CHAPTER 10

The Gift of Transparency

ANNUITIES

In the realm of personal finance, no word has been dragged through the mud more times than the A-word—Annuities. Yet annuities survive and even thrive. How they do is not a mystery.

There is not an outcry on the part of consumers demanding annuity products. The reason for the continued vibrancy of annuity sales is that they pay a big honkin’ commission to the selling broker or agent. And, as most of the financial sales tactics exposed in this book, I’m especially qualified to make such a statement, because I have sold them myself. I wasn’t a bad person in those days, conniving to separate people from their hard-earned money for my own selfish benefit. Conversely, every time in years past when I sold an investment product to a client for a commission, I did so thinking it was in their best interest. My recommendations met all the legal requirements of suitability required of a broker, but I acknowledge to you now that in hindsight there is no question my judgment was partly influenced by the amount of money I could make (or not make) on the sale.

And how could it not be? Let’s say you, as a salesperson, had three different products to sell with the following characteristics: one would pay you one percent for every year that the investment continued to be held by the client, one would pay you 5.75 percent up front followed by .25 percent each additional year, and another would pay you 12 percent—all up front. Which one would you be likely to pick, all things being considered equal? Hmmmm. Let’s add to the scenario the assumption that you were selling in the midst of an economic downturn resulting in a significant loss of income for you and your family. Is it possible that in those circumstances you may be inclined to favor the product paying 12 percent up front over the one paying 5.75 percent? And forget about the one that pays one percent, because in tough times, that simply isn’t going to butter the bread. These aren’t imaginary numbers I’m using. One percent is an average amount a financial advisor may charge for discretionary management of your investment assets; 5.75 percent is the standard commission paid to a broker who sells a mutual fund (A share); and annuities pay up to—and in some cases over—a 12 percent commission!

The sale of annuities is justified entirely too often because of the massive commissions going to the broker or agent selling the product. Powerful organizations have made it their lives’ work to decry this very notion and have built elaborate systems designed to convince themselves, their brokers and agents, and the consuming public to believe in the justness of their actions. I was a part of one such group and was encouraged—along with a room full of other financial folks who had been invited to San Diego for an all-expenses-paid trip to hear what this organization had to say—to join the ranks of the “Safe Money Specialists.” Other people were selling products; we were selling peace of mind, and getting paid 10 times as much to do so!

I repeat: People who sell annuities aren’t bad people. But, they are salespeople. You expect time-share salespeople to have an economic bias to sell you a time-share. You expect a phone solicitor who interrupts your dinner to keep you on the phone to convince you to buy something before you hang up the phone. You don’t, however, expect someone who refers to himself or herself as a financial planner or advisor or professional to have the primary aim of selling you something. Unfortunately, many of them do. Your broker or agent may have drunk the company Kool-Aid and genuinely believe that he or she is doing the best thing for you, so be respectful when you tell him or her you’ll be moving your business. As I learned growing up in the Baptist church, we should “hate the sin, not the sinner.” We will be discussing in much greater detail the ways financial services employees and financial advisors are compensated and what you should look for in Chapter 15.

Timeless Truth

There is a continuum on which products and services are rendered based on the level of care provided by the product or service providers to their prospect or client. At the far left of that continuum is lying. While it is illegal, people do it every day on eBay, Craigslist, in newspaper advertisements, and in e-mail solicitations. Of the many benefits the Internet revolution has brought us, there is little doubt it has also given outright thieves a far vaster and faster medium in which to carry out their trade.

Next on the continuum is deception. Deception is rampant in all too many forms of advertising and packaging, especially in the sale of products. How is it that every single bottle of shampoo at the grocery store is offering “25 percent more!”? 25 percent more of what? Deception is found in the fine print and disclaimers. It comes after someone has already given you their pitch. “Oh, by the way, there is [this] to consider,” once your heart has already embraced the product or service.

