Brokers May Have to Change

“A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest.  Advisers always have those duties, but brokers often don’t.  The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.” – Jason Zweig.

If you are confused by the difference among these titles: Financial Planner, Stockbroker, and Registered Investment Advisor, you are not alone.  The “Name Game” in the financial services industry is downright confusing.  How does your financial advisor operate?  How does she get paid?  What are the advantages and disadvantages of each arrangement?

Many people believe that they are getting financial planning from a stockbroker, when in fact financial planning is usually only an incidental part of what a stockbroker does.  Similarly, many people are not aware that a stockbroker does not have to act in the client’s best interests.

A June 19th Wall Street Journal article Big Change in Store for Brokers in Obama’s Oversight Overhaul brings home this point.

According to the article, stockbrokers might have to change the way they do business; they might have to act in their client’s best interests, the way a Registered Investment Advisor already does.

Wow!  What a concept.

Here are the relevant quotes:

Buried in President Obama’s proposed regulatory overhaul is a change that could upend Wall Street: Brokers would be held to a higher “fiduciary” standard that would compel them to place their client’s interests ahead of their own.

Currently, brokers are only required to offer investments that are “suitable,” which means they can’t put clients in inappropriate investments, such as a highly risky stock for an 80-year-old grandmother. The move could change the way products are sold and marketed and even how brokers are compensated.

Many investors don’t even know the difference between the two standards, believing their brokers already are acting in their best interests.

But requiring brokers to operate under a fiduciary standard could force them to offer products that are less costly and more tax-efficient. They will have to disclose any potential conflicts of interest, such as any fees they may get for favoring one product over another. That could mean clients will be offered fewer proprietary products if the broker can find a lower-cost option elsewhere.

For example, a broker couldn’t put you in a mutual fund with higher fees — or one he gets a bigger commission for selling — if he could get a comparable fund with lower fees elsewhere, says Tamar Frankel, an expert on fiduciary law at Boston University School of Law. (Emphasis added.)

The article implies that some stockbrokers sometimes put their interests above yours.  Hmm.   This might just be worth investigating.

Luckily, I’ve discussed this topic many times, and in fact I have a series called The Dark Side of Wall Street, which lists all of the relevant posts.  If you start with Choosing a Financial Advisor, Part 1 at the bottom of the page, you can read them in order by following the “To be continued” link at the end of each post.

Avoid Investment Scams, Part 2

“You don’t need 99.9 percent of what Wall Street is selling. It’s expensive, unsuitable, or stupid. Most investments are designed to profit the brokers, banks, and insurance companies, not you.” – Jane Bryant Quinn.

My last post discussed a recent Wall Street Journal article, Laws Take On Financial Scams against Seniors, which stated, “financial scams that target seniors are on the rise, and states are cracking down.”  According to the article, “The recession has spurred more scams that play off people’s fear of stocks. Some investments pitched as low-risk could instead be quite complex.”

The sidebar included advice on what questions to ask when you’re presented with an investment “opportunity.”

What are the risks of this investment?

How much does it cost initially to purchase this investment and what, if any, additional or ongoing costs will I have to pay?

How liquid is this investment?  If I need to sell or cash in the investment, how little he can I do so?

Will my investment be tied up? If so, for how long?

What happens if I decide to sell or cash in my investment?  Are there surrender charges or other fees?

For what type of person is this investment a good idea?  For what type of investor is this a bad idea?

Is this investment registered?  If so, with which regulator?

If the speaker can’t or won’t answer your questions to your satisfaction, and in writing, the investment is not right for you.

Understand Risks and Costs

All of these are good questions and arguably they apply to any type of investment.  Understanding the risk of your investment is very important. My advice is to shy away from any advisor who does not take the time to explain the risks of a particular investment.  If the presentation makes you feel extremely “lucky” that you have attended the session in the first place, it’s time to slow down.  And if all you hear in a presentation are the glorious benefits of an investment, and nothing about the risks, head straight for the door.

In my opinion, the questions above particularly apply to deferred annuities and mutual funds.  It’s important to understand what the costs and fees are of any investment you may make.  Keep in mind that Wall Street is very good at obfuscating, hiding fees, and using doublespeak to confuse consumers.

Regarding deferred annuities and mutual funds, under no circumstance should you accept the answer that “you do not pay any fees, because the insurance company or mutual fund firm pays me.”  This is an example of the “doublespeak” that I referred to in the previous paragraph. To put it simply, it’s a lie. Obviously, any fees that are paid out come from somewhere; in fact, they come from the returns that you could get in an investment product.

