posted on December 4th 2016 in Fort Worth CFP Team Posts with 0 Comments /

Fair warning: this is going to be a “blow your mind” article. Are you strapped in?

Let’s talk about the classic “death benefit” on a variable annuity. Variable annuities are those weird investments that look suspiciously like just another cookie-cutter portfolio full of the high-cost mutual funds that brokers have the reputation of selling to investment illiterates, only they are wrapped up in a form of life insurance. People like to hear words like “guarantee” and anything that implies a tax advantage in their sales pitches, even though they don’t quite understand exactly what is being guaranteed or whether or not the “tax-advantage” is actually an advantage for their particular circumstance. Sometimes the temptation is just too much even for people who normally make good decisions. If I had a dollar for every time I’ve heard an investor say, “I never thought I’d buy an annuity, but…”  

Of course, if you are an annuity salesman, you are trained to explain to just about anyone why it’s right for them. As the old saying goes, “if all you have is a hammer, everything looks like a nail.” Annuity sales pitches are painful to listen to because there are so many different “values.” Separate accounts… Contract values… Income values… Death benefit values… Finally, the pitchman gives some relief by summing it up that you can be invested in the stock market but not have to worry. Whew, that’s a relief. Exactly what you wanted to make money without risk! The worst that can happen is that you don’t make any money, right?

Many people buy annuities for the death benefits because they want to pass the money to heirs. They figure if they make money, great, they leave their heirs more. But if the contract loses money, then they “protected the principal.” Unfortunately, it’s not so simple.  What I’m about to prove to you is that annuities are just a really expensive and inefficient way to buy life insurance.

Let’s compare two different investment scenarios. In the first scenario, you work with an advisor who is a fiduciary, so he can’t get paid to sell you any products like insurance. However, as a fiduciary advisor who is a Certified Financial Planners™ (CFP® professional), he’s concerned with your total financial picture even though he doesn’t sell insurance. He advises you that you can protect yourself with some low-cost and no-load life insurance that he helps you find. In the second scenario, you lock up your money in an annuity sold to you by a broker.

In both cases, let’s imagine you are a healthy 50-year-old person who is changing jobs and wants to explore his options as to what can be done with a 401k from a previous employer. Of course, you could leave it where it is at, but for the purposes of our illustration, we’ll assume you decided it was best to roll it over into an IRA. We’ll assume a “worst case” scenario you invested at the beginning of 2008 and died five years later. I pick this time precisely because it’s the scenario that annuity buyers are trying to avoid! When selling an annuity, “2008” is always brought up. People want to avoid 2008! So, let’s give the annuity the exact environment it was sold to shine in and see how it does in an ideal situation!

Scenario 1 – Planner with no annuity, plus life insurance

First, you get a $25,000 policy with a 20-year term for $25/month. That comes out to $300/year, or $1,500 over the course of five years.

Next, you hire an advisor who uses low-cost mutual funds, but no hedging, options, or anything exotic. (I add this criteria because I want a fair comparison to an annuity.)  You tell him to be aggressive no bonds for you! Let’s assume his fee is 1% and the investments he puts you in cost 0.25%. For the sake of simplicity, let’s assume after all fees, he underperforms the S&P 500 every year by 1%.

The returns over the five-year period: -39.5%, +22.5%, +11.75%, -1%, and +12.5%. To ensure we are being fair when we compare this to the annuity, let’s say he only started with $98,500 instead of the full $100,000.

At the end of five years when you die, the portfolio is worth $90,857, but the heir would also get a life insurance contract worth $25,000.

Total inheritance: $115,857

Scenario 2 – Broker-sold annuity

A broker sells you a $100,000 variable annuity. The performance of the underlying funds before fees is exactly the same as the advisor in scenario 1. The difference is the fees.

There are lots of fees inside the annuity. I’ll provide some approximate numbers that I’d say are about average for the annuities I run into. The M&E (mortality and expense) runs you 1.75%. The administration cost is 0.25%. There is an insurance “rider” that costs you 1%. Then the “sub-account” fees are another 1%. And for good measure, there is a flat annual maintenance fee of around $50 that goes to the insurance company. If you are keeping count, that’s about 4%, which is 2.75% higher than the first option. In reality, many annuities are much higher than this, and some brokers even charge you a fee on top of all that to advise you on how to allocate within the sub-account every year, or their firms charge you account fees. Let’s not assume a worst-case scenario; let’s just assume all in all, you pay another .25% a year for all the other garbage associated with it.

