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“We are made wise not by the recollection of our past, but by the responsibility for our future.” – George Bernard Shaw

Finding innovation in the field of financial services presents a challenge. Both financial advisers and financial products have become highly commoditized. It is difficult to distinguish oneself as providing anything unique. These days, financial advisers seek to establish their worth more on the basis of their personal relationships as a lifetime planner and coach to their clients and/or the specific niche of the population to which they cater. But the investment products themselves are almost the same everywhere. Even if the brokerage firm doesn’t have the open architecture necessary to offer the broad spectrum of the investment universe, one would be hard pressed to find major differences among the products and investment platforms being offered from one firm to the next.

It is an equally daunting task to find a newsworthy financial topic that doesn’t involve a scandal of some sort. Aside from scandals there is simply the occasional unprecedented rise of a company you never heard of or the unpredictable fall of a company, which the week before was the favorite pick for talk show hosts. But there is one investment product that at this point stands in a category of its own. Based upon an obscure Revenue Ruling (Revenue Ruling 4-PLR-125242-02) and a patented rider, the Lincoln National Life Insurance Company offers an annuity product that provides a tax advantage that others cannot claim.

I don’t endorse products of any kind, and I don’t suggest this product would be appropriate for all investors or all circumstances. But the fact that this product’s unique feature has been patented and that Lincoln’s competitors fought hard and lost over the patent issue is newsworthy. And in this possibly recessionary environment, the only type of investment product on the market that can offer anything close to a guarantee while still participating in the market, such as an annuity, seems to be an appropriate topic.

So what is so unique about Lincoln’s annuity? Hold that thought. Before we get to that point let’s first review the pros and cons of annuity products. The first two primary advantages are both elements of risk management. The first is the “guarantee” provided through insurance that provides the function of asset preservation. The annuity does more than minimize the risk of loss. It guarantees there will be no loss. The fact that there is any kind of a guarantee makes annuities unique in the investment world. There is an element of a guarantee in all types of annuities, both immediate and deferred, both fixed and variable (immediate annuities begin the payment of income right away, while deferred annuities start to pay out after a long-term holding period).

Similar to a bond, a fixed annuity guarantees that you will have a predetermined minimum rate of return and that you will not incur a loss, assuming the credit of the bond issuer or the insurance company is sound — be sure to research the credit rating of the insurer. The second risk management feature in the case of variable annuities is that it allows the investor the opportunity to take the risk of investing in the market while eliminating the downside risk (variable annuities, which must be sold by a licensed investment adviser because of the aspect of the underlying investments, allow you to invest the underlying cash in the market in what are called sub-accounts, which act similarly to mutual funds). The secondary advantage is the opportunity for tax-deferred growth outside of a retirement plan. Like an IRA, once you start taking an income stream from the annuity, you pay ordinary income taxes.

There are many different types of additional terms and features that are appended to the annuity contract with the insurance carrier by way of additional riders. And given the fact that each benefit, through a carefully crafted rider (indecipherable to most) carries an associated cost, it is important to fully understand the costs and benefits of each rider. The cost of the various annuity riders is one of the primary disadvantages. You don’t want to be paying for benefits you don’t need or missing riders that would accomplish something you truly need or desire. The other disadvantage is the lack of liquidity, the lack of flexibility and the inability to cash out your annuity if necessary.

The answer to overcoming these disadvantages is quite simple from a planning perspective. Keep your cash for emergencies outside of the annuity, after calculating how much of an annuity you need for your annual fixed expenses. And keep the cost of the annuity down through a careful analysis of the various riders, only using those that accomplish what you want the annuity to achieve. In this manner, the consumer is able to create the product which suits their individual needs without the unnecessary cost of superfluous riders.

The problem most consumers found in the past was that the riders, and their associated costs, were so confusing that they found it difficult to understand and compare, nevertheless construct the annuity of their dreams. Insurance salesmen or unscrupulous financial advisers easily manipulated the most vulnerable consumers. So let’s demystify the riders and their costs. The cost is expressed in terms of “basis points.” Simply put, 25 basis points constitutes one quarter of a percent in cost. One hundred basis points would constitute 1 percent in cost. Simple, once you know the formula. The different riders provide living benefits and death benefits.

