BUNK 15
VARIABLE ANNUITIES ARE ALL UPSIDE, NO DOWNSIDE
I’ve been accused of being hard on variable annuities. So I apologize. I apologize to every high net worth investor for being hard on variable annuities in my public writings instead of über-hard. Instead, it would be better if I had done more to keep people—like you—from buying one. (Hopefully, you haven’t bought one.) There’s little worse for high net worth investors (and plenty of other investors) than these, particularly equity-indexed annuities. That these are a “safe way” to get market-like growth with less risk is first-order slam-dunk bunk.
First and foremost—annuities are insurance contracts, and only as good as the firm behind them. Investors in 2010 and beyond will remember well: Insurance firms can and do go kaput. If the firm issuing your annuity goes bankrupt, your contract may be null and void and the premiums simply lost.
This is radically different from investing in stocks and bonds. The brokerage firm can go kaput (and they do) but with no impact on your ownership of publicly traded stocks. (Unless you happen to own stock in the bankrupt brokerage, which likely went to $0. But then, that’s an issue of never holding more than 5 percent in any one stock so one blow-up doesn’t take your entire portfolio down—basic rule covered in Bunk 33.) You own the stocks and bonds—the brokerage (or bank) is just a transparent piggy bank. You can easily journal those securities to another firm for safekeeping—easy to do in the Internet age. But if the firm issuing your annuity blows up, your loss on the contract may be total. Never forget that!

Two Basic Types

There are two basic types of annuities I’ll consider here—fixed and variable. Fixed annuities are straightforward—you hand over premiums, either periodically or a lump sum, for a guaranteed income stream, now or in the future, for the rest of your life. With these, it’s a race against your expected mortality. If you die by the time the insurance firm’s actuary calculates you will, the insurance company wins. If you die very much sooner, it really wins. If you live much longer than expected, you win. It’s as simple as that. The other risk is the insurance company could go kaput, and with it can go your revenue stream (as stated previously).
Another risk when you pay premiums—they’re called “premiums” for a reason—is that they’re in essence a fee for some agreed-upon contract. The insurance firm now owns that premium payment, not you. Say you open a large lump-sum fixed annuity with $1 million paid in, and next week, you’re tragically hit by a bus. You never collect your annuity payments, and your family gets nothing of the $1 million because the insurance company owns it. Now, maybe they get a death benefit—if you signed up for it and paid for it (called life insurance, which can be bought separately and almost certainly cheaper)—but it’s probably much less than the $1 million. Or maybe your spouse gets some income—again, if you signed up for and paid for a “survivor” feature (which is more expensive to you for obvious reasons). But still, in a scenario like that, your family likely is much better off if they had the $1 million and not an insurance contract.
However, fixed annuities typically don’t grow in value and are rarely sold to high-net-worth investors as an alternative to stocks or bonds. Instead, variable annuities are pitched as a safe-as-mommy way to get growth with no icky market downside. In reality, no such free lunch exists. Most of these are built from standard, everyday mutual fund investments wrapped into an insurance contract dressed up with punitively stiff fees and little upside potential. You would be better off buying the funds directly, in my view.