Again, the investments perform the same as they did in the first option, only there is 3% more in fees! Your annuity contract value would be worth $78,550. But not to worry, that’s why you did an annuity to begin with for the death benefit!  

Total inheritance: $100,000

What’s my point? Variable annuities are just a really expensive way to buy life insurance. The death benefit isn’t always a benefit at all!  

What about taxes?

When you consider the tax consequences to the heir, it doesn’t look much better. Let’s rethink the scenarios but this time assume the heir gets a taxable account. For good measure, let’s go out one more year of life and assume you live six years now instead of five.

Scenario 1 – Planner 6 years

The portfolio goes up 28.5% in 2013 and is worth $116,534. Then there is the $25,000 in life insurance. Generally, there is no tax on the proceeds received under a life insurance contract.  Also, the heir gets a step-up in cost basis of all the investments, so theoretically, the heir could sell all the investments on day one and have all the money tax-free if desired.

Total inheritance: around $141,000

Scenario 2 – Broker-sold Annuity 6 years

The annuity contract is now worth $98,580.

Total inheritance: $100,000

Okay, so I still didn’t get to show you the tax problem. I guess we have to go out another year to 2014 when the planner did 10%.

Scenario 1 – Planner 7 years

Portfolio is worth $128,187, plus $25,000 in insurance.

Total inheritance: around $153,000

Scenario 2 – Broker-sold Annuity 7 years

Annuity contract is finally positive, worth $105,481! But wait, there’s more.

The heir does not get a step-up, so if he wants the money right away, he’s got to pay taxes. But wait, it gets worse again! The gain is not taxed at the capital gain of 15%, but at the income tax level of the heir! So if the heir is in the 28% tax bracket, that $5,481 just took a big haircut!

Total inheritance: around $103,950

It’s shocking, isn’t it? In just seven years, a good planner who invested your money very aggressively and took a major hit in year one, yet didn’t do anything exotic or even have any amazing market-beating returns, was able to beat the pants off the annuity sold to people who “want safety.”  

The reason I set up the scenario this way was to prove several points beyond the obvious one, which is that annuity death benefits are just a very expensive way to buy life insurance.

I understand the first thing people think of is fees and returns. So I made sure the returns after fees weren’t anything special just about average of what the market did in those years, minus fees. I did this to point out that it wasn’t “super special” returns that helped the planner beat the annuity. It was the planning he did for you and the fact that he did it in a conflict-of-interest-free environment. Now, I’m not saying good returns aren’t wonderful, I’m just taking “returns” out of the picture here so we can focus on something else the value of working with a Certified Financial Planners™ who owes his clients a fiduciary responsibility at all times.

In closing, the death benefit is only one reason people buy annuities. There are plenty of other misunderstandings around how “guarantees” are made and what they really mean, or how what “fixed” aspects of the account really mean. Frankly, variable annuities are one of the most complex and easily misunderstood investment vehicles out there, and they’ve become slicker than ever. Believe it or not, I’m not opposed to all annuities all the time. There are cases where certain types of annuities make sense, but those cases are rare.

The best advice I can give is this: if you are considering an annuity, don’t buy it until you’ve spoken to a fiduciary advisor with expertise in the area. Luckily, there are options for people who are stuck in one and want to do some damage control. Hopefully this article keeps a few people from making some mistakes, but if you are stuck, feel free to email me for a complimentary review.

 ¹Disclaimer: There are lots of different kinds of annuities out there. It’s impossible for me to quickly explain all the features of all of them. There is no way for me to describe every possible scenario. This article is designed to be informative in nature and not provide advice of any kind. Certain assumptions and estimates will be made to illustrate how an annuity plays out.
² All returns are rough estimates for the sake of simplicity.
³ I’m sure you’ve heard that annuities pay the broker 5-10% of the value of the annuity sold. This is true. However, that’s a deal between the insurance company and the broker because the insurance company knows it will make that money back. That commission doesn’t “come off the top.” Instead, the insurance company pays the broker a fat fee upfront because it knows it will make so much off you in the long run.
⁴ Working with a CFP®  who works for a brokerage firm is vastly different than working with a CFP®  who owes his clients a fiduciary duty at all times.


about the author: Joshua I. Wilson CMT

Josh-Wilson CMTJoshua I. Wilson, CMT®, AIF® is a partner and wealth manager who has managed over $2B for TD Ameritrade. Joshua led the national training and development program for all of TDA’s new advisors and managers, won a national coaching award. Joshua gave his graduation speech at Brown University. Joshua is a Chartered Market Technician® (CMT®) and a Accredited Investment Fiduciary® (AIF®).

Learn more and/or Contact Joshua

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