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  • Writer's pictureBridget Sullivan Mermel CFP(R) CPA

Three Deadly Annuity Mistakes



In this episode of Friends Talk Financial Planning, John and Bridget discuss the three deadly annuity mistakes that individuals should avoid. They delve into the complexities of annuities, uncovering hidden fees, surrender charges, and the implications of placing annuities in IRAs.


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John's firm website: https://www.trinfin.com


The Alliance of Comprehensive Planners: acplanners.org



TRANSCRIPT:


John: Annuities can be very confusing, yet a lot of people own them. In today's episode of Friends Talk Financial Planning, we're going to talk about three deadly annuity mistakes that you want to avoid. Hi, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.


Bridget: And I'm Bridget Sullivan. I've got a fee-only financial planning practice in Chicago, Illinois. Before we start talking about deadly annuity secrets, please subscribe. All right, John, I can't wait for this episode.


John: Weirdo.


Bridget: Well, I think there's an appeal to annuities. There's an emotional appeal for a lot of people to annuities, because they would really like to have somebody else take care of it and just get a check and not have to think about it. As a financial advisor, I'm like, okay, but look behind the scenes. I try to coach people out of annuities a lot, but a lot of people have them already, and they're not always bad.


John: Yeah, no, that's right. It's not always a bad thing. They get a bad rap in our world because of the high commissions.


Bridget: Yeah, and we’ll show you.


John: A lot of these things have high commissions.


Bridget: Exactly.


John: And then the fees and we'll talk about that. One of the big deadly mistakes that we see is just not knowing what you're paying in fees. And it sounds so basic. How do you not know that stuff? And I'll tell you what, it is confusing.


Bridget: I call you. That’s how I know what people are paying in fees.


John: We just looked at in the past six months for a couple of different clients who had come into us, and they had annuities. And I mean, one of the prospectuses was 211 pages of legal mumbo jumbo stuff. I know, and you would know if you had to do it, where to look for these things. But who's going to read 200 pages, It's a legal briefing document, basically, that's written in confusing language, but it's all disclosed to you as a consumer.


Why didn't you know you had these things? It's all in there on page 37b and all this sort of stuff. And then the other thing about the costs of these annuities is that they don’t show up on your statements at all. It's disclosed and it's buried in there. And it's sort of like the mutual fund fees for people that own mutual funds. We can figure out what the cost of those mutual funds is, but it doesn't show up anywhere on your statements. Unlike for us, when we manage clients' money at Schwab, you see our fee right there on the statement.


We send you the invoice anyway, but there's no surprise. You don't have to sort of uncover it or dig it out. And that's the same thing with these costs. It's in there somewhere. And part of our job as advisors is to help people figure out what you are actually paying for these investments you have, whatever they are. And one of the big things with annuities is just that they are so expensive. So I've got a couple of examples here that we can pull up.

And we have several people that have come over the years with this particular company.


It doesn't make any difference what the company is. But in the annuity prospectus, they always have to list out what these expenses are, and they name them a few different ways, but effectively, there's the base fee or the insurance fee that comes in. That's the mortality and expense fee. That makes it insurance, meaning that that's what they charge so that they can guarantee that you have some income for life. It's an arcane insurance thing.


There's an administrative fee that usually gets built in there, but it's the M and E fees, mortality and expense charges. This contract that we're looking at calls it the base fee, the guarantee of principal death benefit. But you can see what that expense ratio is on there, 1.37%. And they always have to say the current, the minimum, and then the maximum.


There’re some statutory limits. And not that you shouldn't be aware of those, but it's one of those where yes, it is in the worst-case scenario, but really, if anybody ever starts charging those, people move their annuities. So that's the one when I look at this, that minimum column, I go, “Listen, sure we can look at that.” Not that it's impossible for it to go in that direction, but that's usually not what they're charging on these things. It's one of those statutory requirements.


Bridget: So they're required to say what the max is, but they generally don't charge the max.


John: Right. And it's different than other things, too. Like some things you go, “All right, what's the worst case scenario? And that's what we want to base our decision on.”


Bridget: Exactly.


John: In this case, those worst case scenarios are so far out there, in my opinion, that it leads you to make incorrect choices.


Bridget: And so, what we're looking for in that 200-page prospectus, is the half a page that says minimum and maximum annual fees. That’s what we’re looking for.


