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Private Harbour Investment Management & Counsel

A case study of how we helped one of our clients

by Jim Blue



The following real-life case study highlights the issues we discovered as we investigated one family’s situation. It is illustrative of how Private Harbour works with our clients to serve their individual needs in a professional manner. Names have been changed to protect the anonymity of those involved.





We were first introduced to Virginia’s situation late in 2001, when she was 94-years-old.  Her son Michael is a medical professional who does not consider himself to be financially sophisticated.  Michael had some questions about how a local broker was managing her account and asked us to review his mom’s financial affairs.


Virginia’s husband, who had passed away eight years before we were introduced to her situation, trusted the broker and she accepted that as “good enough”.  The fact that he sent her birthday cards each year created a sense of comfort and personal connection that she felt would lead her broker to act in her interest.  Unfortunately, her trust was misplaced.



What We Found


The most striking find was the existence of two variable annuity contracts totaling $540,000.  Given Virginia’s age and current financial situation, she did not have a need for annuity contracts.  With taxable income of approximately $2,000, Virginia was in the lowest tax bracket, while her son and daughter were paying taxes at much higher rates.


In our opinion, there are limited circumstances in which annuities are the right answer to any investment question.  Annuities are often sold because the selling agent is paid a large commission, not because it is necessarily the best investment for you.  For more on this please reference  Virginia’s two contracts were expensive from an annual fee perspective, had limited investment choices and withdrawal flexibility and were ultimately tax inefficient as well.


The total cost to own a variable annuity is comprised of several components, which may be found either in the contract language or the prospectus that relates to each annuity.  In Virginia’s case, the value of the annuity was high enough for the annuity company to waive the $30 annual fee, but several other larger fees were incurred.  The details of one contract are noted below, but both annuity contracts had similar cost structures and provisions.


The mortality and expense ratio was 1.40% annually.  This is the amount the insurance company charged Virginia to cover their risk that they may have to pay you more than her mortality table expectations would indicate.  In addition, the broker selected several investment sub-accounts (similar to mutual funds, but not publicly traded).  These funds and their fees are detailed below:


Sub-account fund

*Expense ratio


Janus Growth


American Century International


Federated High Income Bond


Fidelity Equity-Income


Fidelity Investment Grade Bond


ING VP Bond Portfolio



* Other investment selections showed investment advisory fees ranging from a low of 0.34% for their Money Market Fund to a high of 1.69% for the Developing Markets Fund.


The total annual percentage fee for the investment selections made within this particular variable annuity contract ranged from 1.9% to 2.9% annually (computed as the sum of the mortality and expense ratio plus investment advisory fees).  Further, upon the initial sale of an annuity contract, the selling agent may receive a significant commission of at least 5-9% of the contract.  We have heard of equity-indexed annuities with additional riders paying commissions as high as nearly 20%.


This commission is paid to the agent up-front, but the insurance company earns back that money over time by forcing annuity contract owners to remain in the policy through something called a “contingent deferred sales commission.”  As an example, were you to sign an annuity contract and wait through the 10-day “free look” period, should you choose to exit the contract, you might have to pay the selling agent’s commission back to the insurance company.  This manifests itself as follows on a $250,000 contract (see below chart).  Keep in mind that these are additional charges on top of those already mentioned!

Contingent Deferred Sales Charge

Amount Paid on $250,000 contract


Year 1: 7% - $17,500

Year 2: 7% - $17,500

Year 3: 6% - $15,000

Year 4: 5% - $12,500

Year 5: 4% - $10,000

Year 6: 2% - $5,000

Year 7: 1% - $2,500


The investment options were limited to those provided by the insurance company.  As part of our strategy to effectively deal with these contracts on a tax-efficient basis from a multi-generational standpoint, we concluded that we wanted to exit these expensive contracts in a cost-effective manner.