The standard death benefit provides that your heirs will receive the initial premium amount, the amount you originally invested in the annuity, plus any accumulated growth in the mutual fund sub accounts. The annual “ratchet,” or “step-up,” death benefit rider provides that your beneficiaries will receive the account value on the date of death or the highest account value on any one of the annual anniversaries of the contract purchase date, whichever is higher. This gives you the opportunity to step up the basis annually if the market is making the account value grow. Another more complicated death benefit is the “annual step-up plus,” a percentage roll-up rider, which provides an annual minimum rate of return to your beneficiaries, usually somewhere between 5 percent to 7 percent, in case the market returns were flat or negative. Your beneficiaries would receive either the highest annual stepped up account value or the minimum rate of return, whichever was greater.

The features I find most interesting are the living benefits. The living benefits are all about the creation of an income stream, and in this day and age when everyone is talking about the retirement of the baby boomer generation, that function seems particularly important. Baby boomers everywhere are asking themselves, “How will I support myself throughout my retirement?” Drawing down on your nest egg until it disappears is not the best solution. But annuities offer several different options to create an income stream.

The first option to create an income stream and the least popular to date is annuitization. This involves forfeiting your investment at its current value in exchange for a guaranteed lifetime income. Essentially, you draw down your investment, and there is no lump sum upon your death. If you die prematurely, your heirs may continue to receive your income until the end of 10 or 20 years, depending upon the option you chose. But the payment of income is for your life or a period certain, whichever is longer. A small percentage of consumers choose to annuitize because the rate of return is low. However, the option is expected to grow in popularity as the thought of income for life may look attractive to many who experienced the stock market bursts of the beginning of this century.

Another option to create an income stream is called “systematic withdrawal” or “guaranteed minimum withdrawal” benefit. This option allows you to withdraw the same amount each month, each quarter or each year. However, this method can get complicated because the amount you withdraw can affect other benefits, including living benefits and death benefits. A recent innovation by Sun Life created what are termed “storage buckets,” which allow one to systematically store amounts one might have withdrawn to save them up for future uses like emergencies.

The most popular living benefit rider is the guaranteed minimum income benefit. By investing in an annuity with a GMIB, one can receive an annual income based either upon the annual stepped up account value or a guaranteed minimum rate of return, whichever is greater. In all these annuities, we start to pay ordinary taxes when we take an income stream or withdrawal of any kind. Here is where the Lincoln annuity diverges from the rest. Instead of paying ordinary income taxes on the income stream, a large percentage of the income stream is tax free. The patented withdrawal feature calculates the income stream based upon your age, your life expectancy and forecasted investment performance and the consumer is provided a current and a minimum income level prior to investing. The investments in the subaccounts are managed by American Funds.

As an example, a man who retires at 65 could start receiving an income based upon 8.1 percent of the principal amount and yet 70 percent of that income would be considered to be a return of principal and thus nontaxable. This is a feature worth getting excited about for anyone who has a large amount of nonqualified money they would like to put away to grow on a tax-efficient basis.

One situation that immediately comes to mind is a business owner whose entire net worth is tied up in his business. Perhaps he has been unable to earn enough cash flow to put away money in any kind of retirement plan. Once the business owner decides to sell and retire, he or she is looking at some significant taxable consequences on the sale alone. If that same business owner puts the sales proceeds, or a portion thereof, into an annuity with this patented feature, then a substantial portion of that income will be taken out tax-free. The same is true for personal injury plaintiffs who have a large settlement or award that needs to be invested safely and tax efficiently for their long-term care.

In the final analysis, the key to evaluating an annuity product is to determine first what you would like to accomplish. There are annuity products that do a great job of providing lifetime income but accomplish little in terms of death benefits for one’s heirs. Likewise, there are annuity products which provide great benefits in terms of preserving one’s assets for future heirs, while doing little to support the lifetime income requirements for a couple during their 25 to 30 years of retirement.

In the end, most annuities will cost you between 2 and 3 percent. This may seem like a lot to pay to guarantee a 6 percent rate of return. However, if you take into consideration the cost of investment management, typically at least 1 percent, and the underlying cost of most mutual funds, another 1 percent on average, then you get pretty close to the ordinary cost of using a professional financial adviser to manage your money. In that case, the additional 1 percent for the guarantee seems like a bargain. Also note that it does not cost the consumer extra to use the assistance of their financial advisor to evaluate these different products.

LESLIE A. MARGOLIES , is a certified retirement counselor and a financial adviser with The Quigley & Murray Group of Wachovia Securities in Jenkintown, Pa. She specializes in retirement counseling for attorneys and business owners. You may contact her at 215-572-4213 or [email protected].

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