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Money Magazine, March 2009 - A guarantee, without high fees
Money Magazine hits it right on the head in this article when they discuss a simple way to create your own guaranty. The "guaranty" is the typical pitch made by annuity salespeople to sell their high commission products, such as equity indexed annuities. As mentioned in the article, fees are often 2% to 3% per year, with high surrender charges if you want to get out within 10 years. That is on top of the initial 9% commission to the salesperson. "And if you can decipher the fine print, you'll learn that you get only a fraction of the market's gain." The article goes on to tell you how to create your own Equity Indexed Annuity "like" product, without all the fees, commissions or expenses, and provide a guarantee on your investment.
In a nutshell, the strategy is to buy a 10-year FDIC insured CD (such as a 5.55% CD from Capital One through Costco). If you buy this in your IRA, you will replicate the annuities much hyped tax break. If you have $10,000 to invest, you would only need to buy $5,850 in the CD. This would ensure that you would receive $10,000 at the Cd's maturity in 10 years. Then use the remaining $4,150 to invest in the "market" via a low cost index, such as the Vanguard Total Stock Index exchange traded fund (VTI).
You will get back $10,000 guaranteed. If stocks earn 8% annually, you will have nearly $19,000.
Question: I have heard that annuities are good to own, as they provide guarantees. Should I be skeptical?
Answer: Yes, you should be very skeptical. While each annuity is different requiring a very thorough analysis before purchase (or sale), we believe that most individuals are better off without annuities. Only in very few situations have we used annuities or seen situation where the client would be best served by an annuity (I can count them on one hand). We have to-date avoided them due to the excessive (ridiculously high) costs. When we have used them, we favor low or no-load low cost annuities. The Insurance companies continue to make new annuities that have many bells and whistles, all with an added cost. Some things to consider with annuities:
- Cost: Annuities have a host of different costs that are almost never disclosed to the purchaser (because if you knew what the costs were you would never buy them). We see many clients come to us with annuities that had an Initial Load (commission) ranging from 6% to 10%. To put this in round numbers, assume you purchased a $1,000,000 annuity. The front load (commission) would range from $60,000 to $100,000. Then, there is the annual expense that might be as high as 3% to 4% (per year!). In many cases we are able to get our clients out of these annuities, and create diversified portfolios that have annual expenses of approximately 0.3% per year, saving them up-wards of 3.5% per year.
- Guarantee - The devil is in the details. The “guaranteed value” is often based on the invested amount, and you must die to get it. Rarely would you benefit from this guarantee, unless you died in the middle of a bear market like we are in today. This might be a reason we would want you to hold on to the annuity at this time, at least until values recovered. We would need to review your annuity contract to get clarification on the guarantee, costs, and any fine print.
- Return Guarantee – More details. The return is often “conditional” on you holding the annuity for a number of years, and then annuitizing it. If you ever wanted to take your money out and move it somewhere else, you often forfeit the guarantee.
- Performance: This is fairly straightforward. If you have two investments that have the same performance before fees, the one with the lower expenses will do better. We believe that keeping expenses as low as possible is critical to your long term investing success. Most annuities load their investment choices with high cost actively managed funds (on which the company receives a portion) rather than the low cost index funds we prefer.
- Complexity – The annuity contracts are highly complex. We recommend that you get a copy of the contract before you sign it and review it carefully. Be very cautious if your advisor is recommending that you buy annuities. With the current market environment it is very tempting to want the guarantee that annuities offer, but given that the market has significant upside, we believe this is probably the worst time to buy an annuity. We believe that advisors selling these are using client’s “fear” emotions to help sell these, rather than providing objective unbiased advice.
- 1035 to Low Cost alternatives – If you are in an annuity now, we can probably help you reduce your costs significantly by helping you transfer it (via a 1035 exchange) to a no-commission low cost annuity. We will analyze the costs and benefits, and determine if it makes sense to get out of it altogether.
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