Wednesday, August 24, 2016

Why I Got Out Of My Annuity

Last week, I spoke a bit about annuities. I can see where they may have their place, particularly those that have a fixed, well-defined payout. For me, they are just a bit too complicated and the particular one I had just didn’t have enough positives going for it. It had a heap of negatives though. Let’s look at those.

Fees, Fees, and More Fees

As I have written about before, fees will kill your investment returns. Furthermore, you may not even know how much in fees you are paying because the investment is so complicated and the fees may be charged by different companies. Over time, these fees create a huge drag on your overall return. Looking through my paperwork, I was able to identify four different fees I was being charged.

Commission Fees

This annuity had a commission fee that was paid when it was purchased. My parents paid that, so I have no insight into what it was. It wasn’t a fee I paid, so technically it wasn’t a loss to my daughter, unless you figure my parents could have given that money to my daughter instead. Which they probably would have.

Investment Fees

A couple of years ago, when I was going through the process of checking the expense ratios for the mutual funds in my 401(k), I also looked into the expense ratios for the mutual funds in my daughter’s annuity. They were high. Most were over 1%, which is ridiculous. At that time, I changed the investments to funds with lower expense ratios, but I was limited to only the funds my annuity provider offered. None were what I would consider “low cost” (having an expense ratio of less than 0.3%). Of course, these fees weren’t listed anywhere in the annuity paperwork itself. Instead, I had to go to the prospectus of each mutual fund to find them.

Annual Fees

The annuity itself charges an annual fee equal to 2% of the account value, which right now works out to $260. Want to know just how much of a rip off this is? Consider this:

$12,000 invested at 7% (a reasonable assumption for stock market returns) for 99 years (the length of the annuity) will be worth $9,731,398. Nine million dollars! (Use this compound interest calculator if you don't believe me.)

But if you pay 2% off the top, reducing your return to 5%, guess what you end up with instead? $1,502,871.

That's right.. that yearly annuity fee cost you over eight million dollars!!! Sucks for you. Awesome for the annuity company, though.

Surrender Charge

This annuity had a surrender charge, which is fairly common for annuities. This is a fee you are charged if you liquidate the annuity within a certain time frame after opening it. In my case, there was a surrender charge that decreased each year until, after 10 years, it disappeared altogether.

Then The Market Crashed

Shortly after the annuity was purchased, the stock market tanked. The cash value of the annuity (the amount it was worth if you cashed it out at that moment) dropped.  It reached a low of around $8,000 before the market recovered and it started to climb back up. (Recall the annuity was funded with a $12,000 initial investment.)

I Want Out!

A couple of years ago, I made the decision to get out of this investment. Here are my reasons:

  • It’s hard to understand. This in and of itself, isn’t a bad thing, but it goes against my KISS philosophy. The complexity was also clearly hiding a lot of fees I was paying.
  • It didn’t provide a fixed payment amount. The payment was dependent upon performance of the securities within the annuity. This is no better than a straight investment in a regular brokerage account, so why did I need the annuity ”wrapper" with its extra fees?
  • Tax deferral isn’t worth in this case. Although the gains in the annuity are tax deferred, my daughter’s tax rate will be low for at least the next decade or two. The cost of the fees charged by the annuity would be way more than any tax savings she would reap, so she would actually be losing money. 

At the time I made these decisions, the cash value of the annuity was still less than the purchase price. As humans are wont to do, I didn’t really want to sell and “lock in” my losses. (This is a classic example of loss aversion. I'm not immune to it.) I likely would have bit the bullet and gotten out anyway except for one thing: I was also only 5 years into the annuity and the surrender charges were still fairly high. So I put this on my back burner and decided re-evaluate it each year.

This year, things have reached the point where it now makes sense to exit. The value has rebounded to just over $13,000. It is now year 8 of the annuity and the surrender charge has dropped to $240 (and it doesn’t get any lower until it goes away at year 10). Because the yearly fee ($260) is now greater than the surrender charge ($240), it costs less to pay the surrender charge and get out than it does to remain in the investment.

The funds held within the annuity charged various fees, but a good estimate would be they had an average expense ratio of 1%. That's another $130 we'd pay to remain in the fund for another year.

Like all tax deferred investments, there is a penalty for early withdrawal. My daughter will have to pay a 10% penalty on the profits only plus regular income tax on the profits. (The penalties apply only if I do not roll the investment into another annuity, which I am not doing.) After the surrender fee is charged, the 10% penalty works out to about $70. She has no earned income this year, so her income tax on the approximately $700 in profits, will be zero.

So let's compare:

Remain In Annuity

If I remained in the annuity, I would have incurred the following costs: $260 annual fee plus approximately $130 in mutual fund expenses, for a total of $390.

Exit Annuity Now

To get out early, I pay a $240 surrender charge and a $70 tax penalty, for a total cost of $310.

Even with the penalties, it's still cheaper to surrender (i.e., cash out) the annuity than it is to stay in it for another year.

I also have the added bonus of being able to move my money into a mutual fund that charges only about one-fifth of the fees the annuity funds charged, which will result in increased savings as time goes on.