John: In some fashion, it looks like this. There’re different specifics, and we'll show another one here in a minute, but it generally looks something like this. What are the costs? What's the mortality expense charge? In this case, the base charge. Then down here on that third line down there, we've got investment options. And you can see from left to right, it says the minimum charge is 0.28% and the maximum is 1.18%. That's the mutual fund fee. Just like all mutual funds have fees.


Inside of these variable annuities, we’re talking about variable annuities here, but we'll talk a little bit about other types in just a minute, most of what we see are these variable annuities, and they've got mutual fund expenses, plus they've got that base or that M and E fee. So if you're thinking about it just from a practical standpoint, you go, “Okay, I've got my mutual fund fee no matter what, whether I buy ETFs or mutual funds or an annuity. And then I've got this 1.3% insurance charge on top of that.


Bridget: Right.


John: So there's the extra expense that comes in there.


Bridget: And as far as reasonableness, those are not low fees.


John: Right.


Bridget: 1.18% as the maximum is not egregious, but I would say that's at least twice the fee of any of the things that we recommend. But again, we are telling people up front, “Okay, you pay us this, and we're going to try to keep your fees as low as possible.”


John: Right.


Bridget: So it's a different fee.


John: When you take these into account, you have to have this base fee, you have to have a mutual fund fee. And I would guess that the average is somewhere in the middle of these two things. It depends on your specific investments.


Bridget: So for your decision making. You can think, “Okay, it's not going to be 0.28%, probably won't be 1.18%. It'll probably be right in the middle.”


John: Elsewhere in the prospectus, it lists out exactly what all the funds are and what their expenses are. So when you have somebody come in, we actually look. Well, you are in these three funds, and here's your expenses. That’s usually someplace at the back of this. But if you take the minimum investment fee at 0.28%, plus the insurance expense, you're at 1.65% from a starting point. Then the optional benefits are listed here. And you can see that range. This is the one place where usually we'll see people somewhere in between those.


And a little bit farther down in the prospectus, there's a real long page that lists out, something like 72 different income options and what the costs are on there. So, again, that's one where for the base fee, you can think, “All right, the base fee is the base fee. That's okay. The minimum is okay.” But for this one, it's like, what specific investment options do you have? And we had somebody that came in recently, and 2% was what they were paying for this ability to have some extra income in retirement.


And so, when you take that into account, even at the minimum side down here, we're talking somewhere north of 2%. And maybe as much as 3.5% or 4%. And each year that's getting charged to your account. Let me put that in dollars. If you have a half a million dollars from your goes into an IRA, and you buy an annuity like this, that's charging 4%, that's $20,000 a year that goes to the insurance company, and it never shows up anywhere on your statements.


Unless you do this sort of math, you don't know the answer to that. And so that's the place where these hidden fees come in. And I want to point out that it's not wrong. And one of the places where, if it's really important for you to make sure you never outlive your money and that you have a longevity, maybe in your genes, and you have that, it can be reasonable. There are some other more cost-efficient ways to do that, but this could be a possible place to look at things.


Bridget: And some people have them already.


John: Right. If you already have it, then you think about, where are you on fees? I'll pull up a similar prospectus sheet from a different company. When somebody comes to us, and it makes sense for them to have an annuity, this is the company we go to. Again, the specifics aren't important, but this is a similar sort of company. And you can take a look at what the expenses are over here. They're charging 0.3% for their base fee. And then mutual fund expense is somewhere between 0.1% and 0.48% as you can see.


Bridget: So that's a lot lower.


John: But you're talking about half.


Bridget: Yeah, that's a lot lower than the other base fee.


John: Right. And again, this is the thing that's important to know. If you're buying a car, you know this one costs $60,000 and that one costs $30,000. From an annuity standpoint, because it's buried in there, you don't see that unless you look at these things. So it's really important to take a look and ask, “What am I paying for what I'm getting?” So that's really one of the big problems that we see. One of those big mistakes is saying, “Oh, I bought this, but I just don't know what I'm paying in expenses.”


And then putting it in dollars, it's one thing to say 3% or 4% or 1%, but when you look at how much money you have in there, it makes a difference. And we've seen people regularly who have $200,000, $300,000, $400,000, $500,000 in it, and you go, “Holy mackerel, you're paying a lot for just having that investment.” So what are you paying in expenses? A corollary to that is, what are the surrender charges? What does it take to leave?


In most annuities, if you're going to take money out, you've got to leave the money in there for a certain period of time. So I'll pull up another sheet from our first annuity that had those higher expenses, and you can see here what the surrender charges are for this annuity policy. So when you buy it for the first seven years, you can't take all of your money out without paying a surrender charge.