Beware of B sharers of mutual funds.

Mutual fund B shares are not a scam, but I have met prospective investors who assumed that they were not paying anything to buy their mutual funds.  Actually, they had been sold B shares of mutual funds.  To be kind, the investors were “misinformed,” and the advisor was paid handsomely for this “misunderstanding.”  You decide if this akin to a scam or not.

According to the Securities and Exchange Commission:

Class B shares might not have any front-end sales load, but might have a contingent deferred sales load (CDSL) (a type of fee that investors pay only when they redeem fund shares, and that typically decreases to zero if the investors hold their shares long enough) and a 12b-1 fee (an annual fee paid by the fund for distribution and/or shareholder services).  Class B shares also might convert automatically to a class of shares with a lower 12b-1 fee if held by investors long enough.

In other words, unless you wait for years to sell these shares, you will pay a contingent deferred sales load – in plain English, a commission – to get your money back.  In addition, that quote does not make clear that B shares typically have much higher annual expenses than true no-load funds.

If you read through the prospectus carefully and know enough to ask your “advisor” the “right” questions, you will reach the proper conclusion – that there are better investment alternatives for you.  Actually, there are plenty of better investment alternatives available.

Who Will Guard Your Nest Egg?

“Make no mistake about it, you are engaged in a brutal zero-sum contest with the financial industry — every penny of commissions, fees, and transactional cost they extract is irretrievably lost to you.” – William Bernstein.

Previous posts have discussed the advantages of using a fee-only financial planner and also the possible conflicts of interest that may arise when working with a commission compensated planner.

Certainly, Wall Street investment firms spend a lot of money on advertising, making it seem as though their interests are aligned with yours. So, it is understandable that the majority of consumers are unaware of the difference between a fee-only planner and someone who calls himself/herself a financial planner but who is actually a salesperson.

In Saturday’s Wall Street Journal, Jason Zweig delineates the nature and extent of the confusion.

Brokers must recommend only investments that are “suitable” for clients.

(Registered Investment) Advisers act out of “fiduciary duty,” or the obligation to put their clients’ interests first.

Most investors don’t understand this key distinction. A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest. Advisers always have those duties, but brokers often don’t. The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.

Brokers can sell you any investment they have “reasonable grounds for believing” is suitable for you. Only since 1990 have they been required to base that suitability judgment on your risk tolerance, investing objectives, tax status and financial position.

A key factor still is missing from FINRA’s (Financial Industry Regulatory Authority) suitability requirements: cost. Let’s say you tell your broker that you want to simplify your stock portfolio into an index fund. He then tells you that his firm manages an S&P-500 Index fund that is “suitable’ for you. He is under no obligation to tell you that the annual expenses that his firm charges on the fund are 10 times higher than an essentially identical fund from Vanguard. An adviser acting under fiduciary duty would have to disclose the conflict of interest and tell you that cheaper alternatives are available.

If brokers had to take cost and conflicts of interest into account in order to honor a fiduciary duty to their clients, their firms might hesitate before producing the kind of garbage that has blighted the portfolios of investors over the years. (Emphasis added.)

Conclusion

Panicking and pulling out of the stock market following a steep decline, concentrating your investments within a narrow range of options, and too much trading and too little long term holding are some of the more common mistakes investors make. Any and all of which will likely result in a reduction of your investment returns.

Understand, though, that high costs can absolutely kill your investment returns, whether from the high fees of a variable annuity or 403(b) plan, high (and often hidden) expenses and fees of some mutual funds, or the opaque mark-up on bonds sold to unsuspecting investors. Your best protection is to ask your financial advisor to sign a Fiduciary Oath. To find a fee-only planner near you, view the NAPFA (National Association of Personal Financial Advisors) web site.

It is encouraging that the issue of who is working in your best interests has been brought front and center by Jason Zweig, a respected author and columnist. Now, let’s see if the Securities and Exchange Commission Chairwoman, Mary Schapiro, proposes changes in legislation that will benefit consumers. The stakes are extremely high, as Wall Street firms make billions from unsuspecting customers.

Entrenched interests never give up power or lucrative business practices easily.

Is Buy and Hold Not Working? Part 1

Recently, my son-in-law got a cold call from a stockbroker. “Jim,” the stockbroker exclaimed, “Buy and hold isn’t working!” James, intelligent man that he is, begged off with the response that his father-in-law is a financial advisor and that he was “all set.”