All financial institutions must maintain the privacy of their clients’ financial information.  Private Harbour is no different in this regard.  However, this protective shield also makes it extremely difficult to gather useful information with which to evaluate annuity products.  Since the insurance company would not release the details of the contract term, we called the broker to determine when the contingent deferred sales commissions would expire.

What we learned was that the broker had sold Virginia two annuity contracts when she was age 82 – reaping a nice commission.  Once the seven-year contingent deferred sales commission period expired, rather than allowing Virginia to retain the existing contracts, the broker sold her another two annuity contracts, capturing another large commission for himself.  In her situation, we seriously doubted there was any legitimate merit to owning an annuity.  Furthermore, the decision to swap into a new annuity, forcing a re-start of another seven-year contingent deferred sales charge at age 89 for any reason is highly unethical, in my opinion.

At age 94, and in questionable health, Virginia was at risk of passing away at any moment.  This created the potential for a significant tax problem.  While Virginia was in the lowest tax bracket, her son as a successful medical professional was in one of the higher tax brackets.  Were Virginia to pass away while owning the annuity contracts, her son would inherit it as a beneficiary.  That asset would not receive a step-up in basis on that investment and he would have been required to withdraw the money over a maximum of a five-year period.  This would have pushed his income into maximum the 39.1% Federal Tax Bracket at that time.  That rate plus the relatively high Ohio state tax rates would have done significant tax damage to what was supposed to be a tax-advantaged investment.

The unintended consequences of the broker not thinking on a multi-generational basis was that nearly 50% of the embedded investment gains within the annuity contracts would be lost to income taxes as her son was forced to withdraw the money in the five years following her death.

In order to combat this potentially significant negative, our recommendation was to withdraw the taxable income in Virginia’s name over a 13-month period straddling three tax years.  This served to create a favorable tax-arbitrage, as we were able to utilize the lowest levels of our graduated tax system to shelter some of the income at a rate below that of the son’s very high marginal rate.

In addition to the annuity issues, we also found that Virginia also owned shares of the proprietary “Best of 2001”, Pharmaceutical and Biotech Funds.  Similar to annuities, brokers are often paid commissions through what is called a 12b-1-distribution fee.  These fees are attached to certain mutual funds in order to compensate the brokers for selling an investment company’s mutual fund products. 

In this case, the brokerage firm that employed Virginia’s broker compensated him for selling those funds to her.  The “Best of 2001” fund was a compilation of the brokerage firm’s ten best stock ideas for the upcoming year.  This list was rotated annually, offering the broker an opportunity to swap into the same fund each year, earning another fee opportunity.  Rather than just buying the 10 stocks outright, the broker chose to buy the ten stocks wrapped in a high-cost mutual fund.

Another issue that we discovered in our investigation was Virginia’s emotional attachment to Exxon.  Her husband bought the stock through a dividend reinvestment plan over many years and it had become a very good investment.  Rumor had it that his last words were, “whatever you do, don’t sell Exxon.”  While Exxon has been an excellent company for years, her restriction on Exxon sales required some additional management finesse.

With the taxable investments owned outside of the annuity, the broker had realized tax losses of $30,000 and had additional unrealized losses on Virginia’s investments of approximately $50,000.  The IRS allows you to deduct up to $3,000 of realized capital losses per year, over and above the realized capital gains, against ordinary income.  However, the tax benefit from any non-utilized unrealized loss carry-forwards that exist at her death would be lost forever.  We felt it was highly unlikely to believe that she would be able to fully-utilize the benefit by living to age 120.

Most of the unrealized gains in her portfolio were in Exxon stock, which was deemed untouchable.  Therefore, we had to craft a strategy to realize taxable gains quickly in order to utilize the realized losses in the investments we did not believe were appropriate to retain.  Virginia’s income needs were fully met from her social security and a modest draw on her assets.  Therefore, income generation was not a priority in her mind. 

