Deferred annuities can often be an essential part of a sound financial system. Deferred annuities are insurance contracts that over time, provide the opportunity for growth during the accumulation phase of one’s financial lifecycle. They are also designed to create a pension-like income stream during the distribution phase that is measurable and predictable. You make an initial investment; then the issuing insurer makes payments to you at a future date or a planned series of dates. That frequency can be monthly, quarterly, annually, or in some cases, a lump sum payment. You can opt to receive payments for the rest of your life, or for a set number of years.
Unfortunately, not all deferred annuities are created equal.
Let me introduce you to my friend, let’s call him Mike. Mike came in to see me a few weeks back.
Mike’s a good guy. He is 58, has been married to his wife Jean for about 35 years, they have two daughters in their early 30’s, and have grown up and lived in Sandwich their whole lives.
Mike and Jean have done pretty well financially. They have both saved about two million dollars together. She is a nurse practitioner and he’s a construction foreman for a Boston real estate developer. They have been working with a financial advisor from a large brokerage firm in Hyannis for years. When I asked why they came to see me, the response was, “Something just does not feel right.”
Mike and Jean were directed to invest a large chunk of their “sweat and tears” into a deferred annuity. And folks, you know I never look at things as good or bad when building a financial system, only what is appropriate or inappropriate. I am a huge fan of some types of deferred annuities, such as fixed indexed annuities (FIAs), but that wasn’t Mike and Jean’s investment.
They had invested about $800,000 in what is called a variable deferred annuity (VA) instead. I asked them to help me understand the thought process they went through that led them to put such a large portion of their income in something that had no guarantees, is very expensive, and is subject to such significant market risk.
Mike, now sitting up straight and somewhat leaning across the table, stated strongly, “There are no fees, and I am guaranteed a 5% rate of return annually.”
Hmmm…here lies the problem.
You see, I believe that if the average investor understood the inner workings of VAs, well, they would never buy them. VAs are financial products that benefit the salesperson and the institution selling the product, rather than the investor. And the poor disclosure made by companies selling VAs has been a thorn in the side of federal regulators for years. The Department of Labor’s revised fiduciary rule seeks to remedy that.
VA’s have a very costly fee structure, often never disclosed. Or at the very least, never explained properly. They are frequently built with two buckets of money: one with the actual cash value, and the other with its income value. It is the income value bucket that receives the 5% interest rollup Mike was talking about, but at a significant cost. The actual cash value bucket, which is Mike and Jean’s, is invested in very expensive market-bearing instruments such as mutual funds with no downside risk management. That subjects all their cash value to market risk.
Mike and Jean seemed confused. I suggested we call their VA company so I could teach them the questions to ask, to help them decide if they had made a sound financial decision.
I asked the VA company questions such as, “What is the administration expense?” That was .08%. “How about the Mortality fee?” That is 1.1%. “What are the mutual fund fees?” Well, that is 1.5%. “Income Rider?” That is the fee attached for them to get the 5% rollup on just the income value, not their cash value. That was 1%. The big one is what is called a wrap fee, where the advisor gets paid a 1% fee for the life of the contract – on top of the commission they are already paid.
Folks, by the time we were done adding it all up, our calculations were 5.4% in fees.
VA fees are a big deterrent, but there’s another downside too: VAs expose investors to all the market risk. There are no guarantees. The only question I had to ask them was, “What happened to you in 2008?”
By the way Mike and Jean looked at me, they were getting my point. If the underlying mutual fund investment options powering the VA perform badly, you can lose money, and a lot of it – not just the interest you’ve made, but your principal as well.
The allure of steady income is a big carrot for many annuity investors. But just like most carrots, there are sticks involved as well. While the biggest sticks associated with variable annuities are their fee structure and risk, not all deferred annuities are created equal.
I suggested a Fixed Indexed Annuity (FIA). An FIA gives you the guarantee of principal from market risk while giving you some of the market upside. Essentially, the insurance company guarantees you never to lose principal. While you may not earn all the gains that the market produces, you don’t lose.
As I have taught my clients and the Cutter Family Finance faithfuls for years, if you manage the downside risk of any investment, the upside will take care of itself. Never seek all the gains without understanding the risk and cost associated to achieve those gains.
That’s the strategy of an educated investor, and that is exactly the road Mike and Jean took.
In the end, Mike and Jean elected to move their investment to a Fixed Index Annuity (FIA) instead. Their FIA has a 4% spread on returns. Basically, the insurance company makes the first 4%, and they get the rest. Mike and Jean felt that was a more appropriate investment for their long-term goals. Even after paying a surrender charge, Mike and Jean came out well ahead compared to what they would have paid if they’d ridden out the VA to term.
Annuities can be an appropriate investment opportunity for people looking for steady income in retirement. But now, more than ever, you need to be vigilant and make sure you understand what you’re paying for and is it appropriate for use in your financial system.
Transparency is important. Your investments must offer transparency . . . and so must your investment advisor.
Demand transparency, because you deserve more.
Have a great week.
Jeff Cutter, CPA, PFS is President at Cutter Financial Group, LLC, with offices is Falmouth, Plymouth, and Mansfield. Cutter Financial Group provides private wealth and investment management advice incorporating low risk, low volatility financial strategies. Jeff can be reached at firstname.lastname@example.org.
Cutter Financial Group LLC (“Cutter Financial”) is a registered investment advisor.
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