While I certainly appreciate my son-in-law’s loyalty, the stockbroker’s statement had me thinking. If you had been the recipient of that cold call, how would you have responded to the statement: “Buy and hold isn’t working any more.” My suggestion is that you ask, “Compared to what?”

Well, I suppose one answer would be compared to a strategy which keeps you out of the stock market when it’s going down. Unfortunately, no such strategy exists. If it did, pension funds with billions of dollars would be using high priced managers to implement it.

An October article in Fortune magazine, Is Buy-And-Hold Dead and Gone? had these useful observations on this issue.

You can’t time the market.

The evidence shows that most investors get it wrong over and over again. According to a study called the Quantitative Analysis of Investor Behavior by financial research firm Dalbar, over 20 years through the end of 2007, the average equity-fund investor earned an annualized return of just 4.5%, vs. the S&P 500′s 11.8% return. Why? In large part because investors, chasing performance, shift money out of lagging funds and into hot ones at the wrong times. We buy high and sell low repeatedly.

Need more evidence? Go back to the dot-com bubble. In the first quarter of 2000, according to Morningstar, investors channeled $97 billion into equity funds – nearly double the total of the previous two quarters – right before the S&P 500 peaked on March 24, 2000. And in the third quarter of 2002, they withdrew $41 billion from stock funds just before the market bottom on Oct. 9.

(Emphasis added.)

Conclusion

No one can accurately or consistently predict the short term direction of the stock market, but selling stocks, or refusing to buy them now, because they have gone down in price, is not likely to be a winning long-term strategy. Historically, stock markets have had sharp increases following a bear market. The difficulty is identifying when that move is for real. Bear market rallies, bear traps, etc. tend to keep investors gun-shy, so a sustainable bull market rally will only be identifiable in hindsight.

Nevertheless, individuals who keep their investments in cash or Money Market funds will miss out on most of the move.

To be continued.

Don’t Put Your IRA in a Variable Annuity

I recently received an email from a couple in their 60s requesting advice regarding how to invest their IRA funds. They had been to a “financial planner” who recommended a variable annuity. Luckily they had read my posts on the subject and said in their email that they were “skeptical because of the costs and early withdrawal penalties.”

I heartily concur.

Jeffrie Voudrie’s article Don’t Put Your IRA in A Variable Annuity explains why.

Here’s a quick summary.

If you’ve talked to a broker or agent about rolling over your retirement account, there’s a good chance the advisor recommended you invest in a Variable Annuity. Don’t do it! I believe the only reason a variable annuity is recommended for an IRA is so the advisor can earn more money. Let me explain.

One of the main sales ‘hooks’ used in selling a variable annuity is that you don’t have to pay a commission. That can be very compelling when compared to a mutual fund in which you pay the all the commission up-front. Many advisors will even say that they get compensated by the insurance company, not you. Do you really believe that? Insurance companies are not charitable organizations. If they are paying the broker, they’ll recoup those costs from you—the costs are just hidden so you don’t think you’re paying a commission. The second main argument for using a variable annuity for an IRA is the death benefit (not offered with a mutual fund). “That way you’ll never have to worry about your beneficiary getting less than you invested”, the thoughtful advisor says. This feature may seem nice, but you end up paying through the nose for it.

The real reason that you are recommended a variable annuity for your IRA isn’t that it’s better for you. It’s because it’s better for the advisor. If you invest $500,000 in a commission-based mutual fund, the advisor’s gross commission will only be about $10,000. The same investment in a variable annuity would yield gross commission to the advisor of $30,000-$35,000 or more! If an advisor can earn 3 times more by getting you to invest in a variable annuity instead of a mutual fund, which do you think will be recommended? 

Don’t fall for the ‘put your IRA in a VA’ trap.

Conclusion

I am not sure which is more shameful (1) Wall Street titans who took outsized bonuses that turned out to be based on illusory profits or (2) the bad advice given to consumers every day by “financial advisors.” This self-serving advice costs consumers billions of dollars every year.

There is a better way - fee-only financial planners. To find one near you, consult this web site:

National Association of Personal Financial Advisors (NAPFA)

Financial Literacy, Part 1

Given the state of the global economy, the need for financial literacy should be self evident. Life is complicated. And in that complicated life, we all must make sometimes difficult choices, based on the best information we can gather and our interpretation of it.

