Current Pension Topics: Invariably, Avoid This Annuity

Current Pension Topics
Invariably, Avoid This Annuity

Q.: Except for the people who sell variable annuities for pre-tax investing, I have not come across anyone who thinks it is a good idea. Why is this so?

R.I.

A.: An annuity (fixed or variable) is two products in one and is sold by life insurance companies. The first product is "insurance" and the second is "investment." The insurance feature (annuity) guarantees a future lifetime income stream if you annuitize your investment account balance (convert your balance to lifetime income). The investment feature provides you with a menu of subaccounts from which you make your investment selection. Each of these products/features comes at a cost. The insurance feature costs you about 100 basis points, or 1 percent per year. This fee is called "Mortality and Expense" (M&E) which on a $10,000 balance, amounts to $100 per year. The investment feature costs you for investment management, legal, accounting, marketing and all the other costs associated with running a money-management business. These fees are expressed as an "expense ratio." The expense ratios are substantially less if you buy a no-load (no sales commission) investment, and more if you buy a loaded investment (with a sales commission). The expense ratio can be from a low of about 4 basis points, or 4/100 of 1 percent, to a high of in excess of 100 basis points, or 1 percent, for the same type of investment.

Having said that, let's see if these costs are worth the money. The law doesn't require you to annuitize your account balance at retirement, so why pay for this guarantee of future lifetime income while you are working and contributing to your pre-tax account? The M&E charge has absolutely no value to you even if you plan or the law required you to annuitize sometime in the future. The 1-percent M&E fee should be redirected to growing your investment. Doesn't it make much more sense to first start to pay the M&E fee when you actually annuitize or dedicate your investment balance to generate guaranteed lifetime income? This is the fundamental reason why a fixed or variable annuity should not be bought with pre-tax money, IRA, 403(b), 457(b), 401(k). Moreover, the 1-percent fee is the industry norm and is shark-like. I am firmly opposed to annuitizing, regardless of the M&E fee, and favor using life-expectancy tables instead. Anyone, however, who has decided to annuitize their account balance should not do so with the usual suspects - ING, Prudential, MetLife, Travelers - but with the Teachers' Insurance and Annuity Association (TIAA) that charges a M&E fee of about 5 basis points or 5/100 of 1 percent.

Now let's turn our attention to the investment feature of an annuity. Almost all annuities in a pre-tax retirement savings account are sold through a network of licensed securities brokers. These Registered Representatives are paid a sales commission to sell the products of the insurance company they represent. It makes absolutely no sense to pay a commission every two weeks, month after month, year after year, decade after decade, to acquire an investment that is specifically intended to be drawn down gradually during retirement. Like the M&E charge, the sales commission should be redirected to growing your investment. New York State United Teachers, do you hear me?

Having eliminated the annuity for pre-tax investing, where do we go from here? We go to no-load investments called mutual funds. We buy a Target Date investment fund whose date approximates the year upon which the investor expects to start making regular withdrawals. For example, if one buys a 2050 fund, he or she intends to start making withdrawals in about 45 years. This fund has been designed for the twenty-something crowd. It consists primarily of common stock (equities) with a small portion dedicated to fixed-income securities. Over the next 45 years it will very gradually transpose itself to a portfolio consisting of primarily fixed-income securities with a small portion dedicated to common stock (equities). The Deferred Compensation Plans of the State and City of New York offer these great funds at extremely low cost. If you work for the city or the state and have not invested in these funds, you should do so now. If you work for a local public employer outside of the city, urge your employer to permit you to join the New York State Deferred Compensation Plan (NYSDCP). There are hundreds of local school districts that have not made this great low-cost investment plan available to their employees. They should do so now in order to be onboard for the new school year. NYSUT, do you hear me?

Mr. Frank is a fee-only Retirement Financial Planner. He can be reached by telephone at (732) 536-9472, by fax at (732) 536-7373, or via e-mail at rollover@optonline.net.