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The Investment FAQ (part 8 of 20)

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Archive-name: investment-faq/general/part8
Version: $Id: part08,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

See reader questions & answers on this topic! - Help others by sharing your knowledge
The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance.  This is a plain-text
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for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.  

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly.  Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it.  Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers.  Readers outside the USA can reach
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Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Insurance - Annuities

Last-Revised: 20 Jan 2003
Contributed-By: Barry Perlman, Chris Lott ( contact me ), Ed Zollars
(ezollar at

An annuity is an investment vehicle sold primarily by insurance
companies.  Every annuity has two basic properties: whether the payout
is immediate or deferred, and whether the investment type is fixed or
variable.  An annuity with immediate payout begins payments to the
investor immediately, whereas the deferred payout means that the
investor will receive payments at a later date.  An annuity with a fixed
investment type offer a guaranteed return on investment by investing in
government bonds and other low-risk securities, whereas a variable
investment type means that the return on the annuity investment will
depend on performance of the funds (called sub-accounts) where the money
is invested.  Based on these two properties with two possibilities each,
there are four possible combinations, but the ones commonly seen in
practice are an annuity with immediate payout and fixed investments
(often known as a fixed annuity), and an annuity with deferred payout
and variable investments (usually called a variable annuity).  This
article discusses fixed annuities briefly and variable annuities at some
length, and includes a list of sources for additional information about

Fixed Annuities
The idea of a fixed annuity is that you give a sum of money to an
insurance company, and in exchange they promise to pay you a fixed
monthly amount for a certain period of time, either a fixed period or
for your lifetime (the concept of 'annuitization').  So essentially you
are converting a lump sum into an income stream.  Whether you choose
period-certain or annuitization, the payment does not change, even to
account for inflation. 

If a fixed-period is chosen (also called a period-certain annuity), the
annuity continues to pay until that period is reached, either to the
original investor or to the investor's estate or heirs.  Alternatively,
if the investor chooses to annuitize, then payments continue for a
variable period; namely until the investor's death.  For an investor who
annuitized, the insurance company pays nothing further after the
investor's death to the estate or heirs (neither principal nor monthly
payments), no matter how many (or how few) monthly payments you

Fixed annuities allow you some access to your investment; for example,
you can choose to withdraw interest or (depending on the company etc.)
up to 10% of the principal annually.  An annuity may also have various
hardship clauses that allow you to withdraw the investment with no
surrender charge in certain situations (read the fine print).  When
considering a fixed annuity, compare the annuity with a ladder of
high-grade bonds that allow you to keep your principal with minimal
restrictions on accessing your money. 

Annuitization can work well for a long-lived retiree.  In fact, a fixed
annuity can be thought of as a kind of reverse life insurance policy. 
Of course a life insurance contract offers protection against premature
death, whereas the annuity contract offers protection for someone who
fears out-living a lump sum that they have accumulated.  So when
considering annuities, you might want to remember one of the original
needs that annuitities were created to address, namely to offer
protection against longevity. 

Another situation in which a fixed annuity might have advantages is if
you wish to generate monthly income and are extremely worried about
someone being able to steal your capital away from you (or steal
someone's capital away from them).  If this is the case, for whatever
reason, then giving the capital to an insurance company for management
might be attractive.  Of course a decent trust and trustee could
probably do as well. 

Variable Annuities
A variable annuity is essentially an insurance contract joined at the
hip with an investment product.  Annuities function as tax-deferred
savings vehicles with insurance-like properties; they use an insurance
policy to provide the tax deferral.  The insurance contract and
investment product combine to offer the following features:
  1. Tax deferral on earnings. 
  2. Ability to name beneficiaries to receive the balance remaining in
     the account on death. 
  3. "Annuitization"--that is, the ability to receive payments for life
     based on your life expectancy. 
  4. The guarantees provided in the insurance component. 

A variable annuity invests in stocks or bonds, has no predetermined rate
of return, and offers a possibly higher rate of return when compared to
a fixed annuity.  The remainder of this article focuses on variable

A variable annuity is an investment vehicle designed for retirement
savings.  You may think of it as a wrapper around an underlying
investment, typically in a very restricted set of mutual funds.  The
main selling point of a variable annuity is that the underlying
investments grow tax-deferred, as in an IRA.  This means that any gains
(appreciation, interest, etc.) from the annuity are not taxed until
money is withdrawn.  The other main selling point is that when you
retire, you can choose to have the annuity pay you an income
("annuitization"), based on how well the underlying investment
performed, for as long as you live.  The insurance portion of the
annuity also may provide certain investment guarantees, such as
guaranteeing that the full principal (amount originally contributed to
the account) will be paid out on the death of the account holder, even
if the market value was low at that time. 

Unlike a conventional IRA, the money you put into an annuity is not
deductible from your taxes.  And also unlike an IRA, you may put as much
money into an annuity as you wish. 

A variable annuity is especially attractive to a person who makes lots
of money and is trying, perhaps late in the game, to save aggressively
for retirement.  Most experts agree that young people should fully fund
IRA plans and any company 401(k) plans before turning to variable

Should you buy an annuity?
The basic question to be answered by someone considering this investment
is whether the cost of the insurance coverage is justified for the
benefits that are paid.  In general, the answer to that question is one
that only a specific individual can answer based on his or her specific
circumstances.  Either a 'yes' or 'no' answer is possible, and there may
be much support for either position.  People who oppose use of annuities
will point out that it is unlikely (less than 50% probability) that the
insurance guarantees will pay off, so that the guarantees are expected
to reduce the overall return.  People who favor use of annuities tend to
suggest that not buying the guarantees is always an irresponsible step
because the purchaser increases risk.  Both positions can be supported. 
But the key issue is whether the purchaser is making an informed
decision on the matter. 