Since it was more tax-efficient to save taxes by withdrawing the non-taxed income from Virginia’s annuity contract in her tax bracket, we restructured her portfolio to limit taxable interest and dividend income, while striving to create capital gains.  In doing so, we were able to “create room” in the lower tax brackets for taxable annuity withdrawal income, while also striving to create future capital gains with which to absorb the approximately $80,000 of losses that would be realized after implementing our restructuring plan.

Another item we noted in our review was that Virginia and her husband had created fairly typical A/B trusts, whereby sufficient assets would be owned in a family trust to take advantage of the Federal Estate Tax exemption.  The remaining assets would be held in Virginia’s trust until her passing.  With approximately $850,000 worth of assets in her trust, and a 2001 Federal exemption amount of $675,000, Virginia was in danger of paying both Federal and Ohio state estate taxes should she have passed away in 2001.  One of our observations was that the broker was making cash distributions from the family trust to pay taxes.  The implication of this was that he was reducing the family trust, which had already been through the estate tax process, while not reducing the assets in Virginia’s trust that would have to pay Federal and State estate taxes – a double negative.

The Results


We created an overall portfolio for Virginia that was approximately 50% stocks and 50% bonds.  This was not done because she necessarily needed growth at her age or in her situation, but because we felt that there was a need to strive to realize gains before she passed away to take advantage of her deferred tax asset (the realized losses).  Additionally, with both of her children in good financial situations, and with Virginia not needing current income we felt that this balanced approach would serve both generations fairly well.


In order to reduce the volatility in her portfolio, we restructured the investments within her annuity contract to represent more of a fixed income portfolio (e.g., bond funds instead of stock funds).  This added balance to the overall investment allocation and helped smooth out the ups-and-downs of the stock market.  The income earned in the fixed income investments within the annuity was not subject to direct taxation, achieving our goal of further lowering her taxable income.


We wanted to invest in money market instruments within the annuity to protect the value in case of market turbulence, and because we intended to withdraw the annuity assets over the next several years.  Unfortunately, we found that the cost was too high.  The yield on the annuities Money Market Fund option was 1.0%, but the mortality and expense ratio was 1.4%.  In addition, the advisory fee on that Fund was 0.34%.  This created an expected net return of –0.7%.  We could not even go to cash to protect her assets without locking in a guaranteed loss!


In the end, the plan worked out very well for the family.  The stock market cooperated, climbing up from the bear market bottoms in October 2002 and March 2003.  We were able to generate realized gains sufficient to use all of her tax loss carry-forward before she eventually passed away in 2004.  We did not have to sell any Exxon, preserving the emotional ties she held for the stock.  The annuities were withdrawn in a tax-efficient manner, trading off the lower brackets of her tax situation versus the higher brackets of her successful children.



Points to Consider


  • Even if you have an existing relationship with a financial advisor, if you have any doubts about their actions, it is worthwhile to have an expert double-check the situation.


  • You should always know the total cost of any investment choice – both products and services.  Any reputable professional will be up-front about the cost of his or her service and there is always a fee.  Even if there is no explicit commission, the fee will be buried within the investment vehicle, ultimately limiting your returns.


  • Even if you feel that the investment allocation and composition of the portfolio are sound, there are income tax and estate tax considerations that may do real financial damage – potentially for the heirs.


  • Your broker or financial advisor may not be thinking about your income tax or estate tax situations.  Further, he or she may not be thinking about the impact of asset transfers across generations.


  • If someone tries to sell you an annuity, they better have awfully good reasons.  If you do not have an advisor who understands that product, please find one before you sign anything.


  • Don’t buy products - buy individual investments directly!  That way you can manage the cost of entry and exit as well as the timing of any tax consequences.  While mutual funds are a fine investment when you do not have the money to build a sufficiently diversified portfolio, they do have disadvantages that can be avoided.


  • Proper estate planning means more than just having trust documents prepared.  Trusts have to be funded and ownership has to be checked against tax law changes as well as each family’s personal and financial situation.




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