Housing: The Temporary Reprieve

Let's see. A home-buying credit? Check. A second round of home-buying credits? Check. Tax write-offs of losses for builders? Check. State subsidies for builders? Check. Government "nationalization" of the mortgage origination market(Fannie, Freddie, FHA with 95% market share)? Check. What did all of this get us? Take a look! Here's the Case-Shiller Index of National Housing Prices for 1Q 2010. See the little bump in the graph for a few months? Is that all? Yep.



Sure looks like more declines ahead. Housing as an investment? Nah.

UPDATE 6/4/10: "Credits just shifted demand forward. Price gains not sustainable- Fannie Mae Economist." Story here.

Guess I'm not the only one who thinks so.

The Apprenticed Investor

One of the best investing and trading series ever written, by popular financial/trading/media blog host Barry Ritholtz (The Big Picture). Collected together from various publications, all for the first time.

Find it here.

Thanks, Barry!

The Good, The Bad and The Ugly: GMO Weighs In

In a nice article at Morningstar, the venerable Jeremy Grantham weighs in on valuations of markets and sectors. Long time readers know I really like Grantham's Quarterly Letters (www.gmo.com) and Monthly Outlooks. The link is here.

A few of the key takeaways provided by Morningstar's Ryan Leggio from his notes at a talk given by Grantham and Ben Inker, head of risk at GMO, to investment professionals last Wednesday:

Pension plans assume they can achieve an 8% nominal return with a 60/40 portfolio. Since bonds yield about 4%, this means they assume equities can return about 11% annualized going forward from today's valuations. By contrast, GMO thinks equities will return about 6%. With these assumptions, a 60/40 portfolio is more likely to return about 5% annually.

GMO thinks most equity categories are overvalued. This is because it forecasts the S&P's profit margin will return to its 6% historical level rather than rise to the 7%-plus level analysts are forecasting.

High-quality stocks are a free lunch in GMO's opinion. Since 1965 they have beat the S&P 500, but they should have a lower equity risk premium because they are better companies with better balance sheets than the average S&P 500 company.

Quality stocks are the cheapest they have ever been on a relative basis since 1965 compared to the S&P 500. The last time they came close to this level was in 2000 (tech bubble) and 1969 (right before Nifty-Fifty era).

Thanks Ryan!

Blog Note: Grantham said in his latest Quarterly Letter that a "run to the old highs" was possible. The crisis in Europe and the return of risk and fear in the markets seems to have tempered such optimism.

The Good, The Bad and The Ugly: Returns Going Forward

Morningstar has a good video of Rob Arnott discussing the returns environment for many major asset classes. If you don't know Rob, he is the chairman of Research Affiliates, and he's also the former editor of the Financial Analysts Journal. The link is here.

A highlight (or lowlight) from his video interview:

And yields on stocks--they've doubled in the last 10 years, because it was such a horrific decade. They're still half what they've been historically.

So the yields on stocks are low. The yields on bonds, and an array of other asset classes, are low. People need to ratchet down their return expectations. If you're expecting double-digit returns on your investments, then I'm a bear. I think you're not going to get there.

If you're expecting 5% return on your investments and you're well diversified and you're taking advantage of an array of alternative markets--yeah, that's not just achievable, but reasonably easily achievable. 6% or 8% is possible.

In my opinion, if you are successful timing in to and out of asset classes (this is really what Arnott is suggesting), 6-8% is possible. If you have the usual two-class equities and bond orientation and less than a ten year horizon, getting to 3-4% real returns is going to be a challenge. Not investment advice.

Right On Cue!

It must be something in the water. Or a conspiracy! The same week Bloomberg posts a nice article about the dangers of high yield, Fidelity chimes in with a look at how investors can earn more interest "without excessive risk". Let's see what they have to say. The story is here.

With the average checking account and three-month brokered certificate of deposit (CD) yielding a humble 0.25%,1 you may be yearning for a little more yield on your everyday cash and short-term investments.

Well, don't expect much help from the Federal Reserve, which continues to indicate that it plans to hold its benchmark Federal Funds rate low for an extended period. Still, there are ways that could help you eke out more yield on your cash and short-term investments—without taking on excessive risk.