Now it's time for some cautionary words about the purchase of annuities. 
Many experts feel that annuities are a poor choice for most people when
examined in close detail.  The following discussion compares an annuity
to an index fund (see also the article on index funds elsewhere in this

Variable annuities are extremely profitable for the companies that sell
them (which accounts for their popularity among sales people), but are a
terrible choice for most people.  Most people are much better off in an
equity index fund.  Index funds are extremely tax efficient and provide,
overall, a much more favorable tax situation than an annuity. 

The growth of an annuity is fully taxable as income, both to you and
your heirs.  The growth of an index fund is taxable as capital gains to
you (which is good because capital gains taxes are always lower than
ordinary income) and subject to zero income tax to your heirs.  This
last point is because upon inheritance the asset gets a "stepped up
basis." In plain English, the IRS treats the index fund as though your
heirs just bought it at the value it had when you died.  This is a major
tax advantage if you care about leaving your wealth behind.  (By
contrast the IRS treats the annuity as though your heirs just earned it;
they must now pay income tax on it!)

If you remove some money from the index fund, the cost basis may be the
cost of your most recent purchase (or if the law is changed as the
administration currently recommends, the average cost of your index
investments).  By contrast, any money you remove from an annuity is
taxed at 100% of its value until you bring the annuity's value down to
the size of what you put in.  (The law is more favorable for annuities
purchased before 1982, but that's another can of worms.)

Tax considerations aside, the index fund is a better investment.  Try to
find some annuities that outperformed the S&P 500 index over the past
ten or twenty years.  Now, do you think you can pick which one(s) will
outperform the index over the next twenty years? I don't. 

Annuities usually have a sales load, usually have very high expenses,
and always have a charge for mortality insurance.  The expenses can run
to 2% or more annually, a much higher load than what an index fund
charges (frequently less than 0.5%).  The insurance is virtually
worthless because it only pays if your investment goes down AND you die
before you "annuitize".  (More about that further on.) Simple term
insurance is cheaper and better if you need life insurance. 

Annuities invest in funds that are difficult to analyze, and for which
independent reports, such as Morningstar, are not always available. 

Annuity contracts are very difficult for the average investor to read
and understand.  Personally, I don't believe anyone should sign a
contract they don't understand. 

Annuities offer the choice of a guaranteed income for life.  If you
choose to annuitize your contract (meaning take the guaranteed income
for life), two things happen.  One is that you sacrifice your principal. 
When you die you leave zero to your heirs.  If you want to take cash out
for any reason, you can't.  It isn't yours anymore. 

In exchange for giving all your money to the insurance company, they
promise to pay you a certain amount (either fixed or tied to investment
performance) for as long as you live.  The problem is that the amount
they pay you is small.  The very small payoff from annuitizing is the
reason that almost no one actually does it.  If you're considering an
annuity, ask the insurance company what percentage of customers ever
annuitize.  Ask what the payoff is if you annuitize and you'll see why. 
Compare their payoff to keeping your principal and putting it into a
ladder of U.S.  Treasuries, or even tax-free munis.  Better yet, compare
the payoff to a mortgage for the duration of your expected lifespan.  If
you expect to live to 85, compare the payoff at age 70 to a 15-year
mortgage (with you as the lender). 

For a fixed payout you would be better off putting your money into US
Treasuries and collecting the interest (and keeping the principal). 

Now let's consider a variable payout, determined by the performance of
your chosen investments.  The problem here is the Assumed Interest Rate
(AIR), typically three or four percent.  In plain English, the insurance
company skims off the first three to four percent of the growth of your
investments.  They call that the AIR.  Your monthly distribution only
grows to the extent that your investment grows MORE than the AIR.  So if
your investment doesn't grow, your monthly payment shrinks (by the AIR). 
If your investment grows by the AIR, your monthly payment stays the
same.  When the market has a down year, your monthly payment shrinks by
the market loss plus the AIR. 

If you do decide to go with an annuity, buy one from a mutual fund
company like T.  Rowe Price or Vanguard.  They have far superior
products to the annuities offered by insurance companies. 

Annuities in IRAs?
Occasionally the question comes up about whether it makes sense to buy a
variable annuity inside a tax-deferred plan like an IRA.  Please refer
to the list of four features provided by annuities that appears at the
top of this article. 

The first, income deferral, is utterly irrelevant if the annuity is held
in an IRA or retirement account.  The IRA and plan already provides for
the deferral and, in fact, distributions are governed by the provisions
of Section 72 applicable to IRA retirement plans, not the general
annuity provisions.  I would go so far as to tell anyone who has someone
trying to sell them one of these products in a plan based on the tax
benefits to run as fast as possible away from that adviser.  S/he is
either very misinformed or very dishonest. 

The second, beneficiary designation, is also a nonissue for annuities in
a retirement account.  IRAs and qualified plans already provide for
beneficiary designations outside of probate, for better or worse. 

The third, annuitization, is potentially valid, since that is one method
to convert the IRA or plan balance to an income stream.  Of course,
nothing prevents you from simply purchasing an annuity at the time you
desire the payout rather than buying a product today that gives you the
option in the future. 

I suppose it is possible that the options in the product you buy today
may be superior to those that you expect would be available on the open
market at the time you would decide to "lock it in" or you may at least
feel more comfortable having some of these provisions locked in. 

Finally, the fourth feature involves the actual guarantees that are
provided in the annuity contract.  To take care of an obvious point
first: the guarantees are provided by the insurance carrier, so clearly
it's not the level of FDIC insurance that is backed by the US
Government.  But, then again, only deposits in banks are backed by this
guarantee, and the annuity guarantees have generally been good when
called upon. 

