The Trouble with Variable Annuities

Annuities can very confusing, especially when there is a broker involved who earns compensation through commissions that are built into the cost.  But the broker has to get paid, right?  Actually, no the broker doesn’t have to get paid because many annuity companies offer the exact same annuities with the same riders (except that they don’t have any surrender charges or commissions) that are sold through registered investments advisors (RIAs).  Consequently, all of the costs are the same except for the mortality and expense (M & E) charge because the annuity company has to charge a higher ongoing M & E expense in order to recoup the cost of the commissions paid out to the broker.

Now the broker could come back and say, “The RIA is just going to charge a 1% assets under management fee, which over time, will cost the client just as much if not more than buying a commission-based annuity.”  This statement may be true depending on the annuity and the face amount, but it misses the larger point:  How much work is the advisor or broker doing, and are services provided commensurate with the fee the client is paying?

In both cases, the answer is of course no since there are little if any ongoing “management” services to perform, especially for a tax-deferred investment which has no tax consequences from buying and selling securities.  As Warren Buffet said in one of his annual letters to Berkshire shareholders, dated February 28, 2014:

“If “investors” frenetically bought and sold farmland to each other, neither the yields or prices of their crops would be increased.  The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.

Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions.  The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.  So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My advice to the trustee couldn’t be more simple:  Put 10% of the cash in short-term government bonds and 90% in a very low-cost S & P 500 index fund (I suggest Vanguard’s).  I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, or individuals – who employ high-fee managers.

Brokers, for example, who work for firms that are dually registered as RIAs and brokers should at the very least explain the different compensation arrangements to clients.  Otherwise they aren’t acting in the clients’ best interests.

So in the event that a variable annuity is a fit for a client, it would be best to use Vanguard’s variable annuity that has an annual M & E charge of only 0.20% and offers low cost Vanguard index funds.  If an RIA receives an hourly fee or a flat annual fee that also includes comprehensive financial planning services – meaning the services to place a client into an annuity are simply included in the flat fee to provide a financial plan – then that would make more sense.  But since there are little if any ongoing services required, the annual financial planning fee should be adjusted accordingly.

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