Annuity IQ

I have RSS feeds from all the main news sources that pick up on any annuity story, so I see most, if not all stories written about annuities. This allows me to do my part and try to correct mistakes the authors make, which are usually vast, and it allows me to comment to you on the stories as well. What upsets me the most is when I see stories that keep getting reprinted when they are old and out dated.

This is the case in this post. There was a story on annuities published on the Motley Fool yesterday dated February 6th 2007. The problem is the story is at least 4 years old, perhaps even older, and 90% of the information is outdated and incorrect. I have already commented on this story in the recent past, but I feel the need to comment again because the story is so outdated it is a bit incredulous and they keep reprinting it.

The name of the story is variable annuities: The Lowdown and you can find it by going to Yahoo news and search the term annuity or variable annuity. The story starts out in the usual way, bashing financial advisors who sell annuities.

Here is the opening line: “Insurance salesmen often push variable annuities — mutual fund-like instruments (which generate hefty commissions) upon investors.”

Now, I can easily defeat the commission argument of their statement and will do so in a very near future post. For now I will address why this story should not have been published and how they are negligent in the information they are distributing. If any advisor gave out this blatantly wrong information they would lose their license.

The first thing that comes up is fees and they frame their argument this way: “variable annuity fees can be steep. They’ll typically scarf up more than 2% of your holdings each year, according to Morningstar. That’s negative growth.”

All investments carry fees and all fees are negative growth. Why frame the variable annuity fees this way and let mutual funds, even no-load funds, get away Scott free on their internal charges?

There is no reason other than their biased behavior against these products. Essentially, they believe no one should ever buy an annuity. Any advisor or publication that tells you never to buy one single product or investment is a publication you should steer away from.

The reason I say this is because the publication or advisor either does not understand the product or investment, which is the case with 99% of the anti-annuity crowd, or they are not giving you the full spectrum of products available. In either case it is not unbalanced advice it is the equivalent of pushing there own belief system onto you.

Next, and this shows the date of this article, which I remind you is dated February 6th 2007, is they use the tax argument. The argument is why defer taxes and pay ordinary income on distributions from the annuity versus long term capital gains tax of mutual funds.

Here is what they said: “Earnings grow tax-deferred in a variable annuity, but when the tax is ultimately paid, it’s at your normal rate, which can reach nearly 40%. Compare that with the long-term capital gains rate of just 20%. Even if your tax bracket isn’t very high, if you choose to withdraw most of your annuity funds at one time, that will likely kick you into a higher bracket.”

Here are a couple of points I want to make loud and clear. 1. The top tax rate is 35% not 40% (this is clearly a pre-2003 article republished) and taxes are graduated, which means that not all of your income is taxed at the top rate. 2. The top long term capital gains tax rate is 15% (again, proof this is a pre-2003 article) not 20%.

They also fail to point out that mutual funds tend to spin off more short term capital gains, which are taxed at ordinary income, than long term capital gains. They fail to tell you that the annual distributions from mutual funds can put you in a higher tax bracket and you may be subject to AMT, alternative minimum tax, on top of it. Considering most individuals are in a higher tax bracket when they are working and a lower tax bracket when they are retired this entire statement is plain dumb.

This next quote is a gem. Here is what the, living up to their names, ‘Fools’ say: “It often takes at least 15 years before the performance of your variable annuity will match the after-tax returns of investments in a taxable account. You’ll be tying up your money for a long time.”

They make a blanket statement like this and back it up with zero facts. Here are some facts for the ‘Fools’. A study conducted in 1999 by Arnott and Jeffery and confirmed by Arthur Levitt , former SEC Chairman, concluded that the average mutual fund investor looses between 2.5% to 5% of their total return due to taxes they have to pay on the distributions the investor receives.

Whatever ‘study’ they used to come up with 15 years to break even must be using gross numbers, not net after tax numbers. Plus, they never state where they come up with 15 years anyhow, so until they disclose the study that shows it takes 15 years to break even I consider this argument invalid and incomplete.

The ‘Fools’ went on to write this: “The “death benefit” that will pay your beneficiaries at least as much as you put in to the annuity is often a selling point. But it frequently costs more than it’s worth. Long-term investments in good stocks are likely to increase, not just maintain, their value.” They also bring up the stepped-up cost basis on stocks and mutual funds, but it is covered by the following statement.

Umm, no one is selling or buying a variable annuity because of a death benefit. They are buying or selling annuities because of the living benefits they offer. No soup for you!

They say this next…this is good: “As with instruments such as IRAs, if you withdraw funds before age 59 1/2, you’ll be charged a 10% penalty. Better be sure you won’t need that money soon.”

No way! An annuity is a long term investment? I guess mutual funds are not. 95% of all investments bought or sold in this country are for the long term investor. While the 10% penalty is a very valid point, it makes little sense as I just stated that most investments are long term. Plus, they never mention that you can get money out without the 10% early withdrawal penalty using a 72Q calculation, but hey, never let the facts get in the way of a good story.

I am not surprised by their final bullet point. Here is what they said: “variable annuities offer the option of annual payments. But, you could achieve annual income effectively in other ways, such as by selling off small portions of stock holdings each year or investing in other income-producing securities.”

