My son walked into my office on Friday, the day before Halloween… and said, Hi dad:
Knock-knock!
Who’s there?
Ice Cream!
Ice cream who?
Ice cream every time I see a ghost.
I haven’t seen any ghost lately, but hearing about financial people who mislead consumers really makes me want to scream!
Last week I received an email from Eugene J. from Ann Arbor, MI who inquired about annuity surrender charges and high commissions paid to the agent. He stated that his wife (age 51) had recently left her employer and she wanted to transfer her TSA (Tax Shelter Annuity also known as a 403b) to a self-directed IRA before she started her new job. Eugene was considering transferring the funds to a Fixed Indexed Annuity (FIA) but had heard from an RIA (Registered Investment Advisor) who told him to stay away from indexed annuities because they have high surrender charges and they pay high commissions to the agents who sell them.
I only had four questions for Eugene:
- The first question I asked was: When does your wife plan to retire? Eugene stated, in about 15 or 16 years.
- The second question I asked was: Why was he considering the purchase of a FIA? Eugene stated, that his wife did not want her money in the stock market after witnessing his (Eugene’s) 401k take a big hit in 2008.
- The third question I asked was: What is the maximum surrender charge on the annuity in the first year before it starts to decline on an annual basis? Eugene stated, he was looking at a 10 year annuity with a 10 percent surrender charge in the first year.
- The fourth question I asked was: Does the Investment Advisor who told you to stay away from annuities, offer them to his clients as a wealth building tool that can guarantee you an income stream you can never outlive, or can guarantee your money will never go backwards if the market crashes and can lock in the credited gains annually so as never to be lost? Eugene stated, no.
Whenever I hear criticism or any bad press regarding Fixed or Fixed Indexed Annuities, I always consider the source of the criticism and I recommend you do as well.
The criticism on surrender charges and annuity commissions usually comes from those individual who do not offer Fixed or Fixed Indexed Annuities, such as bank advocates and those individual representing Wall Street. They criticize Fixed Annuities because Fixed Annuities don’t fit their “fee-based” model. The lack of recurring fees is probably the primary reason why Wall Street doesn’t care much for Fixed Annuities. Wall Street wants fees and FEES are what drive Wall Street. Always remember, it’s not what you earn that counts, it’s what you get to keep after fees – more on this in a bit.
Let’s first talk about surrender charges, and then in Part 2 of this blog we’ll discuss the issue of commission compensation vs recurring fees.
On the onset I’d like to mention that the purpose of writing this blog is to help you, the consumer, evaluate what is a suitable amount for you to place into an annuity based on your personal needs. I believe that by proper planning, you can enjoy the benefits of a tax-deferred annuity without being exposed to the cost of surrender charges.
It’s important for you as a consumer to know that if you need to access your money for any reason, Fixed or Fixed Indexed Annuities typically allow you to withdraw up to 10 percent of your account value per year for FREE without a surrender penalty.
Any withdrawal amount ABOVE the policy’s 10 percent penalty-free amount will be subject to a surrender charge – the surrender charge usually DECLINES each year until they ultimately vanish altogether. After the surrender period has expired 100 percent of the account value is available at no charge.
The declining surrender charge schedule on the annuity is much like a front-end sales charge on a mutual fund, which both are in place to allow the issuing company to recover its cost of doing business.
What cost?
In order for the insurance company to provide you the “annuity benefits” such as guarantees, competitive interest rates, stock market linked returns, no downside risk, principal protection, premium bonuses, and offer commission compensation to the agent who sold you the annuity, the insurance company must make long term investments.
The longer the investment commitment, the higher the yield, especially with the carrier’s preferred placement in income-producing bonds. The income from the bonds is then used to purchase options on the S&P 500 stock index, and the return on the options drives the returns of the Fixed Indexed Annuity.
The insurance company knows that if the annuity owner keeps the policy in force for an adequate amount of time, or for the entire term of the surrender period, the annuity investment returns on the FIA will not only cover the cost of doing business as described above, but also make the annuity contract profitable to the annuity owner.
So a surrender charge exists because if you bail out of the annuity early, and the company has to break its long-term investment commitment, the insurance company is going to lose money. So from my perspective, a surrender penalty is actually a positive and not a negative. It’s actually good for you and good for the insurance company, because it allows both parties to know “for certain” what will happen.
Now, if its qualified money (as in Eugene’s case) such as a TSA, 403b, 457, TSP, 401k or IRA that’s going into the annuity… than the surrender charges on the annuity should be nothing more than a very low priority – let me explain.
Qualified accounts already have two forms of built-in surrender charges.
The first is the10 percent penalty for any withdrawal prior to age 59.5, and then you would have to pay income tax on top of that. If we assume that the account holder is in a 25 percent tax bracket, combined with the 10 percent penalty, his built-in surrender charge is 35 percent. So if your liquidity comes at a price of a 35 percent penalty, I’m willing to bet that those funds will be the last money you would consider if you need cash for any expenses.
The second built-in surrender charge is marginalized tax brackets. Although less predictable than the 10 percent IRS penalty, it is just as prevalent and last throughout the client’s lifetime, regardless of age. Taxation is the most significant drag on any investment return.