Normally, any guarantee comes at some cost (well, at least if the
insurer plans to stay in business [grin]) and the cost should be
expected to rise as the guarantee becomes more likely to be invoked. 
Some annuities are structured to be low cost, and tend to provide a bare
minimum of guarantees.  These products are set up this way to
essentially, provide the insurance "wrapper" to give the tax deferral. 

I would note that if, in fact, the guarantees are highly unlikely to be
triggered and/or would only be triggered in cases where the holder
doesn't care, then any cost is likely "excessive" when the guarantee no
longer buys tax deferral, as would be the case if held in a qualified
plan.  Note that the "doesn't care" case may be true if the guarantee
only comes into play at the death of the account holder, but the holder
is primarily interested in the investment to fund consumption during

What this means is that you need a) a full and complete understanding of
exactly what promise has been made to you by the guarantees in the
contract and b) a full understanding of the costs and fees involved, so
that you can make a rational decision about whether the guarantees are
worth the amount you are paying for them. 

It's theoretically possible to find a guarantee that would fit a
client's circumstance at a cost the client would deem resaonable that
would make the annuity a "good fit" in a retirement plan.  Some problems
that arise are when clients are led to believe that somehow the annuity
in the retirement plan gives them a "better" tax deferral or somehow
creates a situation where they "avoid probate" on the plan.  A good
agent is going to specifically discuss the annuitization and investment
guarantee features when considering an annuity in a plan or IRA and will
explicitly note that the first two (tax deferral and beneficiary
designation) don't apply because it's in the plan or IRA. 

Additional Resources
  1. Raymond James offers a free and independent resource with
     comprehensive information about annuities.
  2. Client Preservation & Marketing, Inc.  operates a web site with
     in-depth information about fixed annuities.
  3. Scott Burns wrote an article "Why variable annuities are no match
     for index funds" at MSN Money Central on 15 June 2001.
  4. rated annuity comparison shopping sites on 5 May 00. 
     Also look for the links to two articles by Vern Hayden with
     arguments for and against variable annuities.
  5. Cornerstone Financial Products offers a site with complete
     information about variable annuities, including quotes,
     performance, and policy costs.
  6. "Annuities: Just Say No" in the July/August 1996 issue of Worth
  7. "Five Sad Variable Annuity Facts Your Salesman Won't Tell You" in
     the April 5, 1995 Wall Street Journal quarterly review of mutual
  8. helps investors choose annuities with instant
     quotes and an annuity shopper's library that has extensive
     information about annuities.

--------------------Check for updates------------------

Subject: Insurance - Life

Last-Revised: 30 Mar 1994
Contributed-By: Joe Collins

[ A note from the FAQ compiler: I believe that this article offers sound
advice about life insurance for the average middle-class person. 
Individuals with a high net worth may be able to use life insurance to
shelter their assets from estate taxes, but those sorts of strategies
are not useful for people with an estate that falls under the tax-free
amount of about a million dollars.  Your mileage may vary.  ]

This is my standard reply to life insurance queries.  And, I think many
insurance agents will disagree with these comments. 

First of all, decide WHY you want insurance.  Think of insurance as
income-protection, i.e., if the insured passes away, the beneficiary
receives the proceeds to offset that lost income.  With that comment
behind us, I would never buy insurance on kids, after all, they don't
have income and they don't work.  An agent might say to buy it on your
kids while its cheap - but run the numbers, the agent is usually wrong,
remember, agents are really salesmen/women and its in their interest to
sell you insurance.  Also - I am strongly against insurance on kids on
two counts.  One, you are placing a bet that you kid will die and you
are actually paying that bet in premiums.  I can't bet my child will
die.  Two, it sounds plausible, i.e., your kid will have a nest egg when
they grow up but factor inflation in - it doesn't look so good.  A
policy of face amount of $10,000, at 4.5% inflation and 30 years later
is like having $2,670 in today's dollars - it's NOT a lot of money.  So
don't plan on it being worth much in the future to your child as an
investment.  In summary, skip insurance on your kids. 

I also have some doubts about insurance as investments - it might be a
good idea but it certainly muddies the water.  Why not just buy your
insurance as one step and your investment as another step? - its a lot
simpler to keep them separate. 

So by now you have decided you want insurance, i.e., to protect your
family against you passing away prematurely, i.e., the loss of income
you represent (your salary, commissions, etc.). 

Next decide how LONG you want insurance for.  If you're around 60 years
old, I doubt you want to get any at all.  Your income stream is largely
over and hopefully you have accumulated the assets you need anyway by

If you are married and both work, its not clear you need insurance at
all if you pass on.  The spouse just keeps working UNLESS you need both
incomes to support your lifestyle (more common these days).  Then you
should have one policy on each of you. 

If you are single, its not clear you need life insurance at all.  You
are not supporting anyone so no one cares if you pass on, at least

If you are married and the spouse is not working, then the breadwinner
needs insurance UNLESS you are independently wealthy.  Some might argue
you should have insurance on your spouse, i.e., as homemaker, child care
provider and so forth.  In my oponion, I would get a SMALL policy on the
spouse, sufficient to cover the costs of burying them and also
sufficient to provide for child care for a few years or so.  Each case
is different but I would look for a small TERM policy on the order of
$50,000 or less.  Get the cheapest you can find, from anywhere.  It
should be quite cheap.  Skip any fancy policies - just go for term and
plan on keeping it until your child is own his/her own.  Then reduce the
insurance coverage on your spouse so it is sufficient to bury your

If you are independently wealthy, you don't need insurance because you
already have the money you need.  You might want tax shelters and the
like but that is a very different topic. 

