Not All Annuities Are Created Equal
November 16, 2017 by Jeffrey Cutter
Deferred annuities can often be an essential part of a sound financial system. Deferred annuities are insurance contracts that over time, can provide the opportunity for growth during the accumulation phase of one’s financial lifecycle. They can also be designed to create a pension-like income stream during the distribution phase that is both 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, or annually. With many contracts, you can opt to receive payments for the rest of your life, or for a set number of years. After the expiration of a specified number of years, a deferred annuity can be surrendered for a lump-sum, free of any charges, if an income stream is not necessary.
Unfortunately, not all deferred annuities are created equal.
Let me introduce you to my friend, let’s call him Mike. Mike and his wife, Jean, came in to see me a few weeks back.
Mike’s a good guy. He is 58 and has been married to Jean for about 35 years. They have two daughters in their early 30’s, who 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. Folks, you know I never look at things as good or bad when building a sound financial system, only what is appropriate or inappropriate. And I am a huge fan of some types of deferred annuities, such as fixed indexed annuities (FIAs), but Mike and Jean were not advised to invest in an FIA.
I needed to find out why.
They recently 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 portfolio 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 often only benefit the salesperson and the institution selling the product, rather than the investor. And the poor disclosure made by most 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.
Variable annuities have a very costly fee structure, often never disclosed. Or at the very least, never explained properly. They are frequently built showing two separate values: the actual cash value, and the income value. It is the income value that receives the 5% interest rollup Mike was talking about, but at a significant cost. This is the value used to calculate the payout if the account is “annuitized” or an income rider is turned on, if the income value is higher than the cash value. The actual cash value reflects the amount invested in usually expensive market-bearing instruments, with no downside risk management. In other words, the cash value is usually subject to significant market risk.
Mike and Jean seemed confused. I suggested we call their VA company. I would ask the questions, 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 is .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 charged for them to receive the 5% rollup on just the income value, not the cash value.) That is 1%. “How about a wrap fee?” (A wrap fee is paid to the advisor for the life of the contract – on top of the commission they are already paid.) Tack on another 1%.
By the time we were done adding it all up, we calculated 5.4% in fees.
In addition to the fees, there is another big deterrent to VAs, one that I mentioned above. VAs expose investors to all the market risk. Typically, there are no guarantees on the cash value of a VA. The only question I had to ask Mike and Jean was, “What happened to you in 2008?”
By the way Mike and Jean looked at me, they were getting my point. If the underlying investment options powering a VA perform badly, you can lose money, and a lot of it – not just the interest you’ve made, but your principal as well.
I suggested that a Fixed Indexed Annuity (FIA) may have been a more appropriate investment for them. An FIA gives you a guarantee from market risk on the principal, while giving you opportunity to capture some of the market upside. Essentially, the insurance company guarantees that you never lose the principal of your investment and potentially credits your policy with interest earned.
As I have taught my clients and the Cutter Family Finance faithful for years, if you manage the downside risk of any investment strategy, 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.
Fixed Indexed Annuities can be an appropriate investment opportunity for people looking to protect the downside and participate in the upside of the markets. They can also be used for a steady income in retirement. But now, more than ever, you need to be vigilant. You need to make sure you understand what you’re paying for and that it is appropriate for use in your sound financial system.
Folks, 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 atjeff@cutterfinancialgroup.com.
Cutter Financial Group LLC (“Cutter Financial”) is a registered investment advisor.
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