Annuities…the evil step mother of the investment community just may be cinderella for some retirees


I have found investment advisors who swear by annuities and other investment advisors that just plain swear when you use the (A) annuity word. And in defense of the latter, they are asked to unwind purchases with high expense loaded annuities that charge a second load to get out of the contract. And typically surrendering the annuity is necessary. The annuity is illiquid and the entirety of the client’s investment portfolio was placed in the annuity. So the client paid too much and now has no access to their money. That left a crowd of advisors to sing the praises of the annuity, “They accumulate tax deferred.” And “You may even be able to guarantee the cash flow.”
And being the smart professor I gave the question as a project to my really bright UC Berkeley Extension students. I asked them to compare the use of a mutual fund to an annuity to create retirement income. One group assumed that $500,000 was invested and that an annual withdrawal of $25,000 commenced immediately. And they looked at three annuities, two from the same company.Were the annuities loaded in fees and expenses? Here’s an example of one annuity: Annual
Investment Management Expense 1.25%
Admin Fee and Mortality 1.15%
Cost of Rider to Guarantee Death Benefit .95%
3.35%One Time
There is a state sales tax premium of 2.35% on the initial investment. (One student still refuses to believe it even when I show him where it’s stated in the prospectus.)

If you get out of the contract prior to year eight you have a pro-rated charge of 1-7% of the total amount invested.

In summary, the expenses would be 2.35% up front, then 3.35% each year, not considering the surrender charges.

And here’s my point. Not all annuities are created equal. You can avoid these excessive annual expenses. Two other annuities have annual fees that range from .25 % – .76% (increasing to 1% at age 90).

So if you assumed a common interest rate what would the results look like? Like a $1.0 million dollar difference between two contracts after 30 years. Did the mutual fund comparison perform better? Yes, it did. It beat both. And was it reasonable to assume that the annuity sub-accounts matched the mutual funds in return? Probably not.

So why would someone pay the high fees? What if you were underfunded for retirement and you were told that you could guarantee a 4-5% annual payout, guarantee your principal and that you would earn an equivalent of 7% return on your investment?

So what goes wrong? Those guarantees require that you take no more than the 4-5% guaranteed payout rate. And if you do, your principal is no longer guaranteed. So if you take an excessive withdrawal and the market drops 30-50% you have now reduced your income by a respective 30-50%. Does this happen often?

When I reviewed one contract it included how to make a complaint to the Department of Insurance. My guess is that the people who buy the guarantee riders selectively forget the limitations that preclude them from accessing their principal. And this is compounded by the error of putting the client’s entire investment portfolio into an annuity, leaving the client cash poor. The result is a mess that is difficult to untangle.

My recommendation is to take care that you fully understand the provisions of the contract and that you get a second opinion from an independent hourly financial planner. No names, of course.