Suppose you have a 1 year old child, the wife stays home and the husband
works.  In that case, you might want 2 types of insurance: Whole life
for the long haul, i.e., age 65, 70, etc., and Term until your child is
off on his/her own.  Once the child has left the stable, your need for
insurance goes down since your responsibilities have diminished, i.e.,
fewer dependents, education finished, wedding expenses done, etc

Mortgage insurance is popular but is it worthwhile? Generally not
because it is far too expensive.  Perhaps you want some sort of Term
during the duration of the mortgage - but remember that the mortgage
balance DECLINES over time.  But don't buy mortgage insurance itself -
much too expensive.  Include it in the overall analysis of what
insurance needs you might have. 

What about flight insurance? Ignore it.  You are quite safe in airplanes
and flight insurance is incredibly expensive to buy. 

Insurance through work? Many larger firms offer life insurance as part
of an overall benefits package.  They will typically provide a certain
amount of insurance for free and insurance beyond that minimum amount is
offered for a fee.  Although priced competitively, it may not be wise to
get more than the 'free' amount offered - why? Suppose you develop a
nasty health condition and then lose your job (and your benefit-provided
insurance)? Trying to get reinsured elsewhere (with a health condition)
may be very expensive.  It is often wiser to have your own insurance in
place through your own efforts - this insurance will stay with you and
not the job. 

Now, how much insurance? One rule of thumb is 5x your annual income. 
What agents will ask you is 'Will your spouse go back to work if you
pass away?' Many of us will think nobly and say NO.  But its actually
likely that your spouse will go back to work and good thing - otherwise
your insurance needs would be much larger.  After all, if the spouse
stays home, your insurance must be large enough to be invested wisely to
throw off enough return to live on.  Assume you make $50,000 and the
spouse doesn't work.  You pass on.  The Spouse needs to replace a
portion of your income (not all of it since you won't be around to feed,
wear clothes, drive an insured car, etc.).  Lets assume the Spouse needs
$40,000 to live on.  Now that is BEFORE taxes.  Lets say its $30,000 net
to live on.  $30,000 is the annual interest generated on a $600,000
tax-free investment at 5% per year (e.g., munibonds).  So this means you
need $600,000 of face value insurance to protect your $50,000 current
income.  These numbers will vary, depending on interest rates at the
time you do your analysis and how much money you spouse will need,
factoring in inflation.  But the point is that you need at least another
$600,000 of insurance to fund if the survivng spouse doesn't and won't
work.  Again, the amount will vary but the concept is the same. 

This is only one example of how to do it and income taxes, estate taxes
and inflation can complicate it.  But hopefully you get the idea. 

Which kind of insurance, in my humble opinion, is a function of how long
you need it for.  I once did an analysis of TERM vs WHOLE LIFE and based
on the assumptions at the time, WHOLE LIFE made more sense if I held the
insurance more than about 20-23 years.  But TERM was cheaper if I held
it for a shorter period of time.  How do you do the analysis and why
does the agent want to meet you? Well, he/she will bring their fancy
charts, tables of numbers and effectively lead you into thinking that
the biggest, most expensive policy is the best for you over the long
term.  Translation: lots of commissions to the agent.  Whole life is
what agents make their money on due to commissions.  The agents
typically gets 1/2 of your first year's commissions as his pay.  And he
typically gets 10% of the next year's commissions and likewise through
year 5.  Ask him (or her) how they get paid. 

If he won't tell you, ask him to leave.  In my opinion, its okay that
the agents get commissions but just buy what you need, don't buy some
huge policy.  The agent may show you compelling numbers on a $1,000,000
whole life policy but do you really need that much? They will make lots
of money on commissions on such a policy, but they will likely have sold
you the "Mercedes Benz" type of policy when a Ford Taurus or a Saturn
sedan model would also be just fine, at far less money.  Buy the life
insurance you need, not what they say. 

What I did was to take their numbers, review their assumptions (and
corrected them when they were far-fetched) and did MY analysis.  They
hated that but they agreed my approach was correct.  They will show you
a 12% rate of return to predict the cash value flow.  Ignore that - it
makes them look too good and its not realistic.  Ask him/her exactly
what they plan to invest your premium money in to get 12%.  How has it
done in the last 5 years? 10? Use a number between 4.5% (for TBILL
investments, quite conservative) and 8-10% (for growth stocks, more
risky), but not definitely not 12%.  I would try 8% and insist it be
done that way. 

Ask each agent these questions:
  1. What is the present value of the payment stream represented by the
     premiums, using a discount rate of 4.5% per year (That is the
     inflation average since 1940).  This is what the policy costs you,
     in today's dollars.  Its very much like paying that single number
     now instead of a series of payments over time.  If they disagree
     with 4.5%, remind them that since 1926, inflation has averaged 3.5%
     (Ibbotson Associates) and then suggest they use 3.5% instead.  They
     may then agree with the 4.5% (!) The lower the number, the more
     expensive the policy is. 
  2. What is the present value of the the cash value earned (increasing
     at no more than 8% a year) and discounting it back to today at the
     same 4.5%.  This is what you get for that money you just paid, in
     cash value, expressed in today's dollars, i.e., as if you got it
     today in the mail. 
  3. What is the present value of the life insurance in force over that
     same period, discounted back to today by 4.5%, for inflation.  That
     is the coverage in effect in today's dollars. 
  4. Pick an end date for comparing these - I use age 60 and age 65. 

With the above in hand from various agents, you can see fairly quickly
which is the better policy, i.e., which gives you the most for your

By the way, inflation is slippery and sneaky.  All too often we see
$500,000 of insurance and it sounds great, but at 4.5% inflation and 30
years from now, that $500,000 then is like $133,500 now - truly!

Have the agent do your analysis, BUT you give him the rates to use,
don't use his.  Then you pick the policy that is the best value, i.e.,
you get more for your money.  Factor in any tax angles as well.  If the
agent refuses to do this analysis for you, get rid of him/her. 

If the agent gets annoyed but cannot fault your analysis, then you have
cleared the snow away and gotten to the truth.  If they smile too much,
you may have missed something.  And that will cost you money. 