But, according to a column by Robert Shiller in yesterday’s New York Times, that knowledge is sorely lacking. In How About a Stimulus for Financial Advice? Shiller extols the benefits that would be derived if the government subsidized the financial advice and education that the majority of people desperately require.

Shiller discusses several studies which prove that lower-income consumers are no match for the sophistication of financial service providers. Some of the revelations are quite shocking. Take his example of payday loans. You probably get spamvertisements for them in your email box all the time. But did you realize that  “payday loans — advanced to people who run out of cash before their next paycheck — exploit people’s overoptimism and typically succeed in charging annual rates of interest that may amount to more than 7,000 percent.” You read that right, 7,000%.

Shiller focuses on the need for financial education specifically for those less fortunate, because, in his reasoning, wealthy folks already have access to good advice. I, however, would say that we all need more education, sophistication and good advice; case in point, the billions of dollars lost by wealthy “educated” investors in the Madoff scam.

To confirm that you too need objective advice, ask yourself (or check your records) how much money is your financial advisor making from you? I can pretty much guarantee that your financial service provider knows the answer to that question, probably to the penny. See my previous posts on why it is not in his or her best interest for you to know that answer.

Here are some relevant quotes from the Shiller article.

In evaluating the causes of the financial crisis, don’t forget the countless fundamental mistakes made by millions of people who were caught up in the excitement of the real estate bubble, taking on debt they could ill afford.

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.

A number of government agencies already have begun small-scale financial literacy programs. For example, the Treasury announced the creation of an Office of Financial Education in 2002, and President Bush started an Advisory Council on Financial Literacy a year ago. These initiatives are involved in outreach to schools with suggested curriculums, and online financial tips. But a much more ambitious effort is needed.

The government programs that are already under way are akin to distributing computer manuals. But when something goes wrong with a computer, most people need to talk to a real person who can zero in on the problem. They need an expert to guide them through the repair process, in a way that conveys patience and confidence that the problem can be solved. The same is certainly true for issues of personal finance.

One wishes that all this financial cleverness could be focused a bit more on improving the customers’ welfare!

The theory of capitalism, going back to Adam Smith over 200 years ago, sees an alignment of interest between consumers and businesses. Only those companies that produce what consumers really need will succeed. Those that do not will be beaten in the marketplace as consumers shop elsewhere. This puts pressure on providers to innovate and to better satisfy consumer needs.

This theory assumes, however, that consumers are rational in their choices, and to a large extent they are. But in some areas, notably personal finance, it is important to recognize that a good share of Americans have difficulty figuring things out.

Most people get financial advice only from sales representatives of one sort or another: real estate agents, mortgage brokers, sellers of financial products. Some of these providers could use their sophistication to exploit people’s tendency to behave irrationally, and to manipulate the judgment errors that consumers typically make. And competitive pressures tend to make providers promote products that exploit those errors to the hilt, unless, of course, we offer consumers real financial advice.

Conclusion

Shiller acknowledges that there is no silver bullet to the issue of financial education and risk taking. However, “it’s still likely that advisers who built long-term relationships with their clients, and who pledged to look after their welfare, would have been a helpful influence, suggesting caution to those who were getting over their heads in debt, and warning that adjustable-rate mortgages could be reset upward, just as the fine print said. For these reasons, financial advisers probably would have reduced the severity of the housing bubble.

Professional financial advice is now generally accessible only by the relatively wealthy. Changing this would be an important corrective step. Giving the general public access to trained advisers would be a boon for the nation in this time of doubt and distrust.”

Shiller raises some very good points. He envisions a government subsidy to help pay for one-on-one financial counseling. I personally believe that part of the needed education and counseling could be delivered with a combination of classes and individual consulting, in order to keep costs down. But I am with him entirely when he says that advisers should have long-term relationships with their clients and that advisers should pledge to look after their clients’ welfare.

A previous post discusses the desirability and practicality of working with someone who is a fiduciary, as opposed to a registered representative.

Financial Experts?

 

 

 

 

 

 

 

 

 

 

 

 

This cartoon is courtesy of Nick Anderson, the Editorial Cartoonist of the Houston Chronicle.

I think it captures beautifully the irony of banks and brokerage companies still holding themselves out to be “experts”even though they have imploded due to poor risk management.

Variable Annuities, Part 2

“It has always been said that annuities are ‘sold,’ not bought by investors. Over 90% of all annuity sales are through brokers or life agents… Why are so many people sold annuities? The answer is simple…. high commissions and great sounding stories.” – Scott Dauenhauer.

