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Kudzu invaded the South, obliterating the healthy and attractive vegetation carefully planted by homeowners. Variable annuity (VA) owners are likewise being strangled by excessive fees.
When kudzu came to the American south, homeowners valued it for its broad tri-folate leaves’ ability to shade their steamy summer porches. A highly invasive species native to Asia, kudzu favors any light or shade condition, can root in any soil and, because its leaves can fix atmospheric nitrogen, it can even thrive in the poorest soils. It now grows so thick in rights-of-way, abandoned rural properties and old fallow fields that the shade that made it so valuable to homeowners chokes out all other vegetation and timber.
What made it so good has made it so bad.
Like the “vine that ate the south,” annuity riders and guarantees – long sought for protections that other investments cannot provide – tangled around the annuities themselves, making them illiquid, complex and expensive. In the race to design the “next big thing,” insurers abstracted the solution from the vehicle by focusing on complex features that have been commoditized.
Anecdotally, the RIAs I work with tell me they don't understand annuities and they don't want to take the time to understand them – for good reason. Annuities are often expensive, opaque and difficult to understand. The value of tax deferral can be completely wiped out by fees and charges (often 3% or more), and their clients can't make sense of the product.
These products were initially constructed by insurers to reduce risk that investors were unwilling to shoulder, but Vas have grown overly bloated – choked with the vine-y mangle of features clients may never need and certainly will never fully understand.
A client walks in with an annuity…
I hear this all the time: "This client walks in with an annuity…" It sounds like the opening line of a joke. Sometimes the punchline is good. Sometimes not so much. Because RIAs aren't insurance-licensed, when a new or prospective client reveals an annuity in their portfolio, or asks for guaranteed solutions, they may be at sea as to what to do. Usually there are three courses of action they can take:
- Refer the prospective client to an insurance-licensed agent;
- Ignore the annuity; or
- Call an objective annuity expert to analyze it and offer guidance.
The first option is risky – who's to say an agent, apart from your practice, has your client's best interests at heart? And the second option doesn't work well for those who want to guide their clients holistically. The best option is for an advisor to work with experts she/he trusts to analyze these annuities for them and offer recommendations.
You can look for five fees that will tell you a lot about a VA – and then you get to deliver the punchline.
Look for these fees and charges
If you're looking to move a client out of an expensive old VA, into a solution to extend tax deferral, or are seeking out the protections an annuity offers on behalf of a client, look for these primary fees and charges: mortality and expense risk (M&E), administration charges, rider fees, surrender charges and underlying fund expenses. Insurance companies are required to file prospectuses for all VAs, so you should be able to Google your client's current (or proposed) annuity prospectus and use the handy ”find” (ctrl-f) feature in your PDF reader to locate these costs and examine them.
1. Mortality and expense risk (M&E)
M&E risk charges can range anywhere from a few basis points to 200 or more, depending on the product. Investing isn't free, and this is how the insurance company pays itself (and possibly the insurance agent who sold the annuity). When assessing an annuity, the first place to look is at this cost. This is what your client will pay for tax deferral and any on-board features. Morningstar® and others have estimated that the value of tax deferral is somewhere between 100 and 200 basis points annually. Keeping M&E costs minimal will allow your clients to truly benefit from the compounding power of tax deferral. A base M&E below 60 basis points is a good place to start.
Vas offered for commission will have higher M&E charges than no-load, fee-based variable annuities.
TIP: When considering a VA, look for no-load or investment-only products.
2. Administration and annual maintenance charges
Administration charges (if any) may be assessed as a percentage of the contract value and can start to be meaningfully impactful when they approach 10 basis points. The annual maintenance charge (if any) is typically nominal and flat: around $35 annually. These fees are often waived when accounts reach a prescribed asset level ($50,000, for instance).
TIP: Shop around for products without administrative and annual maintenance charges.
3. Rider fees
There are broadly two classes of riders available in VAs: living and death benefits. These optional add-ons, like all things in life, are not free. Optional living benefits are purchased to protect the account owner's money, and death benefits are like insurance for the owner's legacy. Living benefits like guaranteed minimum withdrawal benefits (GMWB) may add as much as 150 basis points to the cost to own a VA. Layer in M&E and administration charges, and in the end your clients could be paying as much as 3% or 4% to own a VA. Even a simple return of premium death benefit can add another 15-20 basis points in charges.
TIP: If your client currently owns a VA, find out if they're paying for features they are not or may never use.
4. Surrender charges (CDSC)
Surrender charges (or contingent deferred sales charges – CDSC) are baked into some VA products to pay the insurance companies back for any commissions paid on the sale of the product. These charges may buy time for the insurance company to make up what they paid out to make the sale. A surrender period spans a specified number of years, and typically decreases by a percentage point each year the investor holds the annuity. When you hear about a seven-year product or seven-year chassis in the context of annuities, the time period is the duration of the surrender period. Listed in tables in prospectuses, these surrender schedules look like this:
Year 0
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
Year 6
|
Year 7
|
8.5%
|
7.5%
|
6.5%
|
5.5%
|
5%
|
4%
|
2%
|
0
|
The longer you hold the annuity, the lower the surrender penalty.
Look for withdrawal charges. Many of these products allow for a free annual withdrawal (10%, for instance), but charge a fee for any withdrawals over that amount.
TIP: The chief complaint from advisors is that annuities are illiquid. Surrender penalties are the primary culprit. Avoid these lock-up periods and look for next-gen fee-based Vas that don't charge surrender penalties. Also, if your client owns a variable annuity that's in a surrender period, it may be best to wait before executing a 1035 exchange into a lower-cost solution.
5. Underlying fund expenses
The investment components of Vas are mutual-fund like subaccounts held in variable insurance trusts. These underlying funds, like their mutual fund counterparts, charge a fee (listed as an expense ratio). The cost to own these subaccounts in a VA can range markedly. Passive index funds are meant to be held for long periods of time and may cost as little as 15 basis points. Underlying funds built for active trading can cost from 150 to 400 basis points. When assessing the overall cost to own a VA, look at the highest and lowest subaccount costs, and average them to get a complete picture.
TIP: Keeping costs low is always better. Look for VAs offering a diverse selection of low-cost options from managers like Vanguard and DFA.
Bottom vine
VA manufacturers are facing increasing demand for fee-based offerings that deliver more client value. To meet that demand, they've untangled the knot of baroque features and crafted stripped-down solutions that take advantage of the compounding power of tax deferral.
Great options abound for replacing old, expensive VAs, extending tax deferral and providing the safe harbor some investors seek in guarantees and protections. Finding the right solution may be daunting. I recently searched an unnamed traditional VA prospectus for the word ”fee.” In 994 pages (yes, 994) “fee” appeared 1,230 times. A good bet is to rely on experts who can help find low-cost solutions that are simple to use, and easy to understand.
Fun fact: According to the Alabama A&M Extension office, kudzu can grow as much as one foot per day.
David Stone is Founder and CEO of RetireOne, the leading, independent platform for fee-based insurance solutions. Prior to RetireOne, David was chief legal counsel for all of Charles Schwab’s insurance and risk management initiatives. He is a frequent speaker at industry conferences as well as an active participant on numerous committees dedicated to retirement-income product solutions.
Read more articles by David Stone