Never agree to any policy unless you understand all the numbers and all
the terms.  Never 'upgrade' policies by cashing in a whole life for
another whole life.  That just depletes your cash value, real cash
available to you.  And the agent gets to pocket that money, literally,
through new commissions.  Its no different that just writing a personal
check, payable to the agent. 

Check out the insurer by going to the reference section of a big
library.  Ask for the AM BEST guide on insurance.  Look up where the
issuer stands relative to the competition, on dividends, on cash value,
on cost of insurance per premium dollar. 

Agents will usually not mention TERM since they work on commission and
get much more money for Whole Life than they do for term.  Remember, The
agents gets about 1/2 of your 1st years premium payments and 10% or so
for all the money you send in over the following 4 years.  Ask them to
tell you how they are paid- after all, its your money they are getting. 

Now why don't I like UNIVERSAL or VARIABLE? Mainly because with Whole
Life and with TERM, you know exactly what you must pay because the
issuer must manage the investments to generate the appropriate returns
to provide you with the insurance (and with cash value if whole life). 
With UNIVERSAL and VARIABLE, it becomes YOU who must decide how and
where to invest your premium income.  If you guess badly, you will have
to pay a higher premium to cover those bad decisions.  The insurance
companies invented UNIVERSAL and VARIABLE because interest rates went
crazy in the early 80's and they lost money.  Rather than taking that
risk again, they offered these new policies to transfer that risk to
you.  Of course, UNIVERSAL and VARIABLE will be cheaper in the short
term but BE CAREFUL - they can and often will increase later on. 

Okay, so what did I do? I bought both term and whole life.  I plan to
keep the term until my son graduates from college and he is on his own. 
That is about 10 years from now.  I also bought whole life (NorthWestern
Mutual Life, Milwaukee, WI) which I plan to keep forever, so to speak. 
NWML is apparently the cheapest and best around according to A.M.  BEST. 
At this point, after 3 years with NWML, I make more in cash value each
year than I pay into the policy in premiums.  Thus, they are paying me
to stay with them. 

Where do you buy term? Just buy the cheapest policy since you will tend
to renew the policy once a year and you can change insurers each time. 
Check your local savings bank as one source. 

Suppose an agent approaches you about a new policy and wishes to update
your old ones and switch you into the new policy or new financial
product they are offering? BE CAREFUL: When you switch policies, you
close out the old one, take out its cash value and buy a new one.  But
very often you must start paying those hidden commissions all over
again.  You won't see it directly but look carefully at how the cash
value grows in the first few years.  It won't grow much because the
'cash' is usually paying the commissions again.  Bottom line: You
usually pay commissions twice - once on the old policy and again on the
new policy - for generally the same insurance.  Thus you paid twice for
the same product.  Again - be careful and make sure it makes sense to
switch policies. 

A hard thing to factor in is that one day you may become uninsurable
just when you need it, i.e., heart attack, cancer and the like.  I would
look at getting cheap term insurance but add in the options of
'guaranteed convertible' (to whole life) and 'guarranteed renewable'
(they must provide the insurance).  It will add somewhat to the cost of
the insurance. 

Last thought.  I'll bet you didn't you know that you are 3x more likely
to become disabled during your working career than you to die during
your working career.  How is your short term disability insurance
looking? Get a policy that has a waiting period before it kicks in. 
This will keep it cheaper.  Look at the exclusions, if any. 

These comments are MY opinion and not my employers.  All the usual
disclaimers apply and your mileage may vary depending on individual

Sources for additional information:
   * Consumers Reports printed an in-depth, three-part series in their
     Jul/Aug/Sep 1993 issues. 
   * Many sites on the web offer life insurance quotes.  Here are a few
     that have been rated highly by consumer advocates.  Also see the
     article in the New York Times of 1 August 2001. , , , , , . 

--------------------Check for updates------------------

Subject: Insurance - Viatical Settlements

Last-Revised: 19 Aug 1998
Contributed-By: Gloria Wolk ( ), Chris Lott (
contact me )

A viatical settlement is a lump sump of cash given to terminally ill
people (viators) in exchange for the death benefits of their life
insurance.  Along with so much of the English language, the name has its
origins in a Latin word, viaticum , which means provisions for a journey

These settlements are attractive to a viator (seller) because the person
gets a significant amount of money that will ease the financial stress
of their final days.  Viatical settlements are attractive to investors
for their potentially high -- but not guaranteed -- rates of return. 

The way it works in the simplest case is the investor pays some
percentage of the face value of the policy, let's say 50% just to pick a
number, and in return becomes the beneficiary of the policy.  The
investor is then responsible for paying the premiums associated with the
life insurance policy.  Upon the demise of the viator, the investor
receives the death benefit of the life insurance policy.  If the viator
dies shortly after the transaction is completed, the investor makes a
large amount of money.  If the viator survives several years past the
predicted life expectancy, the investor will lose money. 

Like any other deal, there are risks to both parties.  For the viator,
the main risk is settling at too low a price.  For the investor, there
are risks of not receiving the full death benefit if the insurance
company goes bankrupt, not receiving any death benefit if the insured
committed fraud on the insurance application, etc. 

As of this writing, a few honest and a number of less-than-scrupulous
companies market viatical settlements to viators and investors.  Be
careful! This investment is not regulated, so there is little or no
protection for investors. 

Here are a few tips for potential viators. 