In a previous post, I outlined some of the disadvantages of variable annuities. Today’s post goes into this a bit more deeply.

A colleague of mine, Scott Dauenhauer of Meridian Wealth Management, is a former stockbroker and someone who is quite critical of the “so-called” advantages of variable annuities that are usually touted by salespeople. The following quotes from Secrets of the Wirehouse and How to Protect Your Best Interests emphasize the high (hidden) costs and lack of real benefits.

Annuities, Hazardous to Your Wealth?
Variable annuities performance is based on an underlying “sub-account,” basically a mutual fund. The major benefit to an annuity is the ability to defer taxes until the money is withdrawn. Another highly touted benefit is that an annuity can pay an income stream for life. Let me lay out a case for why variable annuities may be hazardous to your wealth.

The expenses inside an annuity are one of the main problems. There are several expenses involved. Today most annuities do not charge you an upfront commission, the fee is charged as an annual fee (which you don’t see). This fee is deducted daily from your balance, there are five possible costs. The costs are: The policy charge, Mortality & Expense, Rider charges, underlying sub-account expenses, & transaction costs associated with those sub-accounts. Below is a range of what these cost can add up to:

Policy Charges                                   $ 30-50

Mortality & Expense                        1.00 – 2.00%
Riders                                                .25 – 1.25%
Sub-Accounts                                   .25 – 1.50%
Turnover Costs                                 .06 – 1.00%

Total Costs                                     1.56 – 5.75%  Annually

These expenses take a toll on the ability of the portfolio to match, or even beat the market. The annuity has to earn 2.5-5% before it breaks even for the year.

Add the fact that gains in an annuity are taxed as ordinary income when withdrawn and the chances of your annuity beating your taxable account come close to zero. In addition, if you die with an annuity you do not receive any favorable tax consequences. You lose what the tax code refers to as the “step-up” in basis, meaning that if you die with a taxable account the entire account gets passed on to your heirs with no income or capital gains tax, not so with an annuity.

You may ask “what about the guaranteed death benefit?”

It is basically worthless in most circumstance. Annuities are long-term investments, they are not meant for periods of less than 10 years. If you end up being one of those poor unfortunate souls that bought at the top of the stock market and still have less money than you started with 10 years ago (extremely unlikely, but it happens, though usually due to idiot broker advice) then your loss exposure is likely minimal. An amount that will be less than what you probably paid for the insurance over that period. In any event, the death benefit is not a logical reason to purchase an annuity.

Now, of course, if you have loved ones that you want to provide for a death benefit may offer you some peace of mind. Keep in mind what you pay for that peace of mind and the likelihood of it ever being collected on. If you are insurable, purchase insurance; if you are not, perhaps a variable annuity with a death benefit makes sense (though I still highly doubt it). If in the extremely rare circumstance that a death benefit makes sense in a variable annuity my choice would be to purchase a variable annuity from the Vanguard Group, as they offer a low cost account with a death benefit.

Let’s recap the problems with Variable Annuities. High expense, high marketing costs, tax penalties if under 59 ½, loss of capital gains status, loss of step-up, limited choice of investment vehicles, & worthless death benefits. So why do people continue to be sold these products? High commissions and high profitability to the companies involved. Profit is the bottom line, not your interests. Variable annuities have become such a problem that the SEC (regulator) has issued a booklet available online through its website that lists the pros and cons of annuities.

Living Benefits

Variable Annuity providers knew that the death benefit just wasn’t enough to keep the sale of variable annuities going, so they came up with a whole new generation of benefits for variable annuity products dubbed Living Benefits. The four major living benefits that are offered are as follows:

Guaranteed Minimum Withdrawal Benefit (GMWB)

Guaranteed Minimum Withdrawal Benefit For Life

Guaranteed Minimum Income Benefit

Guaranteed Minimum Accumulation Benefit

These living benefits are sold with some really great stories and too good to be true promises. I can’t even begin to get into the inner workings of each of these so called benefits because it would bore you and take up a lot of space. Suffice it to say that these living benefits are expensive (despite what your broker will tell you) and are not all they are cracked up to be. If you are being told that you will be guaranteed 7% on your money, beware and read the small print. If you are being told that regardless of stock market performance you can withdraw 7% of your account annually, beware.

The stories that are used to sell these products are wonderful, they sound like an investors dream, but reality is much different. These products are costly and in most cases fixed against the possibility of a claim being made. Always read the fine print and hire a professional who has nothing to gain to review any variable annuities recommended to you.