"It can be done without committing either to long-term bonds or to the volatility that can come from dipping too far down in credit quality," says Richard Carter, vice president of fixed-income securities at Fidelity. "The recent steepness of the Treasury yield curve (see chart below) means that you may be able to get a little more yield for extending maturities a little further than you would have in a period like year-end 2006, when the curve was essentially flat."

What You Can Do

First determine how much of your short-term investments are for immediate needs and has to be easily accessible and liquid. This money should stay in a checking account, money market account or fund, or short-term FDIC insured CD, regardless of the low yield. Beyond that, however, there are a variety of strategies that can help you earn more on your cash and short-term investments. Consider these four:

1. Consider slightly longer maturities

For money you don't need right away, consider investments with slightly longer maturities, including Treasuries, which can provide higher yields. For instance, a 12-month Treasury is currently yielding close to 0.40%, a two-year Treasury close to 1.00%, and a three-year 1.50%. Other options: longer-term FDIC-insured CDs and short-term bonds from agencies or government sponsored enterprises (GSEs). The table below illustrates how slightly higher maturities can bring higher yields. Of course, it's important that your CDs stay within the FDIC protection limits,2 and remember that, while GSEs are strongly supported by the government, in most cases, they aren't explicitly government-guaranteed options.

2. Build a short-term ladder

You can also ladder these securities and invest equal amounts across several maturity buckets. For example, with a three-year ladder, it's now possible to earn annualized returns of roughly 0.8%-1% depending on the bond type chosen (see table below). The three-year ladder strategy won't have as high a yield as buying a three-year bond outright, but it will provide periodic "liquidity events" when your principal matures. That way, if rates rise within the next 6-12 months, you'll be able to reinvest the maturing principal at higher rates.

3. Consider short-term bond funds

Investing in short-term Treasury, government, or other investment-grade bond mutual funds—which is similar to investing in ladders of securities typically maturing in five years or less—may provide higher yields while reducing interest rate and credit risk. They may also provide diversification among issuers and are generally easier to sell than an individual bond.

"As a short-term bond fund manager, I have more opportunities to look at the market and look for attractive investments," says Rob Galusza, portfolio manager of Fidelity Short-Term Bond Fund (FSHBX). "This allows me to allocate assets into higher-yielding bonds more quickly, should rates rise."

4. A more aggressive choice: floating rate or leveraged loans

If you are more aggressive and comfortable with increased credit risk and potential for principal loss, consider mutual funds that invest in floating rate bank loans, which are primarily secured loans made by banks to non-investment-grade companies. Floating rate bank loans have coupons that reset periodically, or "float," based on a fixed premium over a market rate such as the London Interbank Offered Rate (LIBOR), which is the rate that banks charge each other for loans less than one year. And in case of bankruptcy, floating rate loans are senior in standing to bonds on the balance sheets of these companies. The average yield is currently 5.26% according to the S&P/LSTA Leveraged Performing Loan Index.

"The floating rate feature of these loans helps to reduce interest rate volatility, while the combination of seniority, security, and floating rates helps to limit the price volatility of the investment," says Christine McConnell, manager of Fidelity Floating Rate High Income Fund (FFRHX).

Keep in mind the risks of floating rate loans, however. These loans are often lower-quality debt securities, and generally are subject to restrictions on resale. Also, they may not be fully collateralized, which may cause the floating rate loan to decline significantly in value.

Next steps

Despite the low interest rate environment, there are still opportunities to earn more yield by diversifying your cash and short-term investments. Remember, however that because liquidity and risk are key, money for emergencies stills belongs in a checking account, money market account or fund, or short-term CD.

Okay, not much new here. My comments: The floating rate option is not for the faint of heart. At least the article describes it as "aggressive". The longer maturities give you additional interest rate risk. If you keep it short, you can always roll it over at higher rates should they increase. (If rates go lower here, that likely signals big trouble somewhere, either in the economy, the markets or both.) It's a very tough environment for those looking for yield.

The Reach for Yield

Investors are absolutely desperate for returns. Two market crashes and the resultant efforts by the Fed to cushion things by driving interest rates to near zero have investors clamoring for anything with a yield. High yield bonds are not the exception. In fact they may be the poster child for this phenomenon.

