There may be more to a name than you realize

There’s an old saying that goes “A rose by any other name would smell just as sweet.” My take on this is that it would also be just as thorny … and therein lies the rub (or stab, if you will).

In my industry, there are very few products that have as much complexity or confusion about them as annuities. Often maligned, sometimes revered and rarely understood by either the buying public or the registered reps who sell them, this class of assets is controversial to say the least, and completely misunderstood by most. Unfortunately, not all annuities are the same, but they have all been painted by the same thorny brush.

I should start by pointing out that nearly any time a media pundit, financial guru or registered rep talks about annuities, they are referring to variable annuities, or VAs. First offered in the early 1950s by TIAA-CREF, they began gaining wide popularity in the broader market after the Tax Reform Act of 1986 changed the way mutual funds were taxed. Before that, mutual funds were only taxed when the actual fund was sold, making them a great tax-deferred growth vehicle.

After the 1986 legislation, however, any transactions within the funds began to be taxed. To make matters worse, capital gains were taxed at ordinary income rates at that time, so people would get a 1099 at ordinary rates every year, even if the funds they held lost money. Wall Street needed a new way of providing non-qualified, tax-favored actively managed funds – hence the push into variable annuities.

The insurance and the investment industries were delighted to oblige. Insurance companies love, love, love VAs because they can charge high fees and – unlike with fixed annuities, where they must reserve for the entire amount deposited and are on the hook for the entire amount – they are not on the hook for any of the money, as all of the money goes into various market-based funds.

The investment industry loves them as well, as they, too, can charge relatively high fees and have a captive clientele that is trapped by surrender periods and high surrender charges. Of course, the brokerage community also loves them because of the high commissions they generate.

Take, for example, one leading VA from a highly rated company that we run across quite often. This contract has a fee structure that includes the following: mortality and expense (ME), 1.65 percent; guaranteed minimum income benefit (GM/B), 3 percent; death benefit (D/B), 1.2 percent to 1.6 percent; administration, 0.15 percent; and fund management, 0.57 percent to 2.41 percent. That makes the fee range for this very typical variable annuity 5.37 percent to 8.81 percent! In addition, this contract imposes up to 7.5 percent surrender charges for early withdrawals.

Put another way, a person who invests $100,000 in this annuity and holds it to term (10 years) will pay $53,700-$88,100 in fees, whether or not they make any money! So we know why the industry loves them, but why the buying public? How is the industry so successful in promoting these very risky and very expensive financial products?

Because they are promoted as “safe money investment vehicles” with “guaranteed minimum rates of return.” But they are neither safe nor guaranteed. Now, I know I am going to get into trouble with some of my peers for this, but the truth is often unwelcome. Here is the true story.

When you purchase a variable annuity, your money goes into mutual fund-like accounts called “subaccounts.” These are very similar to mutual funds and are usually actively managed. The funds are often included in these contracts through fees paid to the insurance companies and passed along to you, much like the favorable placement that popular soft-drinks and salty snacks receive in endcaps in supermarkets.

The bottom line is, unless you put your money in the fixed account, it is at risk in the market in often very expensive funds. In the meantime, the client is trapped in a contract that provides very limited investment options and paying a premium for the privilege.

But people buy annuities for their safety and guarantees. So the insurance company adds options, called riders, for which it charges to make them safer – things like the guaranteed minimum withdrawal benefit and the death benefit mentioned above. So you end up with an unsafe product made “safer” (they aren’t really … it’s a lot of smoke and mirrors … but that’s for another day) with a lot of bells and whistles that the insurance company is delighted to charge for. And you go to bed at night sleeping like a baby while they insurance company is laughing all the way to the bank.

I started this column with the famous rose quote. Of course, my point was “an annuity by any other name .” The truth is, there are annuities that can work very well for retirement and income planning. Annuities truly build on safety that can leverage your money and provide income for the rest of your life, with true safety and low, if any fees. Stay tuned to next time for more.

“Free Money Guy” Stephen Kelley can be heard, along with his co-host, Mark Perkins, on the Free Money Radio Hour at 9 a.m. every Tuesday and Wednesday morning on 1590 AM WSMN in Nashua, and Sundays at Noon on 980 WCAP in Lowell.