Annuity

[ILLMAS]

Hello to all, just wondering if anyone is familiar with a MasterDex annuity? I have a TP that had intially invested $11K in 2005, it grew over 2 years, then in 2008 it went down to around 10K, losing about 1K from his intial investment. Now TP wants to amend his tax return to reflect a loss on investment, since this is not stocks, I would use Sch A to report the loss?

Here is something I found about MasterDex annuities:

BOSTON (MarketWatch) -- A whole lot of people would settle for "some" of the stock market's gains in exchange for a promise that they would never lose money, no matter how ugly the market gets.

The entire equity-indexed annuity business is built on just that promise. And while it sounds like a great deal, all too often it isn't.

To get a no-lose guarantee, investors often wind up with a hard-to-win-by product like the MasterDex 5 Annuity from Allianz Life Insurance Co. of North America, an investment that sounds good until you get past the simple sales pitch into some devilish details.

That's why MasterDex 5, a product that is fairly typical of the entire genre of equity-indexed annuities, is a clear choice for Stupid Investment of the Week.

Stupid Investment of the Week showcases the danger zones that make an investment less-than-ideal for the average consumer, in the hope that spotlighting trouble in one situation makes it easier to root out elsewhere. The column is not intended as an automatic sell signal, especially with annuities, which can be the "roach motel" of investments, where your money goes in but it's hard to get out.

MasterDex 5 carries surrender charges for 10 years, and the penalty is 15% for anyone who bails out within the first three years. The surrender haircut is more than 6.6% through the first seven years of the contract. Ouch.

Some in the insurance business would argue that MasterDex 5 should not be considered an "investment" at all. Although it combines the features of a traditional insurance product (guaranteed minimum return) with features of securities (return tied to an index), MasterDex 5 -- like most equity-indexed annuities -- is not registered with the Securities and Exchange Commission.

Buyers plunking down a minimum of $25,000 may think they are buying a regulated security, but they're not. Failing to understand the difference is a problem, as investors who miss this basic issue will have real trouble spiriting out danger in the sales literature.

Pat Foley, chief marketing officer at Allianz, sums up MasterDex 5's audience as people "who want tax-deferred growth on their money with no downside risk," and noted that MasterDex 5 fits in somewhere between the buyer's more traditional fixed-income and equity investments.

How they work

Equity-indexed annuities are a contract between the buyer and an insurance company. During the accumulation period -- the time when the buyer makes either a lump-sum payment or a series of premium payments -- the insurer credits the buyer with a return that is based on changes in a stock index, like the Standard & Poor's 500.

The insurer typically guarantees a minimum return, provided the money stays in place long enough. The potential index return is limited; in the case of MasterDex 5, the monthly cap stands at 2.6%.

MasterDex 5, according to its sales literature, "tracks point-to-point monthly changes in the market index. Once a year, those 12 months' values are automatically added up and credited, if positive. ... MasterDex 5 can deliver 100 percent of market index growth."

The first point is confusing. The second, while true, is highly unlikely. Here's why:

Point-to-point progress means you get the index's value, not its total return. Say goodbye to dividend growth; a few percentage points may not seem big, but they add up when an investment is being held for more than a decade.

Admittedly, if the index finishes down by this formula after 12 months, your index credit is zero, rather than a loss. But point-to-point also costs you the compounding effect you would normally get buying and holding an index fund.

And you'll only get 100% of the index's return if the index never goes up more than 2.6% in any month.

Allianz tested MasterDex 5 for the period 1995-2004, and showed that the initial deposit nearly doubled, growing roughly 7% per year; an uncapped investment in the S&P 500 would have more than tripled, with an average gain of more than 12% annually despite the rough years of the bear market.

"You can't assume anything, because even the market cap can change," says Michael E. Kitces of Pinnacle Advisory Group in Columbia, Md., co-author of The Annuity Advisor. "Every contract has its nuances and its catches, and you have to read the fine, fine print to find them."

In fact, when MasterDex 5 was first introduced in 2004, the monthly cap on market returns was 3.2%. While the first buyers might have been aware that the cap could change, they most likely weren't expecting that big a cut so quickly.

One plus to MasterDex 5 is the 5% "premium bonus" you get on the money you plow into it. Foley noted that people like getting what amounts to a 5% return right off the bat.