In a Bloomberg story appearing today the syndicator reports "Junk Bonds Sell With Weakest Creditor Protection Since 2007". The story is here. It's potentially a sad one. I see nothing but grief coming from this if the economy doesn't stabilize.

Two years after suffering $213.2 billion of losses when debt markets froze, investors in junk bonds are accepting what Moody’s Investors Service calls the weakest creditor protections since 2007.

Even with housing starts hovering at their lowest levels on record, Beazer Homes USA Inc. managed to sell bonds this month on terms that allow it to add more debt. The Atlanta-based builder couldn’t even do that when it issued debentures at the height of the housing bubble in 2006 and its credit rating was seven levels higher. In a report last week Moody’s singled out CF Industries Inc., Standard Pacific Corp., AK Steel Corp. as borrowers offering debt on terms historically available only to higher-rated companies.

“We got ourselves in trouble with that in the past and here it is again,” James Kochan, the chief fixed-income strategist at Wells Fargo Fund Management in Menomonee Falls, Wisconsin, said of the trend toward looser debt covenants. “It’s not that surprising, but it is disturbing,” said Kochan, who helps oversee $179 billion.

Lenders are letting down their guard just as worsening government finances raise doubts about the sustainability of the global economic recovery. Money managers say they have little choice but to go along. They need to find a home for the record $29.4 billion that has flowed into high-yield bond mutual funds the past 16 months from retail investors seeking to join in a rally that has produced an average 69 percent return since the market bottom in March 2009.

Weaker Safeguards

About 60 percent of high-yield borrowers this year offered weaker investor safeguards than on debt they issued previously, according to Covenant Review LLC, a New York-based research firm that analyzes bond offerings. Those include no limits on the amount of debt companies can have and few restrictions on using assets as collateral for future borrowing, reducing what’s available to satisfy creditor claims in a bankruptcy.

“This trend represents more than an episode of ‘back to the future,’” Moody’s analysts including Alex Dill, the firm’s senior covenant officer, wrote in their report. “It reflects a weakening in covenant protections even below those existing at the peak of the market, in 2006 and 2007.”

Beazer sold $300 million of 9.125 percent bonds due in 2018 on May 4 that carry lighter restrictions than its 2006 issue on the amount of debt the builder can add and how it can use money raised from selling assets. The terms also allow Beazer to double its capacity to pay dividends to shareholders even after a 90 percent drop in its stock, according to Covenant Review.

‘Poor Standing’

The company’s senior unsecured bonds are rated Caa2, which Moody’s defines as “judged to be of poor standing and are subject to very high credit risk.” Beazer was rated Ba1, one step below investment grade, in June 2006, when it issued $275 million of 8.125 percent 10-year notes.

Jeffrey Hoza, a vice president and treasurer of Beazer, and Chief Financial Officer Allan Merrill didn’t return calls seeking comment. Junk bonds are rated below Baa3 by Moody’s and less than BBB- by Standard & Poor’s.

Overseas Shipholding Group Inc., the largest U.S.-based oil-tanker owner, sold $300 million of bonds in March, its first offering in six years. Debtholders gave the company the leeway to sell assets, new secured debt and pay dividends to equity holders, according to Covenant Review. The bonds, due in 2018, are rated Ba3 by Moody’s and an equivalent BB- by S&P.

‘No Resistance’

“We were not going to do a deal if we were not able to get that kind of flexibility,” said Morten Arntzen, the chief executive officer of the New York-based company. “We had no resistance to it” from potential investors, he said. Proceeds from the sale were used to repay debt under a revolving credit facility, the company said in a March 29 statement.

Overseas Shipholding’s covenants are “nearly useless,” according to Covenant Review. Investors bid up the debt anyway, pushing the 8.125 percent notes to as high as 102.25 cents on the dollar last month, according to Trace, the Financial Industry Regulatory Authority’s bond-price reporting system.

“They’re a high-yield issuer that’s getting away with investment-grade covenants,” said Adam Cohen, founder of Covenant Review. “You shouldn’t have a high-yield bond that gives you less protection than a lot of the high-grade bonds out there.”

Cash is flowing into mutual funds that specialize in high- yield debt at an accelerating pace. EPFR Global, a research firm in Cambridge, Massachusetts, estimates that before last week, investors put $8.57 billion into the funds, up from $7.33 billion in the same period of 2009.

