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.

1 comment:

  1. Nice One!
    You did the right thing.
    this annuity is no better then what you can do yourself.
    In your case I think that every low cost ETF will do the trick and with no extra work for you.