Richard HoeAre 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:

  1.  With current fund expense and M&E charges and a historical growth rate, based on actual sub-account data, looking backwards;
  2. The same, but with maximum fund expense and M&E charges instead of current charges;
  3. 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
  4. 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

Insurance companies make lots of money selling investment annuities. That’s the reason the companies in this market have large and successful sales forces and is, arguably, why the illustrations are quite complex. On the other hand, the idea behind a living benefit is to provide some assurance of investment success in an uncertain world. The good news: even if the investment world goes to hell in a hand basket over the next 20 years and the cash value in our hypothetical annuity winds up being zero, the income base will be $65,000. Isn’t that the whole idea, the big enchilada? The customer is buying the assurance that he or she will base income off no less than a certain number. The income base at $65,000 in year 20 is earning just less than a 5% compound rate, and the income base keeps growing, even though the annuity has no real money inside, until the owner annuitant reaches 59 1/2 and can begin withdrawals. At that age, the growth rate is a bit better than 5% yearly, and the income base numbers are really net. Of course, the income base is not real money. The monthly or yearly income from it for a husband and wife’s lifetimes is the genuine article. That’s what insurance is all about, isn’t it?

Defined benefit

There are two kinds of people. Well, okay, maybe there are more than two kinds — but let’s say that investment types may be broken into two groups:

(1)   Those who like the investment ride, the journey, and who have the ability to be patient and not panic during extreme volatility; and

(2)   The folks who are not against investing and who hope to make money, but who cannot stand the trip from Point A to Point B.

My suggestion is this: the people in the second group belong in investment annuities. Why? Because each investment annuity buyer who opts for an income benefit is essentially given a defined-benefit plan and knows his or her worst case scenario from the get-go.

There is nothing wrong with earning 5% yearly off an income base pre-retirement and having an assurance of retiring on a 5% or 6% lifetime income stream. If anyone — from Warren Buffett to the commission-driven wire-house broker — sneers at this idea, say to him or her, “Okay, if you are right and I’m wrong for this customer, let’s do it your way. But you promise the customer a minimum 5% compounded return and a lifetime income after age 59 1/2 that is no less than 5%.” Here’s the thing — you won’t get any takers because only an insurance company has the math, money and statistical power to make the scheme work. (Well, Bernie Madoff might have said, “Sure, bring the deposits on; I’ll guarantee ‘em!”)

While I, at times, must seem militantly against indexed annuities and sometimes investment ones, too, the truth is that — in an environment where an ad in the paper says a 22-month CD is available yielding 1.15% or an 84-month (ye gods, 84 months is like an inverse auto loan) callable one (if the bank thinks it can get a better deal, it can call the CD, cancel it, pay accrued interest, and get out) is paying 3% — if you use an indexed annuity as a bond or CD-alternative or for ultra-low-risk investors, I don’t blame you. And, with an investment annuity, you have the opportunity for growth, but, more importantly, the promise of a future secure income.

Investment annuities aren’t for everyone, but neither are mutual funds, investment accounts or long-term stock purchase plans. Some folks don’t have the psychological ability and patience to invest without a Plan B. And sure, the fees are high, but income benefit annuities are one of the few certain things in an uncertain world. An investment annuity has a Plan A (the stock market gets good returns, and the result over 20 or more years is a triple or home) and a Plan B (the income benefit). Some even have a Plan C — an optional extra death benefit — if the customer is not around to use Plan A or B.

Now, I can tell you a thousand good things about investment annuities. A few follow:

-          Investment annuities are about the only game in town where you can rebalance for free every quarter.  If you rebalance virtually any other investment, it generates costs to the customer, and if often generates taxes, too, and — wait for it — MPT and other education teaches us that we should rebalance, right?

-          Investment annuities package sometimes incredible sub-account selections. I use one that has more than 300 sub-accounts. And there are some that use strategies offered by investment gurus that might need $1 million or more of your hard-earned cash just to let you through the door if you came in any other way than through an investment annuity.

Hey, there’s good and bad, isn’t there? It’s our world; it’s investing. (Eyes wide shut II will appear next month. It details ongoing income from mutual funds and mixed portfolios.)


Readers may email Richard Hoe at Mr. Hoe, an investment professional for 42 years, is a member of Prosperity Network’s five-person investment team, as well as an investment advisor representative and registered representative. Paul Ewing’s Kansas City-based Prosperity Advisory Group has over $2 billion in AUM. Mr. Hoe has been writing professionally for more than 50 years and is a member of the adjunct faculty at the California Institute of Finance, a graduate school at California Lutheran University that offers an M.B.A. in financial planning. He holds five designations, including Chartered Financial Consultant, Chartered Life Underwriter and Accredited Estate Planner, and is a member of both the Society of Financial Service Professionals and the Financial Planning Association. He helps edit each edition of Andy Kilpatrick’s “Of Permanent Value,” a book about Warren Buffett and Berkshire Hathaway published yearly in advance of each shareholder meeting.

This information is intended for financial professionals only, not the general public. This is not a solicitation to buy or sell any specific security. Mr. Hoe may have positions in the securities or other investments discussed. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions, and when sold or redeemed, one may receive more or less than originally invested.