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MY FRIEND JIT learned the hard way that you can never be too careful when dealing with a financial advisor. Despite being a cautious and responsible investor, he made one small oversight—and ended up with his money trapped in an unsuitable product.
I’ve known Jit for more than 15 years. He’s smart and financially savvy. He saves diligently and manages his own investments. He funds his son’s 529 plan, maxes out his 401(k), uses the backdoor Roth and so on. He does pretty much everything that a rational, informed investor should do.
A few years ago, he consolidated his investments at a single online brokerage firm. He qualified for the firm’s complimentary advisory service, so he decided to get feedback on his existing investments from his designated “account consultant.”
Jit’s consultant made a few sensible suggestions and quickly earned Jit’s trust. Jit had a large amount of cash from some recently matured CDs. He debated whether to pay down his mortgage or put the money in the stock market. Tax was a consideration, too. He checked with his consultant.
The consultant suggested putting the money in the market. Given Jit’s risk tolerance and overall situation, this was good advice. The advisor, however, directed Jit’s attention to a retirement product with unlimited after-tax contributions and tax-deferred growth—in other words, a variable annuity. Jit had no interest in the lifetime income option, but the advisor argued that the product itself had no surrender charge and that the balance could be withdrawn in part or whole without annuitizing. The goodwill the consultant had already earned, coupled with convincing charts about the value of tax-deferred growth, swayed Jit. He moved a good chunk of his cash into the annuity and invested it in one of the annuity’s investment options, a total stock market index fund.
To be fair, this particular annuity is one of the better ones available. It has tons of flexibility, many fund choices and few restrictions. The cost is relatively low compared to most other variable annuities. Still, it was an inappropriate product for Jit.
Why? He was looking to make a long-term investment in a total stock market index fund. The annual dividend is a small component of the fund’s likely total return, plus it’s taxed at the favorable qualified dividend rate. There isn’t much value in deferring that tax. Indeed, the annual tax on a low-cost total U.S. stock market index fund in a taxable account would be less than the annuity’s fee.
On top of that, the total market fund in a taxable account would receive the favorable long-term capital gains rate when it’s sold, whereas the annuity will be dunned at the higher ordinary income tax rate. This was Jit’s oversight: He should’ve realized the tax treatment was different.
Even though the product itself has no back-end sales commission, Jit is many years from age 59½, when he can withdraw from the annuity without paying the IRS’s 10% early withdrawal penalty. He’s basically stuck with the annuity—and his money is going to be trapped for a very long time.
What can we learn from Jit’s momentary lapse?
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles were A Rich Life and Cost of Living. Self-taught in investment and financial planning, Sanjib is passionate about raising financial literacy and enjoys helping others with their finances. Earlier this year, he passed the Series 65 licensing exam as a non-industry candidate.
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Because I’m anonymous, I will share this experience: I was a new “financial rep” with a major mutual insurance company. I was reaching out to friends and family early in my career and was pretty green about anything more complex than term life, whole life, and disability insurance. For the first 15 months of my career I could not discuss variable products with my clients. When people wanted to talk investment vehicles I had to turn to experienced veterans of my firm. Most of them were quality people. One of the experienced advisors I did joint work with ended up selling my friend a variable annuity inside a tax deferred account (I wasn’t even licensed then so I couldn’t really comment and I wasn’t going to see commission from the product) but I had my reservations for my client. I demanded of the veteran advisor that she walk me through all the reasoning why she was recommending this product and that was like pulling teeth (very haughty attitude as in “who are you to question ME?”) However, she was convincing once we sat down and it was instructive. I since left that company and still wonder if the VA sold to my friend was the right fit. What I should have done was told her to get a second opinion and that by doing so, I was only looking out for he best interests and I had some doubts. I wish I had done that but I was too “green” to be that confident. Moral of the story: Get a second opinion.
Thanks for sharing your experience. It’s great to hear that despite being a newbie in that company, you did everything to ensure the best interest of your client.
I think as an investment type, annuities can be a good fit for specific circumstances (e.g., immediate annuities for lifetime income assurance). The main problem I see is in the fees of most products, as well as the complexity and fine-prints.
As far as I can tell from all the math I have run and seen on the internet, and I have spent several hours on this, there is only one type of investment that is worth owning in a variable annuity wrapper. And that’s a “barely”.
That is high-yield corporate bonds (Junk Bonds).
If you are owning literally anything else… equities foreign or domestic, government bonds, etc…. you are better off just buying it in a taxable account.
But even then… even if you buy that one special category that makes sense, you typically must hold it for 20-30 years for the compounding effect of the tax savings to surpass the higher costs of the variable annuity versus a low cost taxable fund.
Lastly, if the above two conditions are met, and only if, then you have to ensure that you pick the 1% of variable annuities with low fees.
The vanguard one, which they aren’t going to be running themselves for much longer, is the only one that made sense.
From all the above, because I met all three criteria for about a 3% portfolio allocation to high-yield junk bonds, I put in about 3% into the Vanguard one and have been relatively happy with the decision over the last decade.
But for 99% of people, they should run, not walk from anything called a “variable annuity.”
And if you want simplicity, park it over at Vanguard and just buy broad based index funds and go on with your life. Even if marginally less tax effective, the low fees and flexibility will benefit you.