Anyone who has done a study or a hypothetical illustration of systematic withdrawals from equity portfolios knows it is not always as simple as they are saying it is. They totally ignore the living benefit income guarantees in their final statement. I guess I am not surprised considering the article is at least 4 years old and living benefits where really just beginning to come to the marketplace.

I wrote the ‘Fools’ and told them to stop reprinting old and out dated information, I doubt I will hear back from them. To give out wrong information on current tax rates is almost criminal or at the very least blows their credibility right out of the water. If an advisor gave out wrong information even wrong simple information like the current long term tax rates and they gave out the wrong information, like the ‘Fools’ did, they would be in serious trouble.

I do not know who read their material and why, but clearly people should go elsewhere for their information, especially concerning annuities. I do not care if you dislike annuities, as I have always stated, but if you are going to write a negative article about them please use the right information. Do not run a story that is old and try to pawn it off as something new otherwise you will look foolish.

I usually reserve article specific comments on variable annuities for the members area of Annuity IQ, but this article was full of so many errors and misinformation it is ridiculous! This article was published on Fed 4th, 2007 at dailrecord.com and was written by Christopher Cordaro, a CFP, CFA.

In his article titled: Deferred variable annuities, Mr. Cordaro takes what appears to be his best pop shots at variable annuity contracts. Unfortunately, he is wrong because he is disillusioned by his own, admittedly, biased opinions against annuities and he does not get the facts plus he insults annuity owners and advisors who sell annuities. I will summarize what he has written and offer the real facts.

In his article, Mr. Cordaro was asked, supposedly by a reader, but no name or location was given, how he feels about deferred annuities. He opened his argument with this statement: “Bashing variable annuities is my favorite pastime. If only we could do it in a stadium, with cheering crowds, beer and hot dogs!” Of course, this peeked my interest right away and assured me from the start where the article was going.

He then goes on to describe the two kinds of popular annuities, fixed and variable. He actually spent exactly two sentences on fixed annuities, comparing them to CD’s without FDIC insurance, and he actually said this about fixed annuities: “This is very similar to a CD without the Federal Deposit Insurance Corp. protection.”

Anyone who knows anything about FDIC insurance would not phrase it as ‘protection’. Especially considering FDIC carries a zero balance and all the funds have to be appropriated by Congress, and it can take FDIC up to 80 years to pay back your money. I am not saying FDIC is bad, it just is not all it is pitched as being….Plus, look at the name: Federal Deposit INSURANCE Corporation. Anyhow, on to the nuts and bolts.

He then goes on to give a very brief description of variable annuities, exactly two sentences, and then goes on with his personal misled facts on these products. In his third sentence on Variable annuities, he says: “The variable annuity does not provide you with any protection against declines in the stock market.” Well, that statement is not 100% wrong, but it is about 95% wrong. Most variable annuities now carry a living benefit of some kind, including return of principal….More on that in a little bit.

Then he gives 3 reasons why they are bad, which are misled by his opinions and not exactly facts. These statements or ‘facts’ may be offensive, remember I am quoting.

He said:

“There are three main problems with variable annuities:

1. High fees.

2. Poor tax efficiency.

3. Sleazy sales practices.

variable annuities ding you with fees. There is the mortality and expense charge, which can range from 1 percent to 2.5 percent. This is mostly compensation for the agent and the insurance company.”

Here is the thing, he is right and wrong. Fees seem high, but are not that much more than mutual funds. Yes, the fees may be one percent or more than a traditional mutual fund, but a mutual fund does not protect you or your heirs against a decline in the stock market through either a death benefit or living benefit.

With the whole tax efficiency thing, (I do not know where he gets his research), but he is dead wrong on that issue. A study by Arnott and Jeffery conducted in 1999 shows that the average mutual fund investor loses 3% of their total return due to taxes. Arthur Levitt, former Chairman of the SEC, has also cited studies that show the average mutual fund investor loses 2.5% to 5% of their total return due to taxes.

To boot, mutual funds are taxed more often than annuities and open you up to the Alternative Minimum Tax. Mutual funds, in a nut shell, are taxed like this: annual distributions, which contain long term and are taxed at ordinary income rates, and short term which are taxed up to 15%. These distributions happen every year and will be distributed no matter how well or poorly your mutual fund performs. Let us not forget that there may still be capital gains tax when you finally sell your mutual fund, which can be long or short term gains, depending on how long you held your mutual fund. We can talk more about this in a future post or if you read my past articles, you will see what I am referring to.

Sleazy sales practices….I wonder if he is referring to scaring people into buying an annuity or if he is referring to scaring people into not buying a variable annuity. He is scaring people into not buying an Annuity, so is he calling the kettle black? I think so, and it should be obvious to all who read this article. In my opinion, this article is sleazy because he does not have the facts and is just plain wrong, so why even dignify that statement with a response.

variable annuities can charge 2.5% or higher in fees. It is up to the broker and their client to choose the best annuity for their needs and objectives regardless of cost, although the client is better off with a cheaper product. What he does not clearly state is all investments carry fees that pay for the compensation of either the advisor that sells the product or the mutual fund company’s costs for advertising the mutual fund.