The “Bonus” Annuity Scam
If you are an annuity holder, chances are you have been approached by an insurance agent trying to sell you an annuity that pays you an ‘upfront’ bonus. Whatever you do, do not succumb to the sales pitch for the new “bonus” annuities. This is a new and highly aggressive tactic of the industry, to keep investors “imprisoned” in a high cost product, and generate new and even larger commissions for the sales force. Annuity holders with a few years left in their surrender charge period are approached with the following “typical” story:

“I understand that you are unhappy with your current variable annuity because of poor performance, lack of investment choices & a fading death benefit. I also understand that you have a surrender charge left. We are going to “help” by giving you an up-front ‘bonus’ of 3-6% to cover the surrender charge. It will not cost you anything to switch.”

Unfortunately, the only “bonus” is to the salesperson. The new sale starts the surrender period all over again and the salesperson gets another commission. It is a great deal for the agents, they get two commissions from you.

To pay for the bonus and the commission and any extras, the insurance company raises the expenses on your investments. Since these expenses are buried in the prospectus and hidden from you on your statements, you never know that you are being taken advantage of. When all is said and done, everybody is making money except you! I have actually been in meetings and heard brokers laugh at how they duped another person into a “bonus” annuity.

They refer to the extra commission internally as the “Yield to Broker.” It appears that the SEC is coming down hard on this practice. On June 5th, 2000, they issued an “investor alert” and placed a brochure on its website to help investors understand the benefits, costs, and risks of variable annuities, which combine features of mutual funds and insurance.

Insurance companies have been hit with rounds of lawsuits stemming from churning and suitability. It seems that the real “bonus” will be new business for trial lawyers!!!

Conclusion

When someone, specifically a salesperson who is compensated by commissions, recommends a variable annuity or a “bonus” variable annuity, you should seriously question whether the recommendation is in your best interest (or his). Take it from an ex-stock broker; that recommendation may very well be prompted by the promise of a very high commission.

Read about IRAs and Variable Annuities.

photo credit: loop_oh

Variable Annuities, Part 1

“High fees, low flexibility and ‘horrendous’ tax treatment make variable annuities less attractive than ever, except to the people who sell them.” – Liz Pulliam Weston.

Annuities may come in more flavors than Baskin Robbins ice cream, but don’t make the mistake of assuming that they are as simple as choosing between chocolate and vanilla. In truth, they are very complicated products. A variable annuity is an insurance contract that allows you to invest your premium in various mutual fund-like investments. If you are considering buying an annuity, you must do your homework before making a final decision. CNN.com’s annuity guide is a good on-line primer

SmartMoney.com summarizes as follows.

A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn’t subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as “subaccounts.” Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it’s time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

Since the person recommending the annuity will (no doubt) tell you how “great” this product is, this article will temper that by focusing on the disadvantages of a variable annuity.

Sold not Bought

In financial circles, it has often been said that annuities “are sold, not bought.” And sold they certainly have been — there is more than $1 trillion invested in variable annuities, and new sales total well over $100 billion every year.

However, the popularity of an annuity as an investment does not necessarily suggest that it is wise for you to invest your hard-earned money in it.

So are variable annuities good for investors?

Liz Pulliam Weston, who writes a column for MSN Money, gives away the answer in her article’s title The Worst Retirement Investment You Can Make.

Calling it the “worst” investment may, perhaps, be a slight exaggeration. Let’s look at her main points.

Tax treatment. Your gains in an annuity grow tax-deferred, but they are taxed as income when you withdraw the money. That contrasts with other investments such as stocks and mutual funds, which can qualify for lower capital gains treatments.

Penalties for early withdrawal. Variable annuities are designed as retirement savings vehicles. So, you pay a 10% federal-tax penalty if you withdraw money before age 59½. Insurance companies typically levy surrender charges of their own if you withdraw more than 10% of your balance in the first few years. Surrender charges usually start at 7% of your investment and decline to zero over the next six to eight years. They can range, however, up to 16% and last for as long as 15 years.

Death benefit. Variable annuities typically come with a death benefit that ensures your heirs get back at least as much as you invested if you’re unlucky enough to die while your investments are down. Your heirs will have other problems if you die owning an annuity, however. While most other investments get favorable tax treatment — a so-called “step-up in basis” that eliminates or drastically reduces the taxes heirs must pay when they sell — withdrawals from an annuity are taxed at regular income-tax rates.