I think most advisors would agree with me that it would be pretty crazy to draw out a lot of money from their IRA or any qualified funds… if at all possible to avoid it.
So in the case of Eugene’s wife (age 51) who does not want to cope with the giant swings of the stock market, she wants principal protected growth for the next 16 years before her retirement, then the length of the surrender charges on the annuity really doesn’t matter. In fact, in this scenario with 16 more years before retirement and the fact that she has qualified funds, I would actually recommend that Eugene start by looking for an annuity with the longest surrender charge he can find.
Yes, you read it correctly; start looking for a Fixed Indexed Annuity with the longest surrender charge you can find.
So it stands to reason (as we’ve just discovered) that the longer the surrender charge, the more the insurance company can commit to long-term investments – the longer the investment period, the higher the yield with the insurance company’s preferred placement in income-producing bonds.
According to the market research firm Wink the average annuity surrender charge period is 10 years.
Let’s run some numbers and take a look at a typical example of a $100,000 annuity with 10 year surrender period, 10 percent penalty-free withdrawal after the first year, and first year surrender charge of10 percent declining by 1 percent every year as follows:
Year 1 = 10%, Year 2 = 9%, Year 3 = 8%, Year 4 = 7%, Year 5 = 6%, Year 6 = 5%, Year 7 = 4%, Year 8 = 3%, Year 9 = 2% and Year 10 = 1%, Year 11 = 0%.
For this first illustration I’m not going to factor in any account value growth (0% credited interest), and I’ll show what it would cost for you to access $10,000, $20,000 and $30,000 in the first year. Let’s look at the chart below:
You’ll notice that 1st year you withdraw $10,000 – No Charge on the first $10,000 (10% penalty free withdrawal – $0 exposed to surrender charges).
1st year you withdraw $20,000 – No Charge on the first $10,000 ($10,000 exposed to surrender charge of $1,000 or 1% as a percentage of account value to access $20,000)
1st year you withdraw $30,000 – No Charge on the first $10,000 ($20,000 exposed to surrender charge of $2,000 or 2% as a percentage of account value to access $30,000)
I know what you’re thinking?
You’re thinking… “Okay Dan, you’re telling me that if I withdraw $20,000 at the end of my first year, it would only cost me 1% as a percentage of the account value, and if I withdraw $30,000
It would only cost me 2% as a percentage of the account value? In fact, by most standards, this is cheap money.
But what if the annuity had very conservative growth… of only 3 percent compounded? How long would it take for the annuity owner to walk away with 100 percent of his principal?
Okay let’s run the numbers: $100,000 compounded 3 percent for five years:
As you can see from the illustration above, that even with a very moderate 3 percent compounded rate of return, in year 4, you can bailout of the annuity with more principal than you started with.
There are also Fixed Indexed Annuities that offer a 2 year bailout. This means that at any time in the third contract year and thereafter the client may terminate the annuity contract and receive no less than the contracts net premium. Some Fixed Indexed Annuities also come with Enhanced Withdrawals, meaning 10 percent of accumulation value after the first year and beginning the third year, withdrawals can increase to 20 percent penalty-free if no withdrawals are taken in the previous year.
When I sit down with a client who is risk adverse, and take the time to educate the consumer on how Fixed Indexed Annuities work, the typical response is “Why hasn’t my financial advisor told me about Fixed Indexed Annuities?”
From my perspective, I really don’t care if a financial advisor likes annuities or not…what bothers me the most is that registered representative, investment advisors as well as insurance agents don’t educate their clients on how Fixed or Fixed Indexed annuities actually work.
But whether you like annuities or not, it does not negate the fact that according to the major research institutes, LIMRA SRI, Wink and Beacon Research have put Fixed Indexed Annuity sales at $38.7 billion for 2013 and $48.2 billion in 2014. That’s $9.5 billion more than the previous year. The combined totals for both Fixed Annuities and Fixed Indexed Annuities were almost $85 billion in 2013 and $95.7 Billion (with a capital B) in 2014.
Fixed Indexed Annuities are simply proving to show solid returns according to a recent study by the Wharton Financial Institutions Center. The study, “Real World Indexed Annuity Returns,” showed that some indexed annuities produced better than average returns even at par with equities at times.
Fixed Indexed Annuities are unlike any other retirement savings tool, because when it comes to guaranteeing you an income you can’t outlive, the insurance company is taking all the risk, not you. When it comes to investments such as stocks and mutual funds, the consumer is taking all the risk, not them.
So if annuities are the only financial tool that can guarantee an income stream you can never outlive, why do financial advisors representing Wall Street tend to hate them?
As I mentioned earlier, my feeling is that those who represent Wall Street will always criticize Fixed or Fixed Indexed Annuities – because Fixed or Fixed Indexed Annuities don’t fit their “fee-based” model and Wall Street is all about FEES.
In Part 2 of this post I will address the issue of annuity commission vs Wall Street’s recurring fess.
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If you have any questions regarding this or any other topic, I would be more than happy to help you in any way I can or lead you in the right direction.