Big Fees and Tax Trauma

Yes, some annuities can have the benefit of tax-deferred growth of deposited funds. Perversely, very many investors amazingly buy these and hold them in their IRAs—of all darned things. (This is the selling of ice to Eskimos—and defeats a major reason to buy the annuity. Funds held in IRAs grow tax-deferred anyway!)
Worse, when you withdraw money from the annuity, it’s (usually) considered income, so you pay tax on the gains at ordinary income tax rates—not at the long-term capital gains rate, which is lower for many investors. And death benefit payouts may be fully taxable—unlike traditional life insurance payouts. Simply, tax-wise, annuities can be confusing, and if you do buy one under any circumstances, make sure to employ a tax adviser. (More fees!)
One easy debunkery: A way to know if something is bad for you is to check the broker’s or salesperson’s fee. Annuity salespeople typically get a huge, huge, how-do-you-say-humongous upfront fee. The bigger the salesperson’s commission is on something, typically the worse it is for you, the buyer. He or she is getting that huge commission to sell you something that is bad for you, that you wouldn’t otherwise naturally buy, and that if you truly understood the product you would never, ever buy. With variable annuities, the commission is typically 6 to 10 percent of the total assets1—and even up to 14 percent for some contracts!2 Said another way, if you buy a $1 million annuity, the broker might get $100,000 or more—just for that one sale. Maybe as much as $140,000! And the broker may also get an annual commission for a number of years. Insurance firms have to pay such big fees to brokers because these are very hard to sell. And they’re very hard to sell because they are usually very, very bad for you. Think of it this way: You buy one of these and you’re putting the salesperson’s kid through college. Is that your intent? If so, just give him or her the money and take your investment funds and do what is otherwise best for you. You would be better off.
Some folks may claim, “But my annuity doesn’t charge me an upfront sales fee!” Maybe not! But the salesperson still gets paid—handsomely—and that money doesn’t fall out of the sky.
Speaking of which, variable annuities are also expensive to leave! Most have a “surrender” period. (They need that to keep you in the contract and paying premiums so they can recoup whatever commission was paid upfront to the broker and then make money themselves.) A typical surrender fee starts big and declines over the surrender “period.” So the fee might be 7 percent to withdraw the first year, 6 percent the second, 5 percent the third, and so on.3
And they’re expensive to own. Table 15.1 shows typical annual variable annuity fees. Annually, variable annuity holders pay an average of 2.4 percent, just for the honor of having the annuity. If you have a variable annuity because you want some growth while guarding against downside volatility, that 2.4 percent annually is a massive headwind—you’re giving away a lot of upside each year. See it this way: Would you buy a mutual fund that charged 2.4 percent each year? According to Morningstar, average mutual fund expenses run about 1.2 percent.4 The variable annuity doubles that!
Table 15.1 Typical Annual Fees for Variable Annuities
Source: Morningstar, Inc., as of 2008.
Fee Amount
Fund expense0.94%
Mortality and expense risk charges1.21%
Administrative fees0.16%
Distribution0.09%
Total 2.40%
And those fees add up over time. Table 15.2 shows a hypothetical comparison of the impact of 1.2 percent in annual expenses (an average mutual fund fee) versus 2.4 percent, assuming an average annual return of 10 percent (about what stocks have done over long periods).
Over 20 years, the amount lost to fees is no small sum—a difference of over $1.1 million in our hypothetical scenario. And that’s in addition to paying any upfront fees and a huge fee to get out (if you’re still in the surrender period) when you sober up and come to your senses. And that’s assuming you can get similar growth inside an annuity to what you’d get outside. Your investment choices are typically very limited.
Remember, the money most times is basically being invested in mutual funds. If stocks in the long-term future did average 10 percent a year, you’ll keep giving up about 24 percent of your annual return (2.4 percent relative to the 10 percent return). Those would have to be pretty special mutual funds to make that work. The way Warren Buffett used to describe it: If stocks do 10 percent a year and you pay an extra 1 percent in fees, you have to be 10 percent smarter than everyone else on average to make up for it. How smart are those mutual fund managers?
Table 15.2 Impact of Fees on Returns ($1 Million Invested)—Taking a Lot Off the Top
017
I’ve got a longtime buddy who has been married and divorced five times. He knows now he chooses females badly. He has taken to heart the old axiom: “The next time I feel like getting married, I’m going to find a woman I could really hate in the long term and just give her a house.” Think that way when a variable annuity salesperson pitches one to you. Just find one whose kid you want to put through college and give the kid the money. Then invest elsewhere.
Variable annuities may sound safe as houses when you’re talking to the salesperson, and in some cases, there may be some insurance features to them that are. (As long as the firm is solvent.) But as far as a smart alternative to investment growth is concerned, whatever growth you may happen to get, you’re likely giving a huge portion of it away in fees. There are much easier, more efficient, and more liquid ways to get middling returns, all without the risk you might lose it all on a failed insurance firm.
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