But with the sales person getting a commission that can be as much as 9% on the first premium, and with the money locked up with those heavy surrender charges, it's a safe bet that Allianz can afford the "bonus" without hurting its profit margin.

Throw in headache-inducing rules for withdrawals -- pull your money out at the wrong time and you can kiss off a year's worth of gains -- and loans against the annuity contract and you've got a product the average investor almost certainly doesn't understand well enough to actually purchase.

"It's for people who are absolutely deathly afraid of losing principal, and those people should be in a CD or a bond," says David Bohannon of Consultants Corner in Louisville. "This takes them out of their comfort zone, and the only reason they get comfortable with a product like this is that they really don't understand what they are getting. If they did understand it, they would never do it."

What to consider

Every equity-indexed annuity is different, with unique quirks to consider.

As a result, consumers should ask their agent or broker plenty of questions before investing -- or they should hire an independent insurance consultant to review the contract before plunking down so much money. Here are some basic concerns that financial advisers suggest reviewing before signing the deal:

What is the annuity's term? You most likely are tying up your money for at least five to 10 years, but you need to know the expectations up front.

What happens if you want out early? Surrender charges can reach double digits, but it's more than that. In some contracts, if you pull money out, it goes against your balance from the start of the policy year, meaning it can cost you 12 months worth of gains. Some policies credit just a part of your earnings. And, depending on the timing, getting out early can mean taking a loss.

What exactly do you earn when the market goes up? The percentage rate you earn (called the participation rate) may change from year to year. You want to know what your share of any gains is going to be, and find out how you would be notified of any changes.

Are there limits to how much you can earn? Sometimes, equity-indexed annuities put a cap on how much you can earn during the year. It pays to know this upfront.

What happens if stock prices decline? This depends on how your annuity is indexed. Since the purpose of an equity-indexed annuity is to protect you from losses, you want to see either no loss or a minimal gain. Either way, you want to know what kind of downside protection you are getting, because that's what you are paying for.

Chuck Jaffe is a senior MarketWatch columnist. His work appears in dozens of U.S. newspapers.

[TAXBILLY]

>>I have a TP that had intially invested $11K in 2005, it grew over 2 years, then in 2008 it went down to around 10K, losing about 1K from his intial investment. Now TP wants to amend his tax return to reflect a loss on investment, since this is not stocks, I would use Sch A to report the loss?<<

Are you saying he cashed in the annuity in 2009?

taxbilly

[JohnH]

I absolutely MUST remember the part of line 7 in the article which says anuuities "can be the 'roach motel' of investments, where your money goes in but it's hard to get out." Best description of this financial product I've ever seen.

I always tell my wife that if I'm gone and if she needs to seek financial advice, any advisor who recommends annuties should be shown the door immediately - no further discussion required because they have proven they have nothing of any significance to discuss with her.

Has the client cashed in the annuity, or is he somehow thinking he can deduct the decrease in value? If it's #2, time to explain what a taxable event looks like.

[Catherine]

<snip>

I always tell my wife that if I'm gone and if she needs to seek financial advice, any advisor who recommends annuties should be shown the door immediately - no further discussion required because they have proven they have nothing of any significance to discuss with her.

<snip>

Most likely true - especially if they start off with annuities -- but I have seen a few rare situations where it was not only the right thing but just about the only thing that would do what the individual needed. Then the trick is to find one that doesn't gobble up in fees anything it might possibly earn.

Catherine

[ILLMAS]

>>I have a TP that had intially invested $11K in 2005, it grew over 2 years, then in 2008 it went down to around 10K, losing about 1K from his intial investment. Now TP wants to amend his tax return to reflect a loss on investment, since this is not stocks, I would use Sch A to report the loss?<<

Are you saying he cashed in the annuity in 2009?

taxbilly

Yes he did, but he cashed out in 2008, but here is the problem, I learned this after I posted the questions, TP is 80 years old, he invested 11K in 2005, between 2005 and 2007 the annuity grew to over 13K, then it started going down, until it went down to about 10K, TP wanted for me to amend his tax return to claim a loss on his investment, from the intial investment + the max. growth - cash out = his loss. He tought his loss was from 13K max growth - 10K cash out = 3K, but I explained to him that his loss is only 1K and not the 3K he was thinking.

[JohnH]

Tell him he's not alone. Most of us have met lots of people in the past couple of years who wished it worked that way on almost any investment. Given that this is an annuity, I'd argue that he came out VERY well.