“How could my financial advisor have done this to me?” Many ask this question after they buy a variable annuity. You’ve heard that most of these products are nasty. Some say high fees burden them. Others complain that they’re inflexible. They penalize investors who try to sell before a predetermined date.
Wall Street Journal writer Matthias Rieker says that many people file complaints about variable annuity sales. Ken Fisher, writing for Forbes, recently called them “scumbag products.” But I’m going to defend the advisors selling them. Somebody has to.
I met a guy who sells variable annuities. As part of his training, he watched a video called The 10 Habits of Successful Financial Advisors. It said advisors could make millions of dollars a year from commissions. Formerly, the trainer was a financial advisor. He said, “For me, it’s the best job in the world. Where else can I go out and meet somebody, drink their coffee, eat their cake, and walk out with $5,000 in my pocket? No other business.”
This might look like a bad deal for the investor. But think about the bigger picture. Jason Lange, reporting for Reuters, says that retail spending is currently high. And this could boost our economy. High commissions get spent on new iPhones, televisions, Christmas gifts and more. It creates jobs. So we all benefit.
But aren’t these bad products? Sticklers for math would say they are. Imagine someone invests $70,000. They have no room in their IRA or other tax deferred accounts. So they choose a variable annuity for its tax-deferred growth. When adding the insurance wrapper with the cost of the underlying mutual funds, an investor in a variable annuity can pay 3 percent a year in fees.
Compare this to a balanced index charging 0.08 percent. If a balanced portfolio of stocks and bonds earned 8 percent over 20 years, odds are high that the balanced index would come out far ahead—even after taxes.
Variable Annuity Versus Balanced Index Fund
$70,000 Invested For 20 Years
|Assume 8% Return For Balanced Stocks and Bonds||Vanguard Balanced Index Fund||Variable Annuity|
|Fees paid||0.08% per year||3% per year|
|Return after fees||7.92% per year||5% per year|
|Number of Years To Grow||20 Years||20 Years|
|Pre-Tax End Value||$321, 467||$185,730|
The index fund is a tax miser. A fund manager isn’t switching in and out of stocks. So other than the interest from the bonds (which gets taxed as income) the balanced index grows nearly tax-deferred until it's sold. But low taxes aren’t always good. It's better for our country if we pay higher taxes. This makes the variable annuity salesperson a patriot. The Financial Industry Regulatory Authority (FINRA) explains it in Variable Annuities: Beyond The Hard Sell.
Variable annuity profits are taxed as ordinary income when withdrawn. In contrast, much of the return on a balanced index fund in a taxable account is taxed less: as capital gains. So which product gives more to the next war effort? Variable annuities do. But don’t pat yourself on the back if you own such a product. You probably didn’t buy it on your own. Financial advisor Tim Maurer, writing for Forbes, says such products are sold, not bought.
Many variable annuities also promise that their investors can’t lose money. If the markets crash, and the investors die, their heirs usually receive what the investor deposited. How can you gain? Buy a variable annuity on the eve of a market crash. Then die the very next day.
You could thank your financial advisor for a job well done.
Andrew Hallam is a Digital Nomad currently living in Chapala, Mexico. He’s the author of the bestseller, Millionaire Teacher.