Soaring Issuance

That money helped push down yields on speculative-grade bonds to 8.23 percent on April 27, the lowest since July 2007, from 21 percent in March 2009, Bank of America Merrill Lynch indexes show. Yields averaged 8.77 percent as of yesterday.

Borrowers are taking advantage of the demand, issuing $109.1 billion of debt this year, compared with the record $162.7 billion in all of 2009, data compiled by Bloomberg show.

Investors are also snapping up junk bonds as Federal Reserve policy makers pledge to hold interest rates near zero for an “extended period” to stoke the economy. Of the 460 companies in the S&P 500 that reported first-quarter results, 77 percent said earnings exceeded analysts’ estimates, Bloomberg data show.

Gross domestic product may expand 3.2 percent this year, after contracting 2.4 percent in 2009, according to the median estimate of 72 economists surveyed by Bloomberg. Housing starts climbed to an annual rate of 626,000 in March, up 1.6 percent from February’s 616,000 pace, though still half the level from October 2007, according to Commerce Department data.

....

No End

Martin Fridson, the chief executive officer of New York- based money manager Fridson Investment Advisors, said the loosening of covenants isn’t at a level yet that would signal the end of the bull market in junk bonds.

Covenants are typically strengthened following periods in which high-yield issuers are blocked from the market, “and at the end of that cycle, there’s an ‘anything goes’ mentality,” said Fridson, 57, who was Merrill Lynch’s head high-yield strategist before leaving to form his own firm in 2002. “We haven’t reached that final stage.”

Cracks in the junk bond rally are emerging on speculation that rising budget deficits in European countries such as Greece, Spain and Portugal may cause lawmakers to curb spending, slowing the global economy.

Bond Losses

High-yield bonds in the U.S. have lost 2 percent this month, according to Bank of America Merrill Lynch index data. This would be the first down month since February 2009, when they fell 3.47 percent.

....

‘Like a Meme’

“Once you get a structure into the market, it replicates itself like a meme and it survives because the investors keep buying it,” Dill said.

Rising demand for junk bonds has also allowed companies emerging from bankruptcy, including Houston-based Lyondell Chemical Co., which sold $2.75 billion of debt in dollars and euros on March 24 and Lear Corp. of Southfield, Michigan, which issued $700 million of notes on March 23, to borrow with few restrictions, Covenant Review’s Cohen said.

Lyondell’s covenants offer no clear limits on the amount of additional secured debt the company can sell and permit it to shift as much as $1.25 billion of assets to units that aren’t covered by the bonds’ limitations, reducing the collateral available to creditors, according to a Covenant Review report.

“In 2008, all the companies that we said would screw the bondholders did it,” said Cohen of Covenant Review. “Now, it feels like 2007 to me. We’re telling them they’re going to get screwed and they’re not paying attention.”

Hurling Rocks at Goliath: Fighting the IRS

Think having your 401k get halved and then sitting out the rally because you switched to bonds (they're safer!) isn't bad enough? Well some people think worse CAN happen: you could get audited by the IRS. This article from the Wall Street Journal (www.wsj.com)talks about this issue.

With Washington searching for ways to cut the budget deficit, IRS officials face intense pressure to collect more revenue. The agency plans more audits, especially of taxpayers in high brackets or those who are self-employed and deal in large amounts of cash. The IRS also has turned up the heat in such areas as offshore tax evasion, including undisclosed foreign bank accounts.

If you become an IRS target, what should you do? For many people, the answer may seem simple: Surrender as quickly as possible, no matter how good a case you have.

Even if you are sure you are right and have all the records to prove it, fighting the IRS, one of the most powerful government bureaucracies on the planet, can be the ultimate nightmare. Seemingly routine struggles can drag on for years, leading to endless frustration and sleepless nights. Even those who eventually triumph may wonder if the fight was worth all the time, effort and expense.

But if you're ready for the challenge, there are many smart ways to fight back—and win. Start by keeping comprehensive, well-organized documents. Always scour the IRS's claims for mistakes. Don't get discouraged when dealing with tax officials. If you are convinced you are correct, consider pushing your case up the chain of command. Try the IRS appeals division. You may also get valuable help from the IRS's taxpayer advocate service. Or go to court.