Next comes full disclosure. Full disclosure is when all the information legally required to pass from the seller to the buyer is disclosed. In many states, a disclosure form is required of a home seller listing anything the seller knowingly recognizes as broken. This doesn’t mean you should count on the seller to tell you what they know is likely to break in the next few months.

Finally, we reach the highest ideal of business practice—fiduciary. Fiduciaries are legally obligated to act in the best interest of the client they serve. The client’s interest must rise above that of their own. Doctors, lawyers, psychologists, pastors, priests, and a small subset of financial advisors are a handful of professionals who are required to act as a fiduciary at all times.

Going through life as a skeptic, distrusting everyone, is no way to live; but you should know that in virtually every product sold or service rendered, YOU are your own best fiduciary. Having a better understanding of the economic bias of the seller will make you a better, more informed consumer.

Jim Stovall

Before we go off the deep end and give you the impression there is never a valuable use for an annuity, let me assure you there is. We’ll be getting to that soon, but know the criteria for appropriate annuity sales are quite narrow. Most of the time an annuity is sold, there’s probably a better option. To understand their use, we must give you a fuller explanation of the types of annuities in existence and how they function.

The best definition for the word annuity is an investment product sold by an insurance company. While many equate the term annuity with a different definition—a perpetual income stream—this definition is too tapered for the broader class of investment products known as annuities. The four broad types of annuities are immediate annuities, fixed annuities, variable annuities, and equity indexed annuities.

Immediate Annuities

The first type of annuity, the immediate annuity, meets the shortsighted definition for annuities mentioned previously. Immediate annuities are those in which a consumer gives an insurance company a set number of dollars in return for a stream of income to the annuity owner, the person making the monetary investment. The annuitant is the person on whose life the stream of income is based. (In most cases, the owner and annuitant are one and the same.) It is the annuitant’s life expectancy that is used for the insurance company’s actuarial calculations in order to determine how much money they will send to the annuity owner on a periodic basis.

In a life-only annuity, the agreed-upon stream of income will be paid to the owner as long as the annuitant is alive. When the annuitant dies, the stream of income ends. If someone receives his or her very first periodic payment and then dies, the income stream ends. The longer the annuitant lives, the better the investment that the life-only annuity becomes. It’s really a bet between an insurance company and a person on when that person is going to kick the proverbial bucket. In some cases, the annuitant will actually present medical information and submit to a physical examination—much as they would with life insurance—to determine the expected periodic payout.

A period-certain annuity will change the time frame from one that is tied to the life expectancy of the annuitant to a set period of time. For example, someone could give an insurance company a lump sum of money that would pay out over the next 10, 15, or 20 years. In the case of the annuitant’s death, the annuity beneficiary would continue to receive the periodic payments until the end of the stated term.

Pension recipients may be familiar with the immediate annuity terminology because the recipient of a pension annuity stream will often be presented a combination of annuity payout options based on the life expectancy of the employee, the employee’s spouse’s life expectancy, or a specified period. Lottery winners, or the far more common lottery daydreamers, are familiar with the decisions between receiving a lump sum or some form of periodic annuity.

Immediate annuities are not registered products that require a securities license to sell them. They are sold by insurance agents with a caveat emptor standard—buyer beware. They can be purchased with cash or converted from an existing fixed or variable annuity. The sale of insurance and insurance products is regulated by states, and in most states, if the insurance commissioner has permitted the product in that state, it is the responsibility of the buyer—not the seller—to ensure the suitability of the product.

Fixed Annuities

Fixed annuities resemble certificates of deposit (CDs). They offer a set or variable rate of interest for a specified period of time. While CDs pay interest that is taxed in the year in which it is received, the interest in fixed annuities is tax deferred until the owner takes a distribution from the annuity. That tax deferral is, for some investors, an advantage of the fixed annuity over the CD, but the two major disadvantages are the lesser degree of principal protection and the surrender charges of annuities.

