There is a great article in Saturday’s (January 13, 2007) Wall Street Journal called “Smart Retirement Shopping.” It talks about the high pressure sales tactics used on senior citizens to sell them ill suited investment products that pay the salesmen high fees. We see it all the time in my practice. Last year we donated our time to help a 93 year old woman who was sold an annuity that she couldn’t touch for years. The salesmen at the bank sold her that annuity knowing it was all she had besides her house. It was despicable. We got her all her money back including fees so she would have something besides social security to live on. She did not want to pursue any type of legal action though she had a great case. She just wanted it settled quickly because the stress was keeping her up at night.
Last year I published a column addressing annuities and how much I hate them. Boy did I get hate mail from annuity associations and annuity salesmen from across the country. I’ve kept all those letters and even framed one of them. Annuities are a great tool in a few select situations but most annuities are sold to people who don’t need them. If you really want an annuity then buy it someplace like Vanguard where the investment choices are sound and the fees are reasonable. I’m sure I’ll get more hate mail again but here’s the reprint of my column:
The Financial Pragmatist
Annuities, Annuities, Annuities, Why are people buying annuities?
Annuities are complicated tax deferred investment vehicle that make sense for only a few people in very specific circumstances. If annuities aren’t the right investment for most people then why are they being sold like produce at a farmers market? The person selling them to you makes a huge commission usually 5% of the funds you’ve invested. Ain’t that sweet!
I have never meet with anyone who owned an annuity that understood what they were invested in, why they were invested in it and what fees they were paying. After learning about their annuity’s features and fees, most people are upset. If annuities were simpler to understand most people would not buy them. It is the deferred annuities that cause the most confusion. It allows an investor to accumulate funds for the future tax deferred. Let’s be clear about the tax consequences: An investor does not get a tax deduction for the money put in (unlike a 401(k)), the funds inside the annuity compound tax free, and the earnings are taxes as income rather than that lower long term capital gains rates at withdrawal. You can’t withdraw your funds until you are over 50 ½ or you’ll owe a 10% penalty plus fees, plus taxes….
With the current lower capital gains tax rates it is hard to justify buying a deferred annuity. The current low tax environment makes annuities a bad deal for most people when you factor in the high fees. There are multiple layers of fees when it comes to variable and equity-indexed annuities, some of the most common fees are
Mortality and Expense Charges (M&E) which cover the minimum guarantees provided by the insurance company and are typically 1% to 1.25% of your account each year. In addition, there are Management Fees which in a variable annuity are usually 0.9% annually.
Surrender Charges are only incurred if you were to move your money out of the annuity before a stated period of time had passed usually 7 years (but can be as high as 10 years). It is assessed on the money you withdraw before the surrender period is up. I have seen surrender charges as high as 12% (they can be as high as 100%). That’s right you changed your mind and decide to move the funds to another annuity company, you are giving up 12% of your money in fees.
There are also Performance and/or Death Benefit Guarantees which generate additional fees to for the insurance companies and pay hefty commissions to the salesmen. Some annuities guarantee that if you die before 70 ½ your beneficiaries will receive the sum of your contributions to the annuity plus a certain minimal amount of interest. Others guarantee that after 10 years of being invested they will make you whole if you have less than what you put into the annuity. All of these guarantees have costs, often another 1% to 2% a year.
When everything is said and done, it is not uncommon to see someone paying 2% to 4% in fees each year for a deferred variable or equity-indexed annuity. When you add up all these fees and factor in the cost of leaving, you aren’t casually dating an annuity you are marrying it.
What fees are you paying on your annuity, well good luck finding out. While mutual fund information is easily accessible, especially on the internet, there are very few objective third parties that provide information on the performance and expenses of particular annuity subaccounts. The only free source of this information is the annuity company, through their website, your statement, and their prospectus, which is only updated once a year. As an advisor I have software that I’ve purchased from Morningstar that clearly states all these expenses but it is not available online to the public. This lack of transparency should make you suspicious.
Here is my final annuity tirade. Annuities are frequently sold into investors’ tax deferred accounts such as IRAs. If you buy an annuity you are paying a hefty fee to save money tax deferred. Why would you then put an annuity in an investment account that is already tax-deferred? Placing an annuity in an IRA, 403(b) or 401(k) plan is ludicrous because you are already receiving the tax deferred benefit free of charge. Therefore, purchasing an annuity in a 401(k), IRA and 403(b) does not make tremendous sense because you are getting very little for the high fees you are paying.
All in all, annuities aren’t such a great deal because of their complicated structure, high fees, lack of portability and declining tax benefit in a low capital gains rate environment. So when a financial salesmen suggests an annuity well lets just say, Caveat emptor, buyer beware!