At the same time, there are some classically dumb mistakes to avoid—everything from simply ignoring the IRS to arguing that it somehow is voluntary to pay federal income tax.

Here are some combat tips from lawyers, accountants and "enrolled agents," who are federally licensed tax experts authorized to represent taxpayers at all levels of the IRS.

Dumb moves

Hire the wrong tax preparer: Beware of someone who asks you to sign a blank tax return. Or whose fee is based on a percentage of how much you save in taxes. Or who promises to get you a significantly higher refund than anyone else can. People like these are likely to prepare outrageous returns that will land you in deep trouble with the IRS.

The Ostrich approach: One of the biggest mistakes is to bury your head in the sand and ignore IRS notices and letters, hoping the tax collectors eventually will lose interest and go away. "When dealing with the IRS, the best thing someone can do is to maintain regular communication," says Charles P. Rettig, a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez P.C., in Beverly Hills, Calif. "Whether during an audit or in the tax-collection process, ignoring the IRS is simply a bad idea."

Act professionally throughout the process and reply to IRS correspondence on time. The IRS is very serious about deadlines. Also, "keep a record of all communications and correspondence with the IRS, including proof of delivery, and keep your records organized," says Caroline D. Ciraolo, a tax lawyer at Rosenberg Martin Greenberg LLP in Baltimore.

Frivolity: Some people tell the IRS and judges that it somehow is voluntary to file a federal income-tax return and pay taxes. Or that their wages, tips and other income for personal services aren't taxable. Or that they are residents of a state but not of the United States. Or variations of these themes.

Don't even think of making any of those claims. Tax Court judges routinely label these as "frivolous" arguments, delaying tactics or both. More important, judges often impose stiff monetary penalties on those foolish enough to persist.

Bribery: This is even dumber—and far more dangerous—than frivolity. In a case last year, for instance, a Houston-area resident was sentenced to prison for two years for trying to bribe an IRS agent, according to a report by the Treasury Inspector General for Tax Administration. The U.S. Attorney's office in the southern district of Texas said the man offered the agent $2,500 to reduce his tax liability to around $500 from $49,000. In addition, the man "repeatedly offered the agent pizza from his restaurant as part of the deal."

Automatic surrender: Just because the IRS says you owe money doesn't mean that's correct. The agency makes mistakes—plenty of them, even in computing penalties and interest. "I have had several clients receive notices regarding unreported securities sales," says Stephen W. DeFilippis, the owner of West Suburban Income Tax Service in Wheaton, Ill., and an enrolled agent. "In these cases, the clients exchanged mutual funds one for another and didn't realize that's a taxable event." The IRS, he says, sent a notice "including the gross proceeds in income and assessing tax on the additional income."

But the IRS missed a vital point, he says: "The clients brought me these notices, and in each case the mutual-fund exchanges resulted in a loss. So instead of owing a large sum to the IRS, the clients got a refund."

This story shows how foolish it can be to pay what the IRS says you owe without "thoroughly investigating" the subject, says Mr. DeFilippis.

But if the amount in question is relatively small and the issue is confusing, some may conclude it isn't worth the time, trouble and expense of challenging the IRS and may decide to pay in order to make the problem disappear. It depends on the details of each case, including how confident you are of victory and how much time and expense you are willing to devote to the battle.

But often the smartest move is to get someone involved on your side: either an accountant or a tax attorney. The IRS makes mistakes. Loads of them. But the presentation and proof of those mistakes can be critical. And even when the IRS is proving obstinate, having that expert on your side can give you enough gumption to fight on. The IRS is no longer the automatic winner in appeals. As it used to be. And an appeal may be your only avenue of relief.

Consult your planning or tax professional if you have questions.

A Taxing Dilemma

You know in your heart that tax rates are going to rise. In fact you plan on it. You advise clients so and in your personal accounts you are positioned that way. They HAVE to, right? How else to fund the massive bailouts and stimulus programs.

But in the past, unlike this year, the IRS gave you some inkling by now of what it intended for the next year. Congress too. But they haven't and that is causing some stress among financial advisers.

