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The Best of Both Worlds

These days, baby boomer investors want both security and low fees. To get both, product makers are blurring the distinctions between mutual funds and annuities

For years, there have been clear distinctions between mutual funds and variable annuities. Annuities charge insurance fees — mortality-and-expense (M&E) fees — and come with a variety of protections, including the option to select lifetime income. Mutual funds have no income guarantees and charge relatively low fees. Now a few new investment vehicles are beginning to challenge the old definitions. That is, several mutual funds offer investors guarantees and a group of annuities charge fees that are lower than the costs of most funds.

Is the line between funds and annuities disappearing? Not yet; regulators and corporate bureaucracies insist on separating the two investments. But in the next decade, the distinctions could blur. Demand from clients is changing. More and more, investors want a combination of security and low fees. In short, they crave an investment that combines the attributes of funds and annuities. Eventually the market will figure out how to deliver what customers want.

In the meantime, advisors should examine some of the innovative products that have begun to appear. While their track records are still short, the new offerings represent intriguing steps toward the merger of annuities and funds — and perhaps suggest the direction that the investment industry will take in coming years.

High Watermark

To satisfy the need for security, Prudential Retirement recently introduced Capital Guarantee mutual funds. These come with so-called high watermark protection. Say an investor puts $200,000 into a fund. The assets appreciate to $220,000 then drop to $180,000. The investor is guaranteed to receive the high watermark of $220,000 — if he waits until the fund's maturity date. “The guarantee appeals to clients who worry about the market crashing three years before they retire,” says Joseph Tobin, a registered investment advisor with National Planning Corporation in Brea, Calif.

Prudential's guaranteed investments are target-date funds, which come with a series of maturity dates, such as 2010 and 2015. The longer the time horizon, the more aggressive the investment's asset allocation. The 2010 Prudential fund holds 50 percent of its assets in equities, while the 2015 fund is 88 percent in equities. As the maturity date approaches, the fund shifts to a more conservative allocation. “We want investors to stick with the investment and not sell during a market downturn,” says George Palms, senior vice president of investment products for Prudential Retirement.

The Prudential funds are subadvised by Trajectory Asset Management, which adjusts the allocations using mathematical models. For security, Prudential holds zero coupon bonds that mature on the target date. The Prudential funds can only be used in qualified retirement plans. Investors who wish to follow the strategy outside a retirement plan can get a similar approach from the High Watermark funds operated by AIG's SunAmerica funds.

While the High Watermark funds emphasize their guarantees, some new annuities focus on their low fees. One of the cheapest is Monument Advisor, Jefferson National Life's flat-fee annuity. Designed for fee-only advisors, the Jefferson product charges no upfront commissions and monthly insurance fees of $20. The savings can be particularly notable for wealthy investors. A client who puts $1 million into the Jefferson annuity would pay $240 annually; the same client would pay about $1,350 in insurance charges for the average annuity, which has mortality and expense costs of 1.35 percent. The Jefferson annuity has no commissions and no surrender charges.

To make the low price possible, the annuity is bare bones. There is no death benefit — the common annuity feature that guarantees heirs will at least receive the initial principal. “A lot of people are really looking for tax-deferred savings,” says Laurence Greenberg, CEO of Jefferson National Life. “They don't need fancy death benefits.”

By keeping the product simple and costs low, Greenberg hopes to reach investors who have never tried annuities before. “Variable annuities should play a much bigger role than they do currently,” says Greenberg. “People have avoided traditional annuities because they have been expensive and confusing.”

Death Bennies

Investors who do want death benefits might consider a variable annuity from Ameritas Direct. The product has no upfront commissions and charges annual insurance mortality-and-expense fees of 0.55 percent. Ameritas makes it possible to build a diversified portfolio run by well-known managers. Choices include managers from PIMCO, Fidelity and Vanguard.

One of the most versatile of the new annuities is Northwestern Mutual's Preservation Plus. The product can be sold with low commissions or in fee-based wrapper programs. Many companies promote variable annuities by paying advisors bigger commissions to sell them. But Northwestern aims to even the playing field. An advisor who sells Class-A Northwestern mutual fund shares receives a maximum upfront commission of 2.5 percent, the same fee that is paid for a front-load variable annuity. The front-load annuity comes with annual M&E costs of 0.50 percent. “Our advisors often put together portfolios that include annuities and mutual funds,” says Rebekah Barsch, vice president of investment products for Northwestern Mutual. “The advisor is not driven toward one product or another because of the commissions.”

Besides offering relatively low costs, Northwestern's Preservation Plus comes with a range of guarantees. Cautious clients can elect to be assured that they will receive back all their initial principal at the end of the eight-year term. To receive the 100 percent guarantee, clients must agree to keep at least 70 percent of assets in fixed-income vehicles. If a client wants to keep only 30 percent of assets in fixed income, the guarantee would cover less than 100 percent of the assets. For example, an equity-heavy investor might receive a guarantee that he would receive at least 75 percent of his assets back.

In the past, some companies offered principal-protected funds, but typically the insurance company managed the assets. With the Northwestern product, the client has some freedom to pick and choose investments — within boundaries. The investor can select any combination of funds he wants, as long as the minimum amount of assets comes from the fixed-income category. “As they approach retirement, clients want some flexibility to customize their holdings,” says Northwestern's Barsch. “But investors want to be sure that they don't lose their assets.”

Innovative Products

New investments blur the line between annuities and funds.

Annuity Front-End Commission M&E Expenses New Feature
Ameritas Direct 0 0.55% No load, direct sale
Jefferson Monument Advisor 0 $20 a month Flat charge regardless of assets
Northwestern Preservation Plus 2.5% 1.16% Guarantees assets
Mutual Fund Ticker Maximum Front-End Load New Feature
Sun America High Watermark 2010 HWIX 5.75% Guaranteed high watermark return
Source: Companies
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