Many financial advisors tout their independence and ability to choose from the large pool of products created for clients by the manufacturers and distributors of financial products.

Industry insiders know two things that are very critical about this.

First is that many advisors are not truly independent, and can only make products available for their clients to the extent that their firm or custodial firm has an agreement with that manufacturer or distributor. Ironically, sometimes the household-name behemoths in the industry have more proprietary and less independent products than others. And while this may indeed limit your options as an advisor, it does not necessarily hurt your client.

The second is that even if a firm has a huge selection of products, it is nearly impossible for an individual advisor to be knowledgeable about all of the choices. As a result, it is common for advisors to concentrate their client service efforts using the products that they are familiar with and use frequently.

The huge selection for clients and the never-ending flow of new products are both good news and bad news for advisors. The good news is that you do have a lot to choose from for your clients. But the bad news is that you really need to understand all of the options to truly offer your clients independent advice, and that in and of itself can be an all-consuming task.

For the purposes of this column, I'll focus on the newer products that seem to be getting a lot of attention today. And as you may expect on the heels of the "Lost Decade" and the Baby Boomers' work careers ending with thousands of employees retiring each week, many of today's innovations in products are focused on two major issues: capital preservation and income generation.



Capital preservation is the cry of the day for many of the same Boomers who demanded 20 percent per year during the go-go technology days. These clients went from thinking that a monkey throwing darts could achieve at least a 10 percent per year return to begging for products that may offer some upside but that either limit or prevent losses.

Income generation is a close second as Boomers retire from work and many realize that their nest egg is not as cushy as they once thought. As soon as their financial planner starts talking about safe withdrawal rates, reality sets in pretty fast and they must either postpone retirement or look for ways to reach for yield in the hopes of hitting their needed rates of return to have their assets last for their entire life.

Once upon a time, financial products were pretty much classified into a few broad categories. Stocks, bonds and cash were the main three classes that the average investor used to diversify their holdings. In addition to the original three in the eyes of your clients, other asset classes sometimes held a prominent role in your clients' lives. These included their closely held businesses, their investment real estate and their insurance portfolios. These additional asset classes -- the backbone of true wealth-building for many clients -- were frequently ignored by advisors when designing allocations for the remaining liquid portfolio of assets.

Today, popularity is rising for a number of products that offer some sort of principal protection. The two that I see most frequently are annuities and structured products. When talking about principal-protected products, your clients will hear the words "guaranteed" and "can't lose" frequently from the sellers of such products. While there may indeed be guarantees, to say that you can't lose is also misleading. Ask yourself the question, "Who is guaranteeing the guarantee?" As CPA financial planners, we understand guarantees and also realize that the guarantee is only as good as the guarantor. Should the guarantor fail, your guarantee may also be worthless or provide lower benefits than guaranteed.

Annuities appear to be among the most widely used of all protected products. Even the fee-only crowds that frequently talk down on annuities are now admitting the possibility that there may be merit to holding annuities as a portion of certain portfolios.

Annuities come in two flavors -- fixed and variable -- and are hardly new products. But what is new is the use of riders and benefits that come and go so fast that most advisors are hard-pressed to know which company is offering what benefit and at what cost. In the fixed annuity world there are again two types. First is a traditional deferred fixed annuity. These are deposits with an insurance company where the insurer tells you each year or for a guaranteed term exactly what your rate of return shall be. Other than the actual credit risk of the insurer, your principal and the stated interest rates are guaranteed by the insurance company.

Another form of fixed annuity is known as an index annuity. The big difference between indexed annuities and traditional fixed annuities has to do with the interest-rate crediting process. With an indexed annuity, the annuity owner may choose from a basket of indices that determine your rate of earnings for a given period. The basket may include the S&P 500, the Russell 2000 or a number of other possibilities offered by the insurer. These products typically offer protection of principal during down years for the index that you have chosen, but they also have limits on your upside. Insurers limit your upside by either stating a cap on the maximum amount that you'll be able to earn in any given year or by reducing your index's rate of return by an amount that is called a spread. Partly because of today's low-rate environment, caps are historically low and spreads are historically high, leaving a fairly limited upside to purchasers of index annuities today.

A highly regulated product, index annuities have been a sore spot for financial planners largely because of insurance-based advisors who use the index annuity as the be-all and end-all for their client portfolios. Like any financial product, index annuities used for a part of an allocation may make sense.

The variable annuity, another product frequently bashed by the popular press because of the high expense structure, is also frequently used as a principal-protection strategy. We could write a book on the topic of annuity pros and cons, but for our purposes here, we'll address the most common uses.

First is pure principal protection. One may purchase a variable annuity, invest in equity or fixed-income investment sub-accounts and, like an index annuity, participate in any investment upside with limited or no loss on the down side.

More popular in the variable annuity space are living benefits. The living benefit options are generally designed to provide income benefits to purchasers for their lifetime. Early objections to these products have been their inability to keep pace with inflation over a lifetime, but many of the newer products provide the potential for increasing income throughout life.

Right now in the variable annuity marketplace, insurers are dealing with headwinds that include a low-interest-rate environment and the high cost of derivatives, which are frequently used as the hedge tool that may help to limit losses for the underlying portfolio of the insurer. As a result, benefits are dropping, with some even disappearing completely from the annuity landscape.



Structured products are not that new to the marketplace, but are relatively new to retail investment. A structured product is set up much like an index annuity, where an investor may participate in an upside of the chosen index available within the structured product that one purchases. The upside frequently has a cap. On the downside, investors are frequently offered a cushion or elimination of losses.

Structured products typically have two components -- a note and a derivative -- and a fixed maturity. They are complicated investments intended for a "buy and hold" strategy and offer protection from downside risk in exchange for foregoing some upside potential. Principal protection may vary from partial to 100 percent.

Investing in structured notes is not equivalent to investing directly in the underlying securities or index, and carries risks such as loss of principal and the possibility that you may own the referenced asset at a lower price, due to economic and market factors. At maturity, if the derivative turns out to be valuable, the investor can gain exposure to the upside of that index.

A clear difference between this and the annuity format is taxation. In a structured product, income often accretes to the owner's tax return each year based on the income or phantom income produced by the structured product internal appreciation or growth.

Structured products are each individually registered securities, and each individual offering must have its own prospectus and be approved by regulators for offering. As a result, many sponsors of such products offer fairly short windows for you or your clients to decide and then act on making the investment. Once you understand the inner workings of structured products, the due diligence may become less time-consuming, enabling you to act more quickly.

On the insurance side, the newest side of the business is the warp speed with which companies are entering and then exiting specific markets. On short to no notice, many carriers have pulled out of markets or decided to compete in what may feel like a crowded space. Long-term-care insurance appears to me most affected, with annuities a close second. But in terms of newer products gaining traction, hybrid life policies and LTC policies appear to be gaining momentum.

These types of policies require a large lump-sum deposit, frequently refundable at any time. In exchange for that deposit, the insurer will give you a permanent death benefit that drops over time, and long-term-care coverage comparable to a traditional LTC-only policy. While rates are so low, this type of product has great interest among fixed-income investors. As your deposit is fully refundable at any time, the real cost of the coverage is the opportunity cost on the deposit that will earn zero percent interest from the insurer. If the safe interest rate on cash was higher, this type of coverage might not be so popular.


John Napolitano, CFP, CPA/PFS, is chairman and CEO of U.S. Wealth Management, in Braintree, Mass. Reach him at (781) 849-9200.

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