As an example. advisers have been waiting to see what the tax rates on dividends will be for next year. This conundrum, and what investors want to know, were examined in a recent Wall Street Journal article:

Next year, what will the top tax rate on dividends be?

Investors like Clint Myers, an investment actuary in Georgetown, S.C., want to know. Some experts cite a 20% figure, while others say 39.6%, and still others talk about a tripling of the current 15% rate. "Lately I have seen figures citing almost any rate you can imagine," Mr. Myers says.

The short answer is that the 2011 nominal rate on dividends could be either 20% or 39.6%. Or something else—it is impossible to say given the legislative mood these days.

This is a big issue. Dividends provide approximately 40% of the total return to investors. How you tax them directly affects the allocations an adviser suggests for his/her clients. When will Congress act? We simply don't know but the present structure expires soon.

Next Jan. 1, a package of tax changes enacted under President George W. Bush expires. These provisions contained a historic change for dividends: For the first time, most were taxed at the same low rate as capital gains. Until then dividends had been grouped with interest, with both taxed at the higher rates levied on wages. In 2003 the nominal top rate on qualified dividends (usually, on stocks held longer than two months) dropped to 15%, where it has been ever since.

If Congress doesn't act, this reclassification will lapse at the end of 2010, and next year the top dividend rate would automatically revert to 39.6%.

The upshot is that next year the after-tax value of a 4% dividend yield on $100,000 of stock could be anything from $3,400 to less than $2,500 (before state taxes), and higher tax rates could lower the value of the underlying holding. Hardest hit, says Robert Gordon of Twenty-First Securities, could be utility stocks and fixed-rate preferreds with no way to adjust upward. He suggests a portfolio review to check for vulnerable spots.

Good advice.

An Annuity Bubble?

In an article entitled "Annuities: Their Surprising Comeback" Elizabeth O'Brien of SmartMoney chronicled the "surprising" explosion of annuity purchases, especially by boomers. It seems that boomers, having been twice burned by the stock market in their peak investing years, are now twice shy. We have talked about this phenomenon before. My take? The push for yield continues and investors expectations for this asset need to be moderate at best. Maybe something on the order of 6-7% per annum, barring further financial distress.

The link is found here.

When Karin Kuder retired in 2007 from her career as an occupational nurse, she hardly imagined she’d wind up writing a six-figure check to an insurance company and signing away control of her nest egg. But after she lost tens of thousands of dollars in one scary swoop in 2008, she found herself enduring sleepless nights. So Kuder, who’s 62, put more than $150,000 in a fixed annuity, where it grows at a steady rate and can’t shrink if the market drops. “I don’t worry about that money,” Kuder says. “It’s safe.”

They can be a nightmare to understand, even harder to shop for. And yet the inscrutable annuity, a product that’s been around for centuries, is fast becoming the country’s most tempting retirement investment, offering the kind of security that financial advisers say aging baby boomers are grasping for. For years, of course, annuities have been picked apart by critics, and even by some advisers who sell them, for their high fees and bewildering rules. (The number of pages in a typical prospectus for one kind of annuity: 700.) But as economic insecurity lingers, some experts are seeing annuities as a product that can deliver the kind of guaranteed monthly paycheck—in good times and bad—that our parents enjoyed in the age of the company pension.

In a twist that fits a cautious era, it’s the least sexy of these investments that have fared the best. In 2009 so-called fixed annuities attracted $108 billion in assets, 48 percent more than they did two years prior, according to Limra, an insurance trade organization. Although sales slacked off somewhat as the stock market recovered, Americans have still sunk their money into these investments at a rate of about $300 million a day, and the insurers that sell them are pouncing. Major annuity sellers have stepped up their efforts to get employers and mutual fund companies to include annuities in workers’ 401(k) plans. And advisers who’ve backed annuities all along are saying they told us so. Jean Fullerton, a planner in Manchester, N.H., says the number of her clients buying annuities has surged in the past year. “Now that we’ve had the market crash,” she says, “they’ve finally caught up to my thinking.”

