "stuck": If you put 25k into an annuity a few decades ago and, more or less, forgot about it, you may see it is worth 125k today, and you might decide to dump it and use that piece of money toward a purchase of a home in a golf community. The problem is that 100k of that money is now taxed fully as "income," not capital gains. Therefore,
There are some clean interest-bearing annuities out there that can get you a good return much like a certificate of deposit, but it is vital to review your options before jumping into the world of annuities, many of which offer guarantees -- but at a price that can turn retirement into something short of paradise.
You Don't Buy Guarantees. You Buy Risk
You cannot have a high return without assuming risk. Investing is not about buying guarantees; it is about buying risk. By purchasing risk, you can make a nice return for assuming that risk. Good investors understand the risks they are taking and they can differentiate between a low level of risk and a high-risk investment. They also understand diversification. They know how to spread risk and hedge risk. With this knowledge they can build a portfolio that can make a decent return, at rates better than a treasury bill, without compromising their retirements.
John R. Ruocco is sole owner of Asset Management Associates and has provided independent, fee-only investment advisory and portfolio management services for over 20 years. For more information and advisory fees, contact John R. Ruocco at 1-800-208-8588 or firstname.lastname@example.org in South Windsor, CT. The first consultation is always free. Information, brochure, and form ADV part II is available upon request or log-on to www.assetmanagementassociates.com. John waives his fees for veterans and their spouses for the first six months of his services.
Editor's Note: This article is for information purposes only and does not constitute endorsement or recommendation of any kind by the publisher. Please seek appropriate investment or tax counsel before entering into any investment or financial transaction.