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November 01, 2011 at 12:49 PM
Are you familiar with the box — sometimes it appears on broker-dealer forms and applications — that asks for a check mark if a variable annuity illustration was used for the sale?
When a customer investment involves a variable annuity, I don’t use an illustration. Even though many of my customers are sophisticated investors, it is hard work — no matter how much or how good the gray matter — to comprehend such insurance company paperwork fantasies. I recently deconstructed two such mythological projections. (Some of these criticisms also apply to indexed annuities, the subject of last month’s column.)
In the first place, any illustration that takes more than one or two pages to explain a concept is going to lose many customers before they ever make it to page three. Anything that is from 15 to 20-plus pages long resembles the engineering drawings required to build a bridge across a wide river more than it does an investment choice. No one wants to go to engineering school in order to be allowed to cross a bridge, right? In my view, when qualified engineers sign off on a bridge, the bridge is good to go, and I’ll drive my auto across. And when qualified financial planners or investment brokers sign off on an investment, it should meet that same standard. However, in the case of securities, customers should know that the bridge may sway back and forth and undulate up and down during the ride. (The word security, as in the term securities industry, has no relationship in the short term to feeling safe. Over the long term, though, a rise in value may be a valid proposition. The CLU, ChFC, CFA and CFP credos are designed to provide at least the assurance that a recommendation has been made by a professional — kind of the financial planning certification equivalent of the licensed engineer’s bridge-building skill.)
Real growth rates vs. illustration growth rates
Many annuity illustrations show four or more scenarios:
- With current fund expense and M&E charges and a historical growth rate, based on actual sub-account data, looking backwards;
- The same, but with maximum fund expense and M&E charges instead of current charges;
- Another run at #1, but with low estimated growth or even negative growth (not based on actual historic performance, but on an estimated average growth rate with current charges); and
- A second run at #2, but also with low estimated growth or even negative growth (again, not based on actual historic performance, but on an average return basis and with maximum charges).
The third illustration might show, for example, that a single investment of $25,000 grows to $51,683 in 20 years at 5.28% yearly. However, the 5.28% average growth does not include either the current or maximum permissible joint income rider charge, which can be as little as 1.2% or as much as 2.75%. If it’s 1.2%, then, to get the “real” interest rate after expenses, one needs to deduct 1.2% from 5.28%. That nets to 4.08%, which gets you to $55,627.01 in 20 years, not the $51,683 in 20 years that’s shown in the illustration, but there are probably other charges buried in the details and small print. If it was really 5.28%, of course, the 20-year result would be equal to $69,961.25 and not any of the insurance company illustration numbers.
(Life insurance companies seem incapable of correctly stating interest or growth rates. Each company always seems to mean that the growth or interest would be 4% or whatever, but only if there were no mortality charges, or no rider expenses, etc. If you or I owned an annuity company, we would probably just say that the actual likely growth rate after all expenses is 2%, or 3%, but then no one would probably get excited enough to buy the product. Well, maybe not.)
But if the maximum joint rider charge is used, then 2.75% must be deducted from the 5.28%, which nets to a 2.53% yearly average, which is not enough to get anyone excited. That results in a 20th year value of $41,205.88, which is lots lower than the amounts shown.
So, the cost of the joint income benefit rider, if it stays at its current rate, is the difference between $55,627.01 and $69,961.25, or $14,334.24. But, if the maximum cost is charged for the joint rider, the cost for the income benefit is the difference between the no-annuity result (from any financial calculator or spreadsheet program) of $69,961.25 measured against the 20th year cash value of $41,205.88. Over 20 years, the difference is $28,755.37, an amount that one might have if there was no annuity and, say, a C-share mutual fund was used instead. (As to mutual funds, J. Alex Tarquinio, in the July Smart Money, points out that the average expense factor is about 1.5% yearly.) That extra annuity charge is a heck of a lot of money to hedge your bet, more than 69% of the 20th year cash value. At maximum rates, the insurance company wins big time.
Before you, gentle reader, become weirded out, whacked over and made generally crazy by all this, please let me write again that the 5.28% rate used in the example is a net rate, after regular M&E expenses and sub-account charges (but not before income benefit riders and other charges). In other words, the company develops the 5.28% rate from a gross rate of 7.73%, and the net rate is after M&E and sub-account expenses have been subtracted. Neither the gross or net rates include the charge for the income benefit.
Please don’t imagine that the C-share mutual fund has higher expenses. It doesn’t. In fact, probably no investment program or fund — other than hedge funds, which often subtract as much as 20% to 25% of profits — charges higher amounts than investment annuities.
Where’s the beef?
Here’s the deal: as Jack Bogle, the founder of Vanguard’s low-cost funds and indexes, has been saying for decades, those little 1% charges can add up. The insurance companies say net rate, but they mean something different. (If this seems repetitive, it is. But there’s a point to make, and it’s going to take some discussion to get to it.) Whether it’s an investment (variable) annuity or an indexed one, the net rates do not include the rider charges for the lifetime income benefits in some illustrations. The net rates only subtract M&E and fund expense charges. However, if you apply lifetime income, you’ll find that the customer winds up with between $10,000 and $20,000 less, and all from that 1.2% joint rider charge (which often may be increased). The discrepancy will be greater if you add death benefits.
So, if a customer averages 5.28% in his or her own brokerage account with TD Ameritrade, where the individual is making all the trading decisions, there should be nearly $69,000 in value at the end of the 20th year, ignoring the $9.99 trading charges. On the other hand, if the same customer averages 5.28% with me, or with you, in an advisory account, the gain is the 5.28% yearly average, less the 1.12% I may charge for managing the investments and making decisions. Of course, I’m a professional and am supposed to do better than a non-professional, but we’ll leave that idea aside and assume that we are exactly equal in skill. (And, of course, the numbers won’t dovetail perfectly in these examples anyway. The sequence of returns will have much to do with the final result, and this particular column is ignoring sequence of returns.)
However, with an investment annuity, the customer could have me manage the sub-accounts, use a C-share model, with a 1% trail (and perhaps 2% upfront) for the advisor, add living benefits, and wind up with a 1.28% average rate, assuming that he or she bought living benefits.
Not all the illustration math is the same. Some companies illustrate a gross rate and then net down to an average at the end. The thing is this: if you need an investment annuity for a risk-averse customer, realize and disclose that the rider costs and various fees can run the expense to between 3% and 4% yearly. For many, the assurance of income down the road (without worry about fees) is worth it. But the folks who hate investment annuities? They hate them because 3% to 4% is a huge mountain to climb year-over-year to realize a good end result. Did someone once write that there is no such thing as a free lunch?
Eyes wide shut