The industry certainly has momentum on its side. Most investors haven’t recouped the savings they lost in the crash. In a recent survey by the Employee Benefit Research Institute, roughly one in four people said they might postpone retirement for financial reasons. Annuity providers say they’re prepared to cover that gap; they often cite a study by Wharton School professor David Babbel, who concluded that a retiree who didn’t annuitize some savings would need a nest egg 25 to 40 percent larger than someone with annuities in his portfolio. That study was financed by the insurance industry, but it has swayed some skeptics—even the Obama administration has since given annuities an implicit endorsement.

Still, annuities haven’t gotten any less complicated, and there’s no easy way to compare investments whose features and costs vary depending on who’s selling them and whose prospectuses can rival War and Peace. With these issues in mind, we put together our first-ever ranking of the top annuities. We combed through more than 100 annuity offerings from two dozen major insurers, ferreting out details about their prices and features; we also turned to researchers at Morningstar and A.M. Best to help us gauge their financial strength and uncover hidden fees.
Making the “mortality” wager

For many years, basic annuities were an afterthought: They were briefly in vogue after the tech bust, but as stocks heated up mid-decade, their popularity receded. The latest crash, of course, changed investors’ attitudes—and prompted an unexpected shout-out from the White House. In January the president’s Middle Class Task Force, charged with helping average Joes repair their bank accounts, said that fixed annuities could reduce the “risks that retirees will outlive their savings, or that their living standards will be eroded by investment losses or inflation.” Today the Labor and Treasury departments are mulling over proposals for bringing annuities into the retirement-savings mainstream.

Fixed annuities play a security-blanket role by setting up a slightly creepy wager: The customer gives the insurer a chunk of money, the insurer bets that the customer will die before she gets her money back, and the customer bets she’ll outlive her money and then some. The older the customer is, the more likely it is the insurer will win. That calculus gets converted into a payout through “mortality credits,” explains Chris Blunt, executive vice president of annuity giant New York Life. So a man who buys an annuity at age 70 might get paid 8 percent a year, while a man who buys at 50 would earn less than 6 percent.

What troubles some investors is that fixed really means fixed—as in set in stone, like Medusa’s victims. If the stock market goes up 50 percent, an annuity owner’s annual 8 percent can feel measly by comparison. That’s why for most of the past decade, variable annuities, which invest the customer’s money in mutual funds and potentially pay more, were the hotter investment. Though still an option, those annuities got into some hot water during the crash, inflicting losses on companies that sold them. Today many advisers look more carefully at an insurance company’s financial strength. These ratings are issued by third-party companies; advisers and insurers will disclose them to customers who ask. Grade inflation is rampant in this world, however: B or B+ is the lowest score that most insurers post, and there can be a big difference between a single-A-rated company and a top-rated, A++ company, says Clifford Michaels, a financial adviser in New York City.

Experts also say that fixed annuities aren’t always quite as restrictive as they sound. More companies now allow the buyer’s heirs to keep receiving payments if the buyer dies earlier than expected. Investors can also get payments that rise to adjust for inflation. These features come at a price, in the form of lower monthly income, notes Judith Alexander, director of sales and marketing at annuity consultants Beacon Research. But annuity companies, including New York Life and Nationwide Financial, say they’re doing more to make those features more flexible and, potentially, cheaper.

Still, even financial planners who love annuities don’t sell them to all their customers. They seldom make sense for people in poor health. And for younger buyers, the meager payouts aren’t usually worth the loss of control. The sweet spot for investors begins when they’re in their early 60s. But advisers stress that even then most investors should stash, at most, 40 percent of their assets in annuities, with the remainder in other investments—they need to keep their portfolios growing and have cash on hand for emergencies. Indeed, for a long time, advisers and investors thought of annuities and other investments as an either-or proposition, says Eric Henderson, senior vice president for individual investments at Nationwide: “More and more, people are saying it’s ‘this-and.’”

Here's the takeaway. Annuities become very popular after crises like the tech bust and 2008. They have a role in a portfolio but it's limited. When an advisor legitimatelt believes that his client may outlive his money, AND A PRODUCT IS AVAILABLE, AFFORDABLE AND SUITABLE, then an annuity my be introduced into the investment mix to maximize the probability of funding retirement. (Nothing in life is guaranteed, folks.) Otherwise, annuities are an insurance policy that most can't afford at a time when least desirable, i.e. right when the asset class you were frightened out of (stocks) have the highest return probabilities.