Certificates of deposit can be purchased with insurance from the Federal Deposit Insurance Corporation (FDIC). The FDIC has federal backing. Annuities are backed only by the full faith and credit of the insurance company, a promise seemingly worth less today than in January of 2008. CDs purchased through a bank often do assess penalties to owners who distribute funds prior to the maturity of the instrument, but that charge is typically not in excess of the expected interest of the CD. Fixed annuity surrender charges, however, are often onerous. It would not be uncommon to purchase a fixed annuity with a maturity of seven years and find that an attempt to retrieve your money in year one would cost seven percent or more, resulting in a net loss in the product. Unfortunately, surrender charges that are long and painful are the answer to the question, “How can these companies afford to pay commissions that are so high to brokers and agents?”

One of the many deceptive tools of annuity products is the fixed annuity “teaser rate.” Many fixed annuities will offer a low annual flat rate of, say three percent, but offer a two percent bonus in the first year. This enables salespeople to position the annuity as having a five percent rate of return with the fine print that reads, “in year one.” Fixed annuities, like immediate annuities, are sold on a caveat emptor basis and regulated by states.

Variable Annuities

Variable annuities are the insurance industry’s answer to mutual funds. A variable annuity is an investment product with multiple investment options inside called subaccounts, which function very much like mutual funds. Like fixed annuities, variable annuities offer tax deferral on growth inside the product until the investor takes distributions from the annuity. Mutual fund owners must pay tax on the capital gains taken by the fund managers and any of the dividend and interest income produced by the fund each year. A major disadvantage of annuities is that when distributions are taken, all of the income is taxed at ordinary income tax rates. Today, taxes on stock capital gains and dividends are taxed at a rate no higher than 15 percent. Ordinary income taxes can be more than twice that much at 35 percent. The “good news” is that you can be reasonably sure both of those tax rates will be on the rise in the future. These concepts, among others, will be discussed in greater detail in Chapter 11 on taxes.

What further differentiates variable annuities from mutual funds is that annuities, as insurance products, come with various types of benefits attached to them, some that offer guarantees. In the world of investing in stocks, bonds, and mutual funds, the word guarantee is expressly forbidden. Annuities, however, offer pseudo-guarantees on the return of principal as well as some gains in accounts. Most variable annuities have a guarantee on the return of principal; the bad news is that you typically have to die to get it! The death benefit guarantee pledges return of your invested principal to your beneficiary—even if the market has gone down. Some products now also offer a “Living Benefit” guarantee, pledging a chance to reap the benefit of that principal protection during your own lifetime. This sounds like a benefit that could come in handy after the market crash of 2008–2009, but these benefits are shrouded in mystery and fine print.

In the June 1, 2009 edition of the Wall Street Journal, the title of an article discussing annuity guarantees read, “Annuity Fine Print: Guarantees Aren’t Always Guaranteed.” The article opens as follows:

For many years, variable annuities with guaranteed minimum returns had a bad reputation for being loaded with fees and traps. And besides, why pay anything for a guarantee against investment losses when stocks inevitably marched upward?

Those guarantees looked a lot better after last year’s market slide. Then investors started checking the fine print—and learned their guarantees might not be as secure as they thought. Under some provisions, the insurance company that issued the guarantee can cancel it, or sharply reduce its annual payout.

In many cases, the guarantees appear less valuable than consumers were led to believe. One of the ways living benefit guarantees are made less beneficial is that they are paid out over a long stretch of time. So, if you invested $100,000 in the annuity in 2007 and the market dragged it down to $50,000, you’d think the purchaser of a living benefit would be able to call the company and ask for their full $100,000 back. No, on at least two counts. First, like most annuities, there is going to be a surrender charge in place, so if you want to take distribution of your money, you’ll have to pay a hefty surrender charge to get it back. Second, you don’t normally get your money back in a lump sum when you call in a living benefit; they can take many years to pay it back to you, further diminishing their risk and your benefit.

