The problem with the world of finance is that you can always count on salesmen preying on investor fear to pitch a product. We saw it in 2009, we saw it in 2011, and we are seeing it again now. While volatility is to be expected when one is investing in stocks, just like turbulence is expected when you fly, it can still be quite scary at the same time. Unscrupulous salesmen magnify that fear with statements such as “the consensus is that markets have much further to fall.” What consensus is that? What did the consensus opinion matter when stocks were far more expensive than they are now? If your investment program is longer-term in nature, why would you sell your stocks after a global bear market has occurred? Fear of another 2008? 2008 didn’t exactly have oil prices below 30, unemployment under 5%, and stellar consumer credit. There was a massive real estate bubble that simply doesn’t exist whatsoever today.
So this is the pitch to expect: Well I know markets have been absolutely crazy. Stocks are very expensive and we could easily see another 2008/2000 type environment. What if I could offer you “guaranteed” returns so that you could plan out exactly what your income will be upon retiring? How nice would it be to avoid the volatility of the stock market? It is just a casino anyways.
Keep in mind that this generous salesman, who is protecting you from stock market volatility, is collecting an 8% commission upon the sale; so on your $1 million annuity he/she is making $80,000, just for putting you in it. Then you have annual fees that are far higher than the vast majority of investment advisors and mutual funds. Also, let’s not forget that we are in one of the lowest interest rate environments of all time. By buying an annuity, you are basically locking in these horrendous rates, meanwhile we have the best opportunity in common stocks since 2009. So let’s imagine a situation where you pull your money from the stock market and now get into an annuity. Over time, it becomes extremely obvious that this panic was drastically overblown. Stocks recover, but you are making your sub-4% returns net of fees. You decide to pull the plug. Well guess what. Now you are getting hit with a surrender fee of 7%, or slightly less depending on how long you have been in the annuity. What a great deal. So not only are the fees egregious, the returns are terrible, and it is also completely illiquid. But, you get that guarantee right? What is the value of that?
With the panic in the stock market, bonds have sold off materially as well! There are a wide variety of quality high-yield bonds outside of the energy sector yielding between 8-10% now. This is an opportunity that hasn’t existed for some time. Many energy-related bonds are yielding over 20-30% in the truly depressed areas. I’ll be writing more about our fixed income program, which is designed to take advantage of these opportunities. It is possible to build a bond portfolio with high single-digit yields that will be less volatile than the stock market and will cost about 1/5th of what annuities cost, without the illiquidity. This selloff has planted the seeds for strong returns moving forward.
There is a reason that the insurance industry is fighting the new law that would require brokers to act in a fiduciary capacity, which we as financial advisors are already obligated by. How could anyone justify those fees given all of the other opportunities that exist? I’d suggest, asking the person selling you the annuity how much of their own money they have in the annuities and if they or their family paid the same fees that you are paying.
At T&T Capital Management (TTCM), 100% of my personal and family’s invested assets are in the same strategy that your money is in. Through good times and bad times we eat our own cooking. We do this, because over the long-term we are confident that above average returns are likely by sticking with the deep value investing strategy. Of course not every quarter or year will be the best, but over 5, 10, 20 years, the probabilities are quite high that this strategy will outperform if executed properly. It is easy to run with the crowd. Like I’ve said before, you don’t get fired for owning Apple.
The best way to generate the best long-term investment returns is by ignoring the crowd and buying deeply undervalued companies, while taking a long-term approach. We can reduce risk and enhance income through selling puts and covered calls. While this downturn has been bad, we’ve greatly enhanced the cash flow yields of our positions via the sales of covered calls way above current prices. This basically manufactures large dividend payments in this low interest rate world, while still allowing ample room for capital appreciation.
Below are just a few of the major problems with variable annuities that the average investor in them is most likely unaware of:
- Most annuities have a multitude of fees that together can add up to several percent and thousands of dollars annually. In addition to the 8% upfront fee, there are fees paid to subaccount companies, administration fees and surrender fees.
- Annuities are often sold as being extremely tax efficient but this can be misleading. Income and realized appreciation on annuity contracts are taxed at ordinary income tax rates, instead of the lower capital gains rates, which can outweigh the deferred status. Because ordinary income tax rates can be as high as 39.6%, this can be a hugely negative issue considering current capital gains taxes are 15-20%.
- Advertised guaranteed growth, such as “5% guaranteed for 10 years,” is not really a guaranteed rate of return that could be withdrawn as a lump sum. Instead the guaranteed growth simply determines the floor for guaranteed withdrawals. Withdrawals then are limited to a fixed annual withdrawal amount, subject to restriction, and are generally not inflation adjusted. Since the 5% guarantee can be followed by many years of 0% interest and a fixed withdrawal, average annual yields can be as low as 1 or 2% over the life of the contract.
- Many variable annuities are sold with optional benefit riders that limit the percentage of the funds that you can allocate to stocks in an effort to limit volatility, but it also reduces the return potential. Even funds that are designed to mimic index funds, will almost definitely underperform due to the absurd fee structure.