What he does not state is that he probably charges a fee for his service which is geared to pay him and in addition, the mutual fund he puts you in will still carry an additional cost. At the end of the day, his fees and the investment costs are just about the same as a variable annuity, but what do you get for his 2% or more total fee? Nothing, there is no guarantee to your heirs and more importantly no guarantee of current or future income. I am sure he guarantees to charge his fee every year and service the account. Again, who is calling the kettle black?

He goes on to say that: “The underlying investment funds also have high expenses because they typically kick part of their fee back to the insurance company.” This statement is correct and incorrect at the same time. It is true that insurance companies and asset management firms do share in fees from the sub-accounts you choose. I am and have been against this practice and believe it should be clearly stated in the prospectus and to the reps who sell the variable annuity product to their clients. To my knowledge, no firm or wholesaler receives ‘extra’ compensation for recommending one sub-account over another.

He is wrong when he says that sub-accounts are more expensive than their mutual fund counter parts. In my experience, even with this revenue sharing agreement, the costs for sub-accounts are equal to, but in most cases, less than its mutual fund counterpart. The average sub-account cost is usually 1% or less, unless it is a specialty or exotic investment.

He then goes on to talk more about taxation, which I have just pointed out was wrong, but he takes it a step further. Here is what he said: “Turning income that could have been taxed at 15 percent into a 35 percent tax bracket is brain dead!” He is making the assumption, which contradicts a previous statement he made, that everyone is in the 35% tax bracket and he does not specify how the tax code works.

Taxes are graduated, which means only a certain portion of your taxes, if you make enough income, (over 150,000 a year), will be taxed at 35%. Also, all those mutual fund distributions that you get every year will promptly increase your tax rate, as much of those distributions are taxed as ordinary income. He also fails to acknowledge that you are really paying more than 15% in capital gains distributions, when you average the short and long term distributions tax rates together. Again, his argument is not accurate.

He then goes on to say annuities in IRA’s are a rip-off. OK, I have had enough on that discussion because all these guys sit there and say that there is no tax benefit to putting an IRA into an annuity. Well, no kidding Einstein! In almost 14 years in this industry I have NEVER seen one broker sell an Annuity in an IRA and talk about the tax benefits. People buy annuities in their IRA for the guarantees that are provided, not for some tax benefit sales tactic you anti-annuity guys just made up.

Then this guy comes out and says this: “Another common rip-off is guaranteed income riders.” Rip-off? Is he serious? I am sure he is, and from what he wrote next it goes to show he knows nothing about what or how living benefits actually work….I think he needs to sign up for Annuity IQ.

Why would I say that? Simple– look what he wrote about living benefits:

“There are a wide variety of these, but the basic theme is you pay an additional charge that will guarantee you (a) a specific return or (b) income level.

The only way to get your guaranteed return or income is to take it in the form of a life annuity. The life Annuity pays a very low return, and it is dribbled out to you over your lifetime.

When you do the analysis, the only thing you are getting for the additional fee is a guarantee that you’ll earn a low return for your lifetime. Not such a great deal.”

Wrong, wrong, right. There are more types of living benefits than he suggests, including income for life, return of premium and guaranteed withdrawal benefits. As usual, he is using one type of living benefit, the guaranteed minimum income benefit, for his example and ignores the rest of the different types of benefits available. How can anyone take you seriously when you do not even know all the options available?

GMIB’s do provide you with up to a 6% compounding benefit, but most allow you to take out the 6% as income right away. This means, unless your account cash value drops to zero, you could theoretically take out 6% forever and if your account value drops to zero most insurers will allow you to annuitize your initial investment, which will last the rest of your life.

Granted, it is at a much lower interest rate, but what else is in the market place that will allow you to withdraw up to 6%. Then if the market does not go in your favor will allow you to annuitize your principal amount. Sounds like an OK deal to me, even if it is not the best option the insurance company is offering, and it is not always the best option.

I just do not get it. How can a guy with, what seems like, such great credentials be so wrong about these products and how they work? He has a CFP and a CFA designation which are two tremendously difficult credentials to receive. Obviously, he framed this article to his specific beliefs and sales practices and that is fine, as long as he uses real facts, not made up or recycled mumbo jumbo.

I do not mind a contrarian approach to annuities, but I do demand that you use facts and not opinions when you write about these products. Clearly he wrote about his opinions in this article and it should not have been printed by dailyrecord.com. I will use his advice for closing this post.

He said: “If someone ever advises you to invest your IRA or other retirement account in a variable annuity, you should run.” I will say this, if any advisor says you should never buy a product, you should run from them.

This means that they either do not know anything about the product or they want you to strictly follow their way of investing, which may be right for them, but probably wrong for you. If they are not well versed in the different options or investments available in the marketplace, they are probably not giving you the big picture.

If they are wrong about something, then it is your financial future at stake, not theirs. An advisor should do just as the name says, advise and recommend products that fit your situation and not recommend products based on their personal belief structure as that does nothing for you over the long term. I think we can add another credential behind this authors name, B.S.