   * Are you holding back from medical treatment, thinking this will
     give you a larger viatical settlement? Don't.  It won't get you
     more money.  Viatical providers take into account Investigational
     New Drugs (INDs) when they price policies.  Even if you never took
     any and don't plan to, they expect viators will try anything that
     gives hope, and they price accordingly. 
   * Was your policy resold by the viatical company? If so, you have no
     obligation to a second buyer -- unless you signed an agreement to
     extend obligations to future owners.  This is like selling a car:
     If you sell the car to B and B resells it to C, you have no
     obligation to C. 
   * Be sure to check with your insurer to find out if your policy
     includes Accelerated Death Benefits.  If so, and if you qualify,
     you will get much more money -- and it will be paid faster.  This
     applies to some group term life as well as individual policies. 
   * Are you are a member of a Credit Union? Credit Unions may be a
     source of information about and referrals to licensed viatical
   * Don't apply to only one viatical company -- even if the referral
     was made by your doctor, lawyer, insurance agent, social worker, or
     credit union.  If you ignore this advice, you're likely to get
     thousands of dollars less.  Here are a few tips for potential
investors in viatical settlements. 
   * Are you thinking of using your IRA for viatical investments? Don't. 
     No matter what viatical sales promoters tell you, life insurance as
     an IRA investment is prohibited by the Internal Revenue Code.  And,
     if you have a self-directed IRA, you are fully responsible for
     investment decisions. 
   * Are you thinking of buying a policy that is within the
     contestability period? Don't.  If the viator committed fraud on the
     application and the insurer discovers this, you could be left with
     nothing more than a return of premiums.  Gloria Wolk's site offers
much information about viatical settlements.

--------------------Check for updates------------------

Subject: Insurance - Variable Universal Life (VUL)

Last-Revised: 26 Jun 2000
Contributed-By: Ed Zollars (ezollar at, Chris Lott (
contact me ), Dan Melson (dmelson at

This article explains variable universal life (VUL) insurance, and
discusses some of the situations where it is appropriate. 

Variable universal life is a form of life insurance, specifically it's a
type of cash-value insurance policy.  (The other types of cash value
life insurance are whole, universal, and variable life.) Like any life
insurance policy, there is a payout in case of death (also called the
death benefit).  Like whole-life insurance, the insurance policy has a
cash value that enjoys tax-deferred growth over time, and allows you to
borrow against it.  Unlike either term or traditional whole-life
insurance, VUL policies allow the insured to choose how the premiums are
invested, usually from a universe of 10-25 funds.  This means that the
policy's cash value as well as the death benefit can fluctuate with the
performance of the investments that the policy holder chose. 

Where does the name come from? To take the second part first, the
"universal" component refers to the fact the premium is not a "set in
stone" amount as would be true with traditional whole life, but rather
can be varied within a range.  As for the first part of the name, the
"variable" portion refers to the fact that the policy owner can direct
the investments him/herself from a pool of options given in the policy
and thus the cash value will vary.  So, for instance, you can decide the
cash value should be invested in various types of equities (while it can
be invested in nonequities, most interest in VUL policies comes from
those that want to use equities).  Obviously, you bear the risk of
performance in the policy, and remember we have to keep enough available
to fund the expenses each year.  So bad performance could require
increasing premiums to keep the policy in force.  Conversely, you gain
if you can invest and obtain a better return (at least you get more cash

If a VUL policy holder was fortunate enough to choose investments that
yield returns anything like what the NASDAQ saw in 1999, the policy's
cash value could grow quite large indeed.  The cash value component of
the policy may be in addition to the death benefit should you die (you
get face insurance value *plus* the benefit) *OR* serve to effectively
reduce the death benefit (you get the face value, which means the cash
value effectively goes to subsidize the death benefit).  It all depends
on the policy. 

A useful way to think about VUL is to think of buying pure term
insurance and investing money in a mutual fund at the same time.  This
is essentially what the insurance company that sells you a VUL is doing
for you.  However, unlike your usual mutual fund that may pass on
capital gains and other income-tax obligations annually, the investments
in a VUL grow on a tax-deferred basis.  Uncle Sam may get a taste
eventually (if the policy is cashed in or ceases to remain in force),
but not while the funds are growing and the policy is maintained. 

We can talk about the insurance component of a VUL and about the
investment component.  The insurance component obviously provides the
death benefit in the early years of the policy if needed.  The
investment component serves as "bank" of sorts for the amounts left over
after charges are applied against the premium paid, namely charges for
mortality (to fund the payouts for those that die with amounts paid
beyond the cash values), administrative fees (it costs money to run an
insurance company (grin)) and sales compensation (the advisor has to
earn a living).  How this amount is invested is the principal difference
between a VUL and other insurance policies. 

If you own a VUL policy, you can borrow against the cash value build-up
inside the policy.  Because monies borrowed from a VUL policy that is
maintained through the insured's life are technically borrowed against
the death benefit, they work out tax free.  This means a VUL owner can
borrow money during retirement against the cash value of the policy and
never pay tax on that money.  It sounds almost too good to be true, but
it's true. 

A policy holder who choose to borrow against the death benefit must be
extremely careful.  A policy collapses when the cash value plus any
continuing payments aren't enough to keep the basic insurance in force,
and that causes the previously tax-free loans to be viewed as taxable
income.  Too much borrowing can trigger a collapse.  Here's how it can
happen.  As the insured ages, Cost of Insurance (COI) per thousand
dollars of insurance rises.  With a term policy, it's no big deal - the
owner can just cancel or let it lapse without tax consequences, they
just have no more life insurance policy.  But with a cash value policy
such as VUL there is the problem of distributions that the owner may
take.  Say on a policy with a cash value of $100,000 I start taking
$10,000 per year withdrawals/loans.  Say I keep doing this for 30 years,
and then the variability of the market bites the investment and the cash
value gets exhausted.  I may have put say 50,000 into the policy -
that's my cost basis, and I took that much out as withdrawals.  But the
other $250,000 is technically a loan against the death benefit, and I
don't have to pay taxes on it - until there's suddenly no death benefit
because there's no policy.  So here's $250,000 I suddenly have to pay
taxes on. 

