A 44-year old woman was referred to me by a mutual friend. She wanted help with her current and future investment strategies. For privacy reasons, we’ll call her Erica.
As I do with most new clients, I asked Erica to bring in all of her investment statements so that I could see what we were starting with. Erica had investible assets of approximately $100,000. When Erica handed her statements to me, she proclaimed: “In this one, I own mutual funds”. I looked at the statement, and I could tell immediately that she did not own mutual funds in the traditional sense—she actually owned a Variable Annuity (VA). So as not to cause alarm for Erica, I gently went through the exercise of explaining what a VA is—and what it is not.
Let me preface the following by saying that I do use VAs in my practice when they are appropriate; however, they are not always appropriate. I often struggle to understand why an investment professional would put a 31 year old into a VA with an income rider, due to the fees and expenses that pile up over the 36 years until full retirement age.
For the purposes of this article, we will focus on the fees/expenses that were inherent in Erica’s VA:
Fee/Expense #1: Mortality and Expense Fee + Administrative Fee = 1.2%/year
Fee/Expense #2: Income Rider Fee = 1%/year
Fee/Expense #3: Average Mutual Fund Expense = 1%/year
Total Fee/Expenses per year = 3.2%
Let’s do the math!
On a $100,000 investment (for simplicity’s sake we will assume no growth), the annual fees/expenses charged to Erica are $3,200/year. From the age of 31 to 67 that is $115,200 in fees/expenses. Of course, there will be growth in her account over the 36 years, but with growth comes a higher account value, and that will mean even higher fees! So a quick recap: initial investment: $100,000; fees and expenses over the duration of this investment: $115,200. This math does not add up—invest $100,000 and pay fees of $115,200??
Erica had been sold this Variable Annuity in 2003, just after her husband had died. The challenge with VAs? If you are under the age of 59 ½, they contain the same 10% IRA penalties that are assessed to “pre-age 59 ½ ” withdrawals from IRAs, even if they are comprised of non-qualified money.
That was a mouthful, I know. Suffice it to say, VAs are subject to the IRS penalty of 10% for moving the money out of the VA prior to age 59 ½. And, if you move the money out of a tax deferred vehicle, the growth becomes taxable in that year.
Great! If I want to stop paying hefty fees, and I move the money out of the VA, then I have to pay the taxes and penalties. Talk about a raw deal! So what do we do now?
There is a reason that I do what I do—I like to solve problems. In this case, there is a happy ending.
A section of the IRS code allows a “like kind exchange” between annuity carriers called a 1035 exchange. So, what’s the benefit to a 1035 exchange?
As I did with Erica, if it is executed properly, I can help you to avoid the 10% penalty AND paying taxes on the withdrawal because we are not actually withdrawing the money, we are transferring it into a “like” investment.
Well, this sounds “doable”, but what is the benefit of going from one carrier to another? Are we not still going to be hit with the fees?
The answer to that question is “yes”, there are still fees, but we were able to find a low cost VA. Let’s compare the fees!
Fee/Expense #1: Mortality and Expense Fee + Administrative Fee = .29%/yr
Fee/Expense #2: Income Rider Fee = 0%/year (inappropriate rider -eliminated)
Fee/Expense #3: Average Mutual Fund Expense = .25%/year
Total fee/expenses per year = .54%
Remember, Erica was paying 3.2% before, now she would be paying .54%, a difference of 2.66%/year.
Now, Let’s Do The Math, again!
$100,000 x 2.66% = $2,660/year. Erica has 23 years until full retirement age. 23 x $2,660 = $61,180 saved in fees (again, assuming no growth; with growth the savings would be even higher).
What about the costs that have already been paid over the last 13 years from the time Erica was sold this product until now? $2,660/year x 13 years = $34,580 in costs that Erica could have avoided paying had the advisor not been asleep at the wheel.
Two questions that I always pose for our readers: Was the investor (Erica) uneducated? No, she was not. She is actually quite sharp.
So it begs the second question: Why would she invest in something like this?
There can be myriad reasons why an investor invests in a product that is not appropriate for them, but it usually comes down to this: They didn’t know the right questions to ask about the investment, and they trusted that the financial representative was looking out for their best interests.
Ah, commissions…..Variable Annuities pay a fairly high commission, especially when they contain income riders. Based on what I know about this case, it would not be a stretch to come to the conclusion that the agent who sold this VA to Erica was looking out for his best interests over that of his client’s. That is never good, and it calls into question the ethical foundation of the industry when someone employs this type of behavior, especially in the case of a grieving widow.
You’ve heard the phrase “rolling over in your grave”? Would you “roll over in your grave” if this happened to your spouse a few short months after you had passed away? I know I would!
For the “inquiring minds”, I think it is important to point out that Vanguard pays NO commission on their Variable Annuities, which obviously keeps the cost of this investment down.
Translation: WealthSmith Financial Planning did not receive any commission for moving Erica into this new annuity. Our compensation was in the form of a one-timefinancial planning fee that was a fraction of the $2,660 that Erica will save each year going forward.
What is your plan for your loved ones when you’re gone? Who will shepherd them down the path that is most appropriate for them?
Don’t keep us a secret! If you have friends or family who are not currently part of the WealthSmith Financial Planning Family, we’d love to talk to them. Call or email us, and put us in touch with the people whose financial plans depend on you! We look forward to working with them.