Think of it this way: An insurance company would never create an annuity benefit they didn’t think would actually benefit them. It would be suicidal! They offer benefits, at a cost, that they think (or at least hope) they’ll never need to pay. If there was a widespread, systemic failure in the actuarial composition of the benefits of a particular product, it could put the company at enough risk to make the guarantees difficult to live up to.

Annuities initially got into hot water with educators and the financial press because of their high expenses, and while the competitive forces have driven costs for consumers down some, they’re still a problem. I pulled the following from a web site actually promoting the sale of annuities:

• Death benefit expenses: The mortality cost is in your contract and is subtracted from your account. Depending on the variable annuity you own or are considering these fees could be as high as 1.25 percent of your total account value.
• Other fees and expenses: Variable annuities can charge fees for added riders and benefits. Each benefit can have a cost associated with it that is subtracted from your total account value. It could be possible that these fees and expenses could be as high as 1 percent to 2 percent and these fees are on top of the death benefit fees discussed in the bullet above. (Please read the prospectus, which by law must reveal fees and expenses.)
• Loads and acquisition expenses: Some variable annuities have a front end or a back end load that can have an effect on the overall performance of your variable annuity. (Please read the prospectus, which by law must reveal fees and expenses.)
• Administration fees and distribution costs: Many variable annuities charge a fee for administration expenses. These fees can range from .15 percent to .40 percent of your total account value and these fees are in addition to other fees in your contract.1

Variable annuities are registered products, meaning they do require at least a Series 6 license (the license to sell mutual funds); however, this license does not require the selling broker to act as a fiduciary. They are held to a lesser standard known as suitability that only sanctions the transaction and does not include advice from the broker. If you thought immediate, fixed, and variable annuities were confusing, wait ’til you get a load of the next varietal.

Equity Indexed Annuities

Equity indexed annuities (EIAs), according to a commentary in the Barron’s April 13, 2009 edition, are designed to deceive. Even though they have the word equity—a synonym for stock—in their title, as of this date, the seller of an EIA is not required to have an investment license. (Amazingly, a legislative push to change that was expected to force agents to have a securities license beginning in 2011, but somehow the insurance industry was able to rebuff those efforts.) These products are relatively new and gained popularity following the tech bust of 2000–2002 because they offer “equity style returns with protection from the downside” in stocks. Well, sign me up, right?

Who wouldn’t want the upside of stocks with no downside? It is true these products offer annual returns that are correlated to stock market indices, like the Dow Jones 30, the S&P 500, or the NASDAQ 100. If the market goes into the tank, you earn zero percent that year. The catch here is that they cap your upside earning potential; some offer a five to eight percent annual cap on earnings while others offer a much lower monthly cap. In addition, many products also have an asset fee (a flat percentage fee assessed in any positive earning years), a participation rate (allowing you to participate only in, say, 80 percent of the market upside), and index terms (which restrict your liquidity for anywhere from five to over 17 years with surrender charges in the teens!). And, by the way, the upside attributed to the respective market indices does not include the gains from dividends.

Frederic Marks, the cofounder and co-chief investment officer of Cheviot Value Management in Santa Monica, California, in analyzing an EIA that was pitched to one of his clients, determined that while the S&P 500 annualized rate of return, including the reinvestment of dividends from 1975 through 2004 had been 13.87 percent, the monthly averaging S&P 500 Equity Indexed Annuity would have returned 5.81 percent.2 That’s 58 percent less than the market in that stretch—hardly equity style upside—and even less than the Lehman Intermediate Government/Credit Bond Index, which earned an annualized return of 8.6 percent from ’75 through ’04. Every great lie is surrounded by a cushion of truth.

