What's in a rate of return?Blog added by Mike McGlothlin CFP®, CLU, ChFC, LUTCF on May 23, 2014
Mike McGlothlin

Mike McGlothlin CFP®, CLU, ChFC, LUTCF

Fort Wayne, IN

Joined: March 06, 2014

If we don't compare apples to oranges, then why do we compare rates of return equally? There are so many components to the real rate of return that people ignore them when they choose investment vehicles. If we look at the real return to clients, many vehicles look similar. So why take on additional risk for similar returns?

Let's take Paul and John as an example. Paul likes the idea of investing in a group of sub-accounts in a variable annuity with an income rider to protect his income. John, on the other hand, wants to protect his income but does not want to risk principal; so, he places his retirement money into a fixed indexed annuity. Paul's investments average 7 percent per year, but he pays 1.25 percent for M&E; 1.35 percent for the cost of the rider; and 0.95 percent for the asset management fees on the sub-accounts. His real rate of return is 3.55 percent (7 percent - 1.25 percent - 1.35 percent - 0.95 percent).

John has an identical income rider with a guaranteed roll-up and income for life. His cap rate is 6 percent. During his holding period, the market hits the cap 80 percent of the time (statistical average) for an index gain of 4.8 percent. After the cost of the income rider (0.95 percent), John's retirement money grows at 3.85 percent, without any downside returns due to the fixed indexed annuity.

The lure of unlimited upside potential comes at a cost in terms of fees and rider costs. It's important to have a discussion with clients about the real rate of return and not just the nominal return. Nominal returns are returns that sell, but the real return is what generates client growth. Said another way, it's not what you earn, it is what you keep.
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