I have a friend who recently immigrated to this country. He is a hard-working professional, with no sophistication in investments. He had accumulated a meaningful amount of money in his 401(k) plan and had additional savings he wanted to invest. He consulted with a number of brokers. All of them made the same recommendation: He should purchase a variable annuity.
This recommendation made no sense to me from an investment perspective. It made perfect sense when you consider the economic self-interest of the broker. According to SmartMoney, commissions on the sale of variable annuities are 5 percent or more. My friend had about $200,000 to invest. You can do the math.
I told my friend I thought he would be wise to consider a target-date retirement fund. The advantage of these funds is they automatically become more conservative over time so there is no maintenance when you own them. He told me he wanted to retire in 2025, so I suggested the Vanguard Target Retirement 2025 Fund (VTTVX). He could open an account directly with Vanguard and there would be no commission. I explained that this fund had 71 percent of its current portfolio in stocks, so he had to be prepared for the possibility of short-term volatility. However, it has a very low expense ratio of only 0.18 percent, compared to the industry average for this kind of fund of 0.49 percent, as calculated by Vanguard. All of the funds in this fund are index funds, which is the reason the expense ratio is so low.
Another benefit is simplicity. He could buy the same fund in his retirement account and in his after-tax account. This investment is totally liquid. If necessary, he could cash out on any trading day, without penalty. Appreciation in the value of his holdings will be taxed at capital gains rates, provided he holds the investment for more than one year.
A variable annuity is a complex investment with often excessive commissions. They have an insurance component, touted to protect you from capital losses. The investment options are often limited to predominately high expense ratio, actively managed funds. You are penalized for withdrawals before you reach age 59 1/2. Additional penalties may accrue if you surrender your policy before a stated period of time (often five years or more after purchase). After you reach age 59 1/2, distributions are taxed as ordinary income, at your marginal tax rate at the time, regardless of how long you held your investment.
The "protection of capital" feature in variable annuities is largely illusory. Much is made of the fact that your beneficiaries will receive at least the amount of your net investment in the annuity if you die before beginning withdrawals. The likelihood of a moderately diversified portfolio being worth less after any meaningful period of time than the amount of money originally invested is very small, making this "benefit" of little value.
Former SEC economist Craig McCann reviewed variable annuities in a white paper. He concluded they are most likely to be unsuitable "in virtually every instance" because investors would probably be better off by investing in mutual funds or a portfolio of stocks. He correctly attributes the sale of over $1 trillion in assets held by variable annuities to "the powerful incentives created by the insurance industry with generous commissions and the massive fraud they engender."
The common recommendation of variable annuities to investors is yet another example of rampant greed on Wall Street. It represents a clear conflict of interest. This is a witch's brew for investors.
Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.
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