Annuity Disadvantages

Believe it or not, we’ve yet to touch on the primary disadvantages of owning annuities. These traits are common among all the varieties mentioned above. Tax detriment is one of the problems, and it’s ironic, because for many years, annuities were sold on the basis of their tax privilege. That is because annuities, indeed, are tax-deferred investment products. So if you put after-tax dollars into an annuity investment, any of the earnings, interest, or gains in the product will be deferred until you take a distribution from the annuity. But then you get hammered, because as mentioned before, even if the gains in your annuity are derived from stock-based investments, you will not get preferential capital gain tax treatment. You’ll be paying ordinary income tax on those gains. I mentioned that initially annuities were sold on the basis of that tax-deferral, which is a good thing, but that was when capital gain tax rates were much higher. At 15 percent currently, that is a far cry from the top bracket of 35 percent.

This tax-deferral allowance has another catch. The IRS allowed the preferential tax-deferral to take place under the pretense that these investments were intended specifically for retirement use. So in granting the tax-deferred treatment, they also imposed an age 59½ rule to annuity distributions. If you take a distribution prior to age 59½, any gains in the policy will be taxed at ordinary income rates and assessed a 10 percent early withdrawal penalty. This is the quirky age rule accompanying Traditional and Roth IRAs that will be discussed in our chapter on retirement planning. If you own an annuity inside of a Traditional or Roth IRA, the distribution rules will not change; they mirror each other.

Additionally, the taxes are handled on a last in, first out (LIFO) basis in annuities. Therefore, if you put $100,000 of after-tax money into an annuity and it grows to $120,000, and then you choose to take a distribution of $20,000 from the annuity, you’ll be paying tax on 100 percent of that $20,000 distribution because the gains were the last thing in . . . and the first thing out. This can be especially painful for the many annuity owners who are in a very low tax bracket. An additional tax disadvantage of annuities is that when an annuity owner dies and passes the annuity to his or her heirs through the beneficiary designation, the heirs receive no step-up in cost basis. An annuity owner who intends to pass a nice inheritance to heirs may actually be creating a tax time bomb for them.

Cost basis is the amount of a given investment that has already been taxed once and is pledged not to be taxed again. For example, if you purchased $5,000 worth of Microsoft stock and it grew to $15,000, you would have a cost basis of $5,000. The additional $10,000 would be considered a capital gain. If, during your lifetime, the stock is sold, you’ll pay capital gains tax on $10,000 of your $15,000 stock position. If, however, you pass the stock to your heirs through your will, they would receive a step-up in cost basis to the price of the stock on the date of your death; therefore, the cost basis they would inherit, if the stock position was worth $15,000 on the date of your death, would be $15,000. If they sold it the next day at the same price, they’d pay no tax whatsoever. If you invested $5,000 in the annuity and it grew to $15,000, and you passed it to them at your death, they would have to pay tax on the entire $10,000 gain—and they’d be paying at their ordinary income tax rate to boot.

We’re coming down the home stretch on disadvantages of annuities. The last we’ll discuss is an investment option disadvantage. Because of the painful surrender charges, changes to an annuity investment are naturally penalized. In markets such as these, when extreme volatility and rapid change are the norm, annuities do not offer the flexibility you need. If you buy a five-year fixed annuity at three percent because it’s paying you one percent more than the two percent one-year CD at the bank, you may think you’ve made an advantageous investment move. But, if interest rates jump to six percent, as is perfectly possible at some point following the biggest stimulus package(s) in the history of the universe, you’ve now locked in a guaranteed loser because you’re afraid to break the chains of the annuity and lose your surrender charge. Variable annuities were supposed to be the answer to that problem, but while they have more choices, it is still a limited number from which to choose. The fewer the choices, the greater the risk. The less liquidity, the greater the risk.

Annuity Advantages

Now, at long last, the good news about annuities. If you just bought an annuity because you were at the bank moaning about the putrid rate of interest you are earning on your savings account and CDs, and the teller said, “Why don’t you talk to our financial specialist who can tell you about investment options that may result in a higher rate of return?” and you signed on the dotted line, most states offer a “free look” of 10 to 30 days in which buyers of an annuity can get out of their contractual obligation without any financial pain. Use this free look and look hard, because annuities are contractual obligations that are very hard to separate from after the free-look period.