The choice is clear. Exit the annuity.

I’m moving the proceeds into a standard UTMA account and will purchase shares of the low cost Vanguard Dividend Appreciation Index mutual fund. The expense ratio there is 0.19% and there is no annual fee.

And for what it’s worth, I don’t have any ill will towards my parent’s financial adviser that steered them to this annuity in the first place. She’s good at what she does (and, actually, she also does our taxes).  I ran through this whole scenario with her and she agreed with my conclusions. She also mentioned she was waiting for the surrender charge period to expire to move her other clients out of the annuities as well. They did not perform as well as she had hoped.

Friday, August 19, 2016

Welcome New Readers!

I just wanted to say hello to those that have found my little site from Rockstar Finance and The Financial Diet. I'm honored to have been mentioned on those sites! Getting mentioned on Rockstar Finance has been a long time goal of mine. Getting mentioned on The Financial Diet was an extra bonus! Kinda like finding a twenty dollar bill in the pocket of an old jacket.

This blog documents my quest to buy a Tesla Model S using only passive income. Well, mostly passive income - I do plan on paying about $15,000 as a down payment. Details about how I will do that can be found here, or by clicking the Featured link at the top, then choosing How This Works.

Along the way, I write about personal finance topics. I don't have a rags-to-riches story to tell. I was not $50,000 in debt and clawed my way out in 14 months. My wife and I both have well-paying jobs and we live below our means most of the time. Boring, right?

Before I got married, I didn't really have any issues with money that required budgeting. Getting married and having a child changed all that. It wasn't so much that our expenses shot up (although, daycare for the first couple of years of our daughter's life was crazy expensive), but that I now had another person spending the household income. Before marriage, if I wanted to buy something, I just cut back my spending drastically in other areas. Or I went all-in and threw as much as I could towards paying off debt. (I got rid of some student loans in two years by throwing basically my entire paycheck at them for a while.) With another person in the house, I couldn't do that. Believe it or not, my wife actually has goals and ambitions of her own! My spending and savings had to accommodate those.

So I developed a budget to make sure we can allocate our money towards both of our goals. I have pretty much been a huge proponent of budgeting ever since. Here's my budget spreadsheet. I'm really proud of it, especially the time-based forecasting feature!

I spent ten years investing in real estate, both renting and flipping houses. My old real estate blog can be found here. These days, the only real estate investing I do is through hard money loans and buying shares of real estate investment trusts (REITs). It's much more hands-off than actively managing properties.

I publish a new post every Wednesday. Once a month, I post a summary of my progress towards my Tesla goal. I also include an overview of my net worth at that time, so I can watch that (hopefully) grow.

I hope you find something useful here. Feel free to leave comments and ask questions!

Wednesday, August 17, 2016

Annuities Are Confusing

I’m a firm believer in the KISS principle – Keep It Simple, Stupid. This is even more true when it comes to financial accounts. No one should ever invest in anything they don’t fully understand. If an investment is too complex for you to understand, it’s likely there are some fees you don’t know you are paying that will cost you a lot of money in the long term (and possibly even the short term too).

Annuities are complex financial instruments. In simple terms, an annuity is an investment that will provide payments over a period of time in exchange for premiums paid either in one lump sum or also over time. For instance, you might make a one-time $10,000 payment to purchase an annuity that will provide you with $1,000 a month income when you turn 65. Or instead of a $10,000 lump sum, you might pay $100 a month for 10 years to get the same payment at age 65.

There are many kinds of annuities – deferred, immediate, fixed, variable. If you think annuities sound similar to insurance, you’re right. They are. Whereas life insurance, such as term life insurance, will pay a fixed amount of money in a lump sum when someone dies, annuities pay a recurring amount of money when someone reaches a certain age, when someone dies, after some number of years, or after some other event, usually far in the future, happens.

Some annuities offer you a choice of investments within the annuity. Just like a 401(k) or IRA offers you differing investments within them (usually mutual funds), so too do some annuities allow you to select from a range of investments (again, often mutual funds).

Annuities can also be used as part of a tax planning strategy because the investment gains within an annuity are not taxed until the annuity makes payments.

Have your eyes glazed over yet? Yeah, mine too. This is the opposite of simple.

So why am I writing about them? Because I had one. Or rather, my daughter had one.

Thanks, I Think.

Eight years ago, my parents wanted to do something for my daughter that would help her financially in the future. (Aren’t grandparents awesome?) Some people buy stocks for their grandkids, some people buy bonds. At the instruction of their financial adviser, my parents purchased an annuity for my daughter. The annuity was funded with a $12,000 lump sum payment and was designed to give my daughter monthly payments once I died. The annuity would continue for 99 years from the date it was opened. So if I lived for 60 years after the annuity started, she would have 39 years of recurring payments. The payments were not fixed and the amount she receives would be based on the performance of the investments within the annuity.

Doesn’t that sound a little strange to you?  I mean, what’s the point? If the payments aren’t a guaranteed amount and instead depend on the performance of the securities within the annuity, how is this any different than just investing the money in the stock market outside an annuity?