Living benefits. Death benefits aren’t the only insurance feature you can get with a variable annuity. Increasingly, insurers are pushing so-called “living benefits” or “life benefits,” which guarantee that you can get back at least your original investment, usually compounded by a certain amount, when you withdraw the money in retirement. Investors stung by the bear market are greatly attracted to these guarantees, Carey said. That’s helped fuel annuities’ rise. Living benefits were available on 20 of the 25 top-selling variable-annuity contracts last year.

Costs. The insurance features of an annuity aren’t free, of course. The typical annuity with just a death benefit costs 50% to 100% more in annual fees than comparable mutual funds. Life benefits can add 20% or more to that cost.

Those extra expenses can seriously eat into your returns. Consider what would happen if you invested $5,000 a year in mutual funds with annual expenses of 1.5%, versus the same investment in an annuity with a 2.5% expense ratio.

If the underlying investments returned 8% a year, after 30 years:

Your variable annuity would be worth $362,177.
Your mutual funds would be worth $431,874 — a difference of nearly $70,000, or 14 years’ worth of contributions.

The gap just widens if you consider the tax implications. In both scenarios, you won’t have to pay tax on your original contributions when you withdraw the money. But the mutual fund gains would in most cases qualify for capital gains tax rates, which range from 5% to 15%, while the annuity’s payments would be taxed at income tax rates — currently 10% to 35%.

Are the life benefits worth it?

Meanwhile, the chances of your actually using the insurance benefits are slim. Relatively few people will die with their annuities worth less than what they paid. The living benefits typically come with a 10-year holding period, and there have been few 10-year periods where investors have actually lost money.

Insurers argue that the life benefits serve as “guard rails,” allowing investors to take more risk with the knowledge that their basic investment is protected. Many financial planners respond that a more appropriate response to risk is to construct a balanced, diversified portfolio with bonds and cash to cushion stock market swings.

Of course, most variable annuities aren’t bought — they’re sold. Only about 2% of variable annuities are purchased directly by consumers; the rest are sold through brokers, insurance agents and bank employees who are paid often-hefty commissions on their sales.

The math is lousy

“When you take the commissions out of the equation, the allure of a variable annuity disappears,” said Miami fee-only financial planner Frank Armstrong, a former insurance agent and author of “The Informed Investor: A Hype-Free Guide to Constructing a Sound Financial Portfolio.” “They cost a bundle,” he added. “And the tax treatment (upon withdrawal) is horrendous.”

“Nobody who’s in the fee-only (planning) business is going to recommend them,” said Armstrong. “Why do you think that is? You think we just have a blind spot that we can’t do the math?”

Some of most vociferous critics of variable annuities are those who, like Armstrong, spent some time in the brokerage firms or insurance companies that push them. Before he became a fee-only planner, Rob Pool of Portland, Ore., worked for a major brokerage firm, and the experience made him wary of the way annuities are sold.

“They’d get recommended even if it wasn’t in the client’s best interest all the time,” Pool said. “I can’t say there’s never a place for a variable annuity in a portfolio, but I haven’t found it yet.”

Conclusion

Personally, I do not recommend variable annuities for my clients, because they are not in my clients’ best interest, and there are much better alternatives. Variable annuities have very high expenses, unfavorable tax ramifications, and they lack flexibility. Before buying one you should understand the surrender charges, early withdrawal penalties and the annual fees. It bears repeating, do your homework before you consider buying an annuity.

Larry Swedroe and Jared Kizer in their new book The Only Guide to Alternative Investments You’ll Ever Need say this:

Some investment products are so complex in design that it is very difficult, if not impossible, for the average investor to fully understand the risks entailed and the costs incurred. Make no mistake about it, the complexity is intentional. After all, if the investor fully understood the product, it is likely that he or she would never purchase it. That is why many of such products are truly “tourist traps” – designed to be sold, but never bought.

Education – or a good fee-only adviser who is not influenced by commission-based compensation – can be the armor that protects investors. The overwhelming evidence from academic studies on Variable Annuities is clear: In general, these investments fall into the category of products that are meant to be sold, not bought.

Read Part 2.

The Dark Side of Wall Street, Part 3

“Not infrequently, brokers become disenchanted and leave the business. Occasionally, they will even become fee-only advisors, whose compensation is not tied to trading.” – William J. Bernstein.

In a previous post, I asked the rhetorical question, “Why would you even consider working with a financial advisor who warns you in writing that ‘Our interests may not always be the same as yours’ and ‘Our profits, and our salespersons’ compensation, may vary by product and over time.’”