Once the policy is no longer in force, all the money borrowed suddenly
counts as taxable income, and the policy holder either has taxable
income with no cash to show for it, or a need to start paying premiums
again.  At the point of collapse, the owner could be (reasonably likely)
destitute anyway, so there may be very little in the way of real
consequences, but if there are still assets, like a home, other monies,
etcetera, you see that there could be problems.  Which is why cash value
life insurance should be the *last* thing you take distributions from in
most cases (The more tax-favored they are, the longer you put off
distributions.) What all this means is that the cash surrender value of
the VUL really isn't totally available at any point in time, since
accessing it all will result in a tax liability.  If you want to
consider the real cash value, you need realistic projections of what can
be safely borrowed from the policy. 

This seems like a good time to mention one other aspect of taxes and
life insurance, namely FIFO (first-in first-out) treatment.  In other
words, if a policy holder withdraws money from a cash-value life
insurance policy, the withdrawal is assumed to come from contributions
first, not earnings.  Withdrawals that come from contributions aren't
taxable (unless it's qualified money, a rare occurence).  After the
contributions are exhausted, then withdrawals are assumed to come from

Computing the future value of a VUL policy borders on the impossible. 
Any single line projection of the VUL is a) virtually certain to be
wrong and b) without question overly simplistic.  This is a rather
complex beast that brings with it a wide range of potential outcomes. 
Remember that while we cannot predict the future, we know pretty much
for sure that you won't get a nice even rate of return each year (though
that's likely what all VUL examples will assume).  The date when returns
are earned can be far more important than the average return earned.  To
compare a VUL with other choices, you need to do a lot of "what ifs"
including looking at the impacts of uneven returns, and understand all
the items in the presentation that may vary (including your date of
death (grin)). 

While I hate to give "rules of thumb" in these areas, the closest I will
come is to say that VUL normally makes the most sense when you can
heavily fund the policy and are looking at a very long term for the
funds to stay invested.  The idea is to limit the "drag" on return from
the insurance component, but get the tax shelter. 

Another issue is that if you will have a taxable estate and helping to
fund estate taxes is one of the needs you see for life insurance, the
question of the ownership of the insurance policy will come into play. 
Note that this will complicate matters even further (and you probably
already thought it was bad enough (grin)), because what you need to do
to keep it out of your estate may conflict with other uses you had
planned for the policy. 

Note that there are "survivor VULs", insuring two lives, which are
almost always sold for either estate planning or retirement plan
purposes (or both).  The cost of insurance is typically less than an
annuity's M&E charges until the younger person is in their fifties. 

A person who is considering purchasing a VUL policy needs to think
clearly about his or her goals.  Those goals will determine both whether
a VUL is right tool and how it should be used.  Potential goals include:
   * Providing a pool of money that will only be tapped at my death, but
     will be used by my spouse. 
   * Providing a pool of money that will only be used at my death, but
     which we want to use to pay estate taxes. 
   * Providing a pool of money that I plan to borrow from in old age to
     live on, and which will, in the interim, provide a death benefit
     for my spouse. 

Once the goals are clear, and you've then determined that a VUL would be
something that could fulfill your goals, you then have to find the right

--------------------Check for updates------------------

Subject: Mutual Funds - Basics

Last-Revised: 11 Aug 1998
Contributed-By: Chris Lott ( contact me )

This article offers a basic introduction to mutual funds.  It can help
you decide if a mutual fund might be a good choice for you as an

If you visit a big fund company's web site (e.g.,,
they'll tell you that a mutual fund is a pool of money from many
investors that is used to pursue a specific objective.  They'll also
hasten to point out that the pool of money is managed by an investment
professional.  A prospectus (see below) for any fund should tell you
that a mutual fund is a management investment company.  But in a
nutshell, a mutual fund is a way for the little guy to invest in, well,
almost anything.  The most common varieties of mutual funds invest in
stocks or bonds of US companies.  (Please see articles elsewhere in this
FAQ for basic explanations of stocks and bonds.)

First let's address the important issue: how little is our proverbial
little guy or gal? Well, if you have $20 to save, you would probably be
better advised to speak to your neighborhood bank about a savings
account.  Most mutual funds require an initial investment of at least
$1,000.  Exceptions to this rule generally require regular, monthly
investments or buying the funds with IRA money. 

Next, let's clear up the matter of the prospectus, since that's about
the first thing you'll receive if you call a fund company to request
information.  A prospectus is a legal document required by the SEC that
explains to you exactly what you're getting yourself into by sending
money to a management investment company, also known as buying into a
mutual fund.  The information most useful to you immediately will be the
list of fees, i.e., exactly what you will be charged for having your
money managed by that mutual fund.  The prospectus also discloses things
like the strategy taken by that fund, risks that are associated with
that strategy, etc.  etc.  Have a look at one, you'll quickly see that
securities lawyers don't write prose that's any more comprehensible than
other lawyers. 

The worth of an investment with an open-end mutual fund is quoted in
terms of net asset value.  Basically, this is the investment company's
best assessment of the value of a share in their fund, and is what you
see listed in the paper.  They use the daily closing price of all
securities held by the fund, subtract some amount for liabilities,
divide the result by the number of outstanding shares and Poof! you have
the NAV.  The fund company will sell you shares at that price (don't
forget about any sales charge, see below) or will buy back your shares
at that price (possibly less some fee). 

Although boring, you really should understand the basics of fund
structure before you buy into them, mostly because you're going to be
charged various fees depending on that structure.  All funds are either
closed-end or open-end funds (explanation to follow).  The open-end
funds may be further categorized into load funds and no-load funds. 
Confusingly, an open-end fund may be described as "closed" but don't
mistake that for closed-end. 