Well, there are two differences. First, any gains would be tax deferred until the annuity starts paying out. Second, no payments would be made until after I die. Compare this to investing in a regular brokerage account I might set up for my daughter: 1) Gains, in the form of dividends and or proceeds from stock sales, would be taxed in the year they occur and 2) Once my daughter turns 18, that money is hers to do with a she pleases. I will have no control over it.

I’m not concerned about issue 2. I’m raising my daughter to be financially literate and responsible, so I’m pretty confident she won’t go wild and buy a Mercedes when she turns 18. (And really, in the case of the annuity, once I’m dead I’m not going to have control over how she spends the money anyway.) As for issue 1, I’m not sure that’s as big of a deal as it seems, especially for this small amount of money. She’s going to be in a low tax bracket probably at least until she graduates from college. After that, if I’ve taught her well, she’ll leave the investment in a low cost, tax efficient mutual fund that pays qualified dividends – meaning the dividends are taxed at a lower interest rate than regular income – and there won’t be much capital gains to pay taxes on due to low stock turnover within the fund. (See my post about this here.)

But you know what the annuity does give her? Fees. Lots and lots of fees.

Come back next week to see why I decided to get out of this investment.

Wednesday, August 10, 2016

Are You Good At Ignoring People? You'll Probably Do Well In Investing!

When I was writing up the post for my June 2016 Goal Update, I was surprised to discover our net worth had increased by over $10,000 that month. When I looked into it, I discovered most of that gain had come from our investment accounts.

That was a total surprise to me. I was actually thinking our net worth might have dropped that month. A few days earlier, the Brexit vote had passed and stock markets all over the world dropped. Here in the US, the Dow Jones index dropped by 610 points (3.4%) and the S&P 500 dropped by 75 points (3.6%). The next day, the Dow continued it's drop, going down another 261 points. But I never bothered checking my accounts to see how they were affected. My coworkers a couple cubes over were bemoaning their loses and saying they were going to sell their mutual funds and wait until the market came back.


By the end of the week, the Dow had recovered almost all of those losses. If my coworkers did sell their mutual fund shares, they sold low and, to get back in the market, they had to buy high. They're doing it wrong.

I was only dimly aware of the market gyrations. I heard about the Brexit vote and I knew markets around the world dropped, but I had no idea how much, nor did I care. In the days following the vote, I made no effort to see how much the market lost and I did not check my account balances. In fact, I didn't even know how much the market dropped until I sat down to write this article and had to look it up. The whole thing just didn't even register with me.

I've learned to tune out news of daily market gyrations.

Becoming Good At Tuning Things Out

I work with computers and, although it is not the main focus of my job, occasionally I have to do some programming. I'm one of those people that requires a modicum of quiet to get detailed work like programming done. It's difficult for me to concentrate in a noisy environment - or at least, it used to be.

Several years ago, I worked at a job where I shared a small room with two other people who liked to play music while working. Being the newest hire, I felt I couldn't really ask them to change their work environment just for me. Instead, I learned to tune out the music.

It wasn't easy and it took a while, but when I needed to concentrate, I eventually became able to tune out the music and concentrate on whatever task I needed to do. Not everything required such high levels of focus, but when it did, I was able to go to the quiet place within my head, even while music around me blared. I like to call this selective concentration.

That turned out to be a useful ability to develop. I now work in an company with an open-office floor plan - one big open area where you can hear everyone talking. Supposedly, this encourages teamwork and better communication amongst workers. (In reality, it creates all sorts of problems and actually decreases worker productivity.)

To survive in such an environment, being able to tune out others is invaluable. I don't always succeed, and I still find I am most productive in the hour or two I am at work before the rest of the employees arrive. However, learning to tune out people in the work environment has had a huge positive impact on my work productivity. In a wonderful bit of serendipity, it has also led to advantages in other area - investing.

Financial Noise

The best way to creating wealth through investing is a buy-and-hold strategy. To be successful at this, you need to be able to weather wild swings in the market and ignore the talking heads on financial news shows expounding on how dire the situation is.

It can be difficult at times, I admit, especially if the downturn goes on multiple days or even weeks. But one thing to keep in mind is that news is now a 24 hour a day business. Media companies need to sell ads, which means they need viewers. That means they need to constantly keep you watching. One way to do that is through hype and sensationalism. The media does their best to convince you that every little thing is of utmost importance and you need to keep watching to stay informed or you will be left behind.

Once you understand their motivation, it becomes easy to ignore their cries of panic. You realize it's just a form of clickbait.

It's OK To Ignore People

So do your best to become a little anti-social and develop the ability to tune people out. A good way to teach yourself this skill is to try reading a book while the television is on. When you can read a chapter or two and comprehend it without being distracted by the TV, you've got it. Then move on to reading while your spouse is talking. (Just kidding!) You'll find selective concentration becomes easier the more you practice.

Now take that skill and apply it to the stock market. Learn to ignore the day to day fluctuations in the market and your portfolio. Take a long term view. Internalize this mantra: You can't time the market. Tune out those talking heads who tell you otherwise.

You'll end up thousands of dollars ahead of those who can't.