Friday’s post quoted exclusively from William Bernstein on the subject of stock brokers’ competence and compensation.

Today’s post quotes a former stockbroker on the incentives and pressures he observed. Scott Dauenhauer, of Meridian Wealth Management, is a colleague who spent five years working for the “big three” brokerage firms. He has written a vivid expose called Secrets of the Wirehouse and How to Protect Your Best Interests.

( “Wirehouse” is an industry term for a large national broker/dealer. Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns are all examples of wirehouses.)

Scott’s article covers many topics including broker training, compensation, and the various investment products you should avoid. Here is what he says about broker competency, compensation and the conflicts of interest endemic in the financial community.

How much training do brokers actually have in financial planning? Major brokerage firms tout intensive training programs almost as much as the stocks they peddle.  They brag about the high level of education their “consultants” receive. The truth is the only requirements are that individuals pass the Series 7, and a state insurance exam.  The Series 7 is an industry test that requires memorization of facts about the markets and represents a minimum standard of knowledge.

The Series 7 does not teach an individual how to manage personal finances, let alone create a comprehensive financial plan. The Series 7 doesn’t even teach about how to properly diversify a portfolio.  The insurance exam is an even bigger farce. While the Series 7 actually requires a bit of studying the state insurance exams only require minimal memorization.

Anyway, once a “recruit” passes the Series 7, he/she is sent to company headquarters to go through “intensive training.”  The training is definitely intensive, though not in financial planning or investment management.  The programs focus solely on sales & product training and lasts anywhere from 1-4 weeks. I attended one such program and 95% of the training focused on cold-calling sales and learning proprietary product. Proprietary products are ones that are sold directly (and typically only) by the brokerage firm and typically have much higher profit margins, though mainly benefit the firm, not the person they are sold too.  Brokerage firms want “salespeople,” not highly skilled financial planners.

If the firms hired highly skilled financial planners, the firm wouldn’t be able to sell proprietary products.  This is because the planners would know better.  When the firm hires somebody with no previous industry knowledge, or experience, they have the opportunity to fill that person’s mind with fairy tales, not fact.  The firms’ way of doing business is to focus on proprietary products, high & hidden fees, cold calling, and quotas.  The truth is that very few new recruits have any experience in handling another family’s wealth.  You end up paying high fees for a service that puts you directly on a recruit’s learning curve.  Even brokers who have been at the firm for years may not have any training in financial planning; they are stockbrokers, not trusted advisors.

When dealing with brokerage firm, conflicts of interest abound and for the most part are not disclosed.  The following is a few conflicts that you should watch out for.

First, please understand to whom a public company owes their loyalty; it is to their public shareholders.  The people who own stock in a company must have their interests protected.  A public brokerage firm’s loyalty cannot be 100% to you.

Let’s take a further look at where other strings are attached. A broker gets paid a percentage of the revenues that he/she brings to the firm, typically 25-40%.  It is not, however, that simple. Brokerage firms determine the payout percentage for each individual “product.”  They control product flow by paying higher amounts to brokers for product they want sold (typically products with higher margins).  While this makes sense from a business stand point and from a shareholder standpoint (why wouldn’t you want to incentivize your staff to sell the most profitable products?) it doesn’t work out so well for the end user, the client.  Each firm works differently but depending on the product a firm wants to emphasize, they will pay a broker a higher percentage of the revenue to induce him to sell what the company wants him to sell.  For example, if the company wants a broker to sell a Separate Account Platform product (individual money managers, more to come on this), they may tell the broker that they will receive a higher percentage of the fees they generate from that particular product and that product may generate more fees than other products.

Let me give you a real life example so that you understand.

Imagine that you had only two products to choose from to sell your client; one is a mutual fund that costs the client 2.25% annually and pays the firm 1% annually.  Of the 1% paid to the firm the broker collects 35% of it or .35% annually. On a $1,000,000 account the firm generates $10,000 in revenue and pays the broker $3,500 (you the client pay $22,500).  The other product is a Separate Account where you have an individual money manager.  This product is sold as the latest, greatest way to have your money managed and costs 2.5% annually.  However, this product pays the firm 1.5% annually and the firm will pay the broker 40% of that revenue or .60% annually. On the same $1,000,000 account the firm generates $15,000 in revenue and pays the broker $6,000 (you pay $25,000 annually).  Now, in all likelihood both accounts will have similar returns over time and will