“Is that it?” you say. “Is that the only good thing you can say about them?” No, I’m holding out on you, but only a little bit. If interest rates do what they’re likely to do at some point and go higher—a lot higher—you may consider locking in a rate of eight percent or higher in a fixed annuity for a minimal slice of your investment nest egg. CDs will typically not offer a maturity as long as a fixed annuity and if you see signs of the ’70s and ’80s, with double-digit interest rates, you may consider locking in some of your money into a fixed annuity at that point; however, if it was my money, I’d probably find some top quality bonds to reap that reward. Because of the inverse relationship of bonds’ interest rates and prices, if you buy a couple of new issue bonds at 10 percent and 12 percent and you wait until interest rates drop back down to normal, you’ll likely have a handsome capital gain on those bonds if you should choose to sell them.

When I recommend an annuity, it is usually to someone who already owns one. While I almost never recommend an annuity for someone at the onset because of my obvious opinion on their lack of benefit to consumers, I am cautious to recommend that a client get out of one. Because of the surrender charges, tax treatment, and age limitations, a decision to take a distribution must be well thought out. When dealing with an annuity you’ve had for many years in which your cost basis is very low compared to the current value, I may recommend annuitizing the product. Let’s go back to the example where $5,000 went into an annuity and it’s now worth $15,000. If you take a partial or total distribution, you’ll have to pay all the taxes first. By annuitizing, you create a de facto immediate annuity and a stream of income. In this annuitization (a word that only exists in the insurance realm), the IRS allows the taxes to be paid on a pro-rata basis, which means each of the payments will be partly taxable and partly tax-free return of contributions. I recommend doing this not as a life only payout, but the shortest period-certain payout available (usually 10 years).3

And, if you do decide to invest at all in annuities, look for no- or low-load annuities that pay little or no commission and have little or no surrender charge if you choose to change your strategy. Admittedly, the options for no-load annuities are miniscule in comparison to the offerings with commissions, but while liquidity is not a tangible benefit, it is a very important benefit nonetheless. If an investment requires that you be held hostage to keep your money there, there’s a better place for your money.

I had been in the financial services industry for over four years before I started to sell products directly to consumers. I went from having a salary and bonuses to strictly commissions. At that point in time, I was married and we were planning to start a family, and with the birth of our first son, my wife made the decision that she wanted to stay home with him. Our mortgage and other living expenses were now fully on the shoulders of whatever business I could sell. I chose to start a fee-based business, not even knowing of the fee-only option. This meant I would be recommending financial products and investments that would predominantly create a small income up front, but one that would be a recurring income, growing with my base of clients.

My sales manager knew my story. He suggested we all buy expensive cars with high monthly payments, forcing us to keep up by selling more, also increasing the amount in his pocket. I didn’t bite. But then, I was counseled in private that if I didn’t start selling products with big up-front commissions, I simply wouldn’t survive in the business, and “if you don’t survive in the business, you won’t be doing your clients or your family any good.” He advised, “Once you become successful enough, you can run your business however you want, but until then . . .” Yeah, I got it. I’ve got to sell.

Some of the new sales trainees in the financial services world enter the business without a care for their future clients and are concerned only with their own financial well-being, but most of them are good men and women who’d prefer to do right by their clients. Many of them have their idealistic visions dashed by an industry that plasters their weekly income on a screen in front of all of their peers in sales meetings. Most of them do as compelled and start selling. Once they’re making good money, it’s very difficult to return to any idealistic vision, if they can even remember it. It is my sincere hope that as a result of the financial crisis, these techniques will be exposed and become a thing of antiquity.

1. I found this on www.annuity.com on June 9, 2009.

2. Frederic G. Marks was the author of “Designed to Deceive” in the Barron’s Monday, April 13, 2009 issue.

3. The tax deferral in an annuity can be transferred to another annuity via a 1035 “Like-kind” exchange. Ordinarily, I wouldn’t recommend this because it means you’ll probably have a new surrender charge in the new product, but there are cases in which it makes sense.