A closed-end fund looks much like a stock of a publically traded
company: it's traded on some stock exchange, you buy or sell shares in
the fund through a broker just like a stock (including paying a
commission), the price fluctuates in response to the fund's performance
and (very important) what people are willing to pay for it.  Also like a
publically traded company, only a fixed number of shares are available. 

An open-end fund is the most common variety of mutual fund.  Both
existing and new investors may add any amount of money they want to the
fund.  In other words, there is no limit to the number of shares in the
fund.  Investors buy and sell shares usually by dealing directly with
the fund company, not with any exchange.  The price fluctuates in
response to the value of the investments made by the fund, but the fund
company values the shares on its own; investor sentiment about the fund
is not considered. 

An open-end fund may be a load fund or no-load fund.  An open-end fund
that charges a fee to purchase shares in the fund is called a load fund. 
The fee is called a sales load, hence the name.  The sales load may be
as low as 1% of the amount you're investing, or as high as 9%.  An
open-end fund that charges no fee to purchase shares in the fund is
called a no-load fund. 

Which is better? The debate of load versus no-load has consumed
ridiculous amounts of paper (not to mention net bandwidth), and I don't
know the answer either.  Look, the fund is going to charge you something
to manage your money, so you should consider the sales load in the
context of all fees charged by a fund over the long run, then make up
your own mind.  In general you will want to minimize your total
expenses, because expenses will diminish any returns that the fund

One wrinkle you may encounter is a "closed" open-end fund.  An open-end
fund (may be a load or a no-load fund, doesn't matter) may be referred
to as "closed." This means that the investment company decided at some
point in time to accept no new investors to that fund.  However, all
investors who owned shares before that point in time are permitted to
add to their investments.  (In a nutshell: if you were in before, you
can get in deeper, but if you missed the cutoff date, it's too late.)

While looking at various funds, you may encounter a statistic labeled
the "turnover ratio." This is quite simply the percentage of the
portfolio that is sold out completely and issues of new securities
bought versus what is still held.  In other words, what level of trading
activity is initiated by the manager of the fund.  This can affect the
capital gains as well as the actual expenses the fund will incur. 

That's the end of this short introduction.  You should learn about the
different types of funds , and you might also want to get information
about the various fees that funds can charge , just to mention two big
issues.  Check out the articles elsewhere in this FAQ to learn more. 

Here are a few resources on the 'net that may also help. 
   * Brill Editorial Services offers Mutual Funds Interactive, an
     independent source of information about mutual funds.
   * FundSpot offers mutual fund investors the best information
     available for free.
   * The Mutual Fund Investor's Center, run by the Mutual Fund Education
     Alliance, offers profiles, performance data, links, etc.

--------------------Check for updates------------------

Subject: Mutual Funds - Average Annual Return

Last-Revised: 24 Jun 1997
Contributed-By: Jack Piazza (seninvest at

The average annual return for a mutual fund is stated after expenses. 
The expenses include fund management fees, 12b-1 fees (if applicable),
etc., all of which are a part of the fund's expense ratio.  Average
annual returns are also factored for any reinvested dividend and capital
gain distributions.  To compute this number, the annual returns for a
fixed number of years (e.g., 3, 5, life of fund) are added and divided
by the number of years, hence the name "average" annual return.  This
specifically means that the average annual return is not a compounded
rate of return. 

However, the average annual returns do not include sales commissions,
unless explictly stated.  Also, custodial fees which are applied to only
certain accounts (e.g., $10 annual fee for IRA account under a stated
amount, usually $5,000) are not factored in annual returns. 

--------------------Check for updates------------------

Subject: Mutual Funds - Buying from Brokers versus Fund Companies

Last-Revised: 28 Dec 1998
Contributed-By: Daniel Pettit (dalacap at, Jim Davidson
(jdavidso at, Chris Lott ( contact me ), Michael
Aves (michaelaves at

Many discount brokerage houses now offer their clients the option of
purchasing shares in mutual funds directly from the brokerage house. 
Even better, most of these brokers don't charge any load or fees if a
client buys a no-load fund.  There are a few advantages and
disadvantages of doing this. 

Here are a few of the advantages. 
  1. One phone call/Internet connection gets you access to hundreds of
  2. One consolidated statement at the end of the month. 
  3. Instant access to your money for changing funds and or families,
     and for getting your money in your hand via checks (2-5 days). 
  4. You can buy on margin, if you are so inclined. 
  5. Only one tax statement to (mis)file. 
  6. The minimum investment is sometimes lower. 

And the disadvantages:
  1. Many discount brokerage supermarket programs do not even give
     access to whole sectors of the market, such as high-yield bond
     funds, or multi-sector (aka "Strategic Income") bond funds. 
  2. Most discount brokers also will not allow clients to do an exchange
     between funds of different families during the same day (one trade
     must clear fist, and the the trade can be done the next day). 
  3. Many will not honor requests to exchange out of funds if you call
     after 2pm.  EST.  (which of course is 11am in California).  This is
     a serious restriction, since most fund families will honor an
     exchange or redemption request so long as you have a rep on the
     phone by 3:59pm. 
  4. You pay transaction fees on some no-load funds. 
  5. The minimum investment is sometimes higher. 

Of course the last item in each list contradict each other, and deserve
comment.  I've seen a number of descriptions of funds that had high
initial minimums if bought directly (in the $10,000+ range), but were
available through Schwab for something like $2500.  I think the same is
true of Fidelity.  Your mileage may vary. 

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

User Contributions:

Gerri Pisciotta
My employer accidentally advised the company handling the 401k investment that I had been terminated, when in fact I had not. As a result, withdrawals discontinued from my pay and I missed a couple years of contributions. Since I never withdrew from the plan, is my employer liable for making up these contributions? If I made a lump sum catchup contribution,could they do the same?
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Truly lots of awesome tips!
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