I’m sure that you have seen the advertisement for Mr. Ken Fisher’s advisory firm – “I hate annuities.” It’s hard to argue with a guy that manages some $65 billion in client assets. In my day to day experience, I meet with hundreds of individual investors seeking advice on a myriad of goals. It’s very common to see an annuity in their investment bag of tricks. I hate annuities.
Insurance products can serve a purpose in a client’s investment portfolio. They have some benefits that would be used for a specific need. In my experience, it seems that insurance sales folks see it as every situation and every need is solved with an annuity! When all you have is a hammer, everything looks like a nail. The insurance person is motivated by the comp structure set by the insurance company – big paydays.
Let me share with you a real life client story of a gentlemen that was sold one of these products and why I agree with Mr. Fisher. Let’s call this client Jim – Changing the name for obvious reasons. Jim retired from his company and accumulated about $400,000 inside of his 401(k) retirement savings plan. The insurance person he met with, a friend of the family, sold him an annuity with large and reputable insurance company. I’ll refrain from using their name – I don’t need a slanderous litigation coming my way.
Jim took his $400k and placed it into this investment product – variable annuity. The variable
annuity has two basic components – investment exposure and insurance exposure. This vehicle allowed an asset allocation to allow participation in various asset classes. Jim’s sales rep allo
cated the portfolio 60% to equities and 40% to fixed income. The $400k is placed into these respected holdings – changing daily with market fluctuations. simultaneously the $400k is placed into the insurance bucket within the variable annuity.
With me so far? Good. This is where it gets complicated.
The insurance bucket has two features. This is the reason that Jim thought this was a great investment choice. The first feature is a guarantee income benefit. The second is a guaranteed death benefit. Let’s dive into the first.
The guaranteed income benefit allowed Jim to elect payments for his entire life at 5% of $400,000. This means that regardless of the investment side of the account, he could receive $20,000 per year for the rest of his life. Sounds great! In order to elect this option, Jim would have to complete a process called annuitization. This means that the insurance company keeps the investment holdings at their current balances ($400K) and starts a static payment of $20,000 a year to Jim’s bank account. Additionally, it allowed a death benefit to be paid to his designated beneficiaries – his $400,000 could grow by 5% per year as well regardless of how the investment value changed. One catch is the death benefit was reduced for any and all distributions. So if Jim took $100,000 out of the account, the death benefit reduces by $100,000. Make sense? Great! Let’s update our visual.
I’m sure that you’re thinking, so far I don’t see the issue. I have an increasing amount that will be paid to our loved ones upon my death as well as protection of income if the market moves against me over time.
If you’re reading it this way, you are right. The owner of this product has those features. Sure, I have to give the insurance company my $400k or current value, but I’m getting $20,000 per year. If I pass away, my heirs receive the death benefit. Again…correct. Consider this – the insurance company distributes your money first. In this example, let’s assume that Jim annuitizes right away. He gives the insurance company $400,000 and they start paying him $20,000 per year. The insurance company has 20 years of payments… $400,000 divided by $20,000 equals 20 years of payments. Additionally, Jim no longer has a death benefit. If he doesn’t select a guaranteed period (referred to as a period certain) the payments will stop upon his death.
Now let examine the costs of this product. You’re paying the insurance company for the investments and the insurance. A little disclaimer here – all insurance products prices are different and we’re slicing apart this particular product. There is cost of the annuity, investments, and insurance features. Let’s examine these closer.
The first cost is referred to as the mortality, expense and administration (M/E/A) and is 1.25% per year. The M/E/A is just to open and maintain the account. The second cost is the insurance features (riders) that are added to the variable annuity. Jim has selected is the guaranteed income benefit (GMIB) which is 1.01% per year. Jim also selected the guaranteed death benefit (GMDB) which is 1.65% per year. Finally there is the investments choices – 1% per year. The total annual cost is 4.91% per year or approximately $19,640/yr. Queue the visuals.
So if you think about this… Jim starts each year with a loss of 4.91% and needs the investments to accumulate $19k to just break even year of year. Also the insurance costs are the same price as the benefits – 4.91% per year to cover 5% GMIB. He would be better off just leaving this in the bank at those rates.
Thrilled about this investment choice so far? Me too. :/
The plot thickens. Jim just entered into a contract with the insurance company. The insurance company requires his investment for a 4 year period at the minimum. If he decides to leave this contract earlier than the 4 years, there is a penalty. This is referred to as contingent deferred sales charge (CDSC). The CDSC is a trailing percentage of the account value and starts at 8% for year one. It looks like this:
This means that if in year one, Jim wanted to close his account and take all the money to Las Vegas for a kick ass weekend, he would pay the insurance company 8% of $400,000 or $32,000 penalty cost.
The penalty costs trail down and after his fourth year it doesn’t cost him anything to get his money back. Feeling the love on this investment decision yet?
Now some state laws allow an annual penalty free withdraw that often is “sold” as a feature of the policy. In my experience this is 10% of the the value. Required law – not benefit. If you remember the start of this story… Jim’s family friend is the one that suggested this product to solve his financial planning need. The commissioned sales person, the friend, is paid by the insurance company once he or she sold this product. The commission is generally a one time payment that is equal to the first year CDSC – 8%. This means the loving family friend, so concerned with Jim’s retirement, benefited to the tune of $32,000. Not too shabby for having Jim sign a handful of papers.
Either way that Jim moved in this policy it cost him money. In order to close the account within the first 4 years it cost money ($32k in year one). Alternatively, staying in the account it cost him about $19k per year… Lastly, annuitize the account he gives up the entire $400,000 to the insurance company. Mr. Ken Fisher is right on this… I hate annuities.
A Jerry Springer final thought –
These insurance products can be useful inside your financial plan. You may have a need to pay some of these costs to have the insurance features. There are plenty of reasons to put some of your investment holdings into these types of products. It’s very important to consider your objectives, weigh the costs of the investment products and types investment vehicles you’re entering. It’s also important to understand how the friend is being compensated. As a general rule of thumb – don’t do it. If you have any questions about your situation or investment product – please feel free to contact me on twitter: @tad_doughty
Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions for a full disclaimer.