And again, we'll use half a million dollars because I can do that math in my head. Look at the surrender charge on that 6%, 6%, 5%. Think about 5%. Say I've owned this investment for three years, and something changes: my health changes, the circumstances change, I'm not happy with my advisor, whatever changes. If I want to move that half million dollars out, 5%, that's a $25,000 penalty for moving my money.


Bridget: Well, and plus, I've been paying 4% a year just to have it there.


John: Right. And you look at that and go, “Jeez, how can you get your money out?” And if you leave the money in there for ten years, maybe it's not a big deal, right, other than I'm paying those higher expenses.


Bridget: I can feel my blood pressure going up.


John: But think about seven years ago. It's 2024 as we're recording. 2017. A lot has happened. I think about my family: death of a parent, moving to retirement, community. Everybody was part of the whole Covid thing. I mean, life changes. And if you need to make a change, you don't have full access to your money without paying these penalties. And I'll flip back over to the other company that we would use if somebody comes and says, “Hey, an annuity makes sense.” In this case, they have the surrender charge listed here at the top of this fee page: “There are no surrender charges.”


So what does that mean? You put the money in today, you take it all out tomorrow. Now, don't put it in if you're planning to take it out tomorrow, but there are literally zero surrender charges. So if you had to choose, if you had these two things side by side, one with no surrender charges, lower expenses overall, one with higher fee expenses, and a seven year surrender charge, which do you choose? And again, that's the thing going into it, knowing that, being aware of that, can be super helpful. If you don't know those things, it can be really damaging. If you know that, then you can be an informed consumer.


And we're running out of time on this episode to talk, but we can talk about other things. There are some policies, some annuities that have guarantees in them. We'll get to that. Maybe we'll have another episode and talk about where they put guarantees, and what makes sense with that. There are some places where, again, having this longevity makes sense. We had a person years ago who came to us, and they had an insurance policy like this, an annuity policy, and we actually use a third party, we outsource to a fee-only actuary to look at these things.


He looked at it and said, “Well, you know what? If you're worried about longevity, it's not the ideal, but this can make some sense.” And I talked to the client about it. Nobody in her family had ever lived past age 74, so she was not really worried about living to 102. Hey, if that's your circumstance, good, let's work with it. If you're counting on your annuity to produce money or your IRA, like you’re living off that, there can be a place for it.


Bridget: Okay, we have to talk about my last deadly mistake, and I think that we've set this up. Why this is probably generally a mistake and why it, again, raises my blood pressure is that generally putting annuity in your IRA doesn't make sense because an IRA, you already get the tax deferred thing, so you don't have to pay any kind of extra fee to get that.


John: Right. And annuities, if you have them outside of an IRA, are tax deferred. So there can be a place to go, “Geez, I want to shelter money from taxes.” There are drawbacks to it in addition to the fees, but it's not unreasonable. When you already have the IRA, like putting an annuity in there is sort of a belt and suspenders thing. I will say that for me, anyway, that's the least deadly of those things. It doesn't do you any good.


And for the expense reasons we talked about, usually it doesn't make sense to do that. There can be some circumstances where, listen, there's a reason, like this longevity thing. You go, “Listen, I'm really worried. That's my primary goal is making sure I've got this cash.” So you go, “Okay, we can put an annuity in the IRA.” It can make sense. But usually not.


Bridget: Well, and there’s a crazy kind that you can buy that shows up when you're 85 for longevity in IRAs. So that's another episode.


John: But it's a sliver. In general, they don't really fit in the IRA. There can be places for it, but that's one of those things that I think a lot of times it's the sales commission that drives those.


Bridget: To me, it's like the green M&Ms flagging that concert venue is not properly set up.


John: That's right.


Bridget: It's like…


John: If it's in there, you look at, you go, okay, I know, I need to dig in.


Bridget: Absolutely. Exactly.


John: Well, great. So there's a couple of things you need to look at if you have one, if you're thinking about buying one, to really protect yourself from making some of those mistakes. So with that, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.


Bridget: And I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. John and I are both taking clients, but if you're interested in advisor who thinks like us in your area, we're both members of ACP, or the Alliance of Comprehensive Planners, which is a nationwide group of fee only, comprehensive, tax-focused financial planners.


John: So check out acplanners.org to find an advisor in your area.


Bridget: And don't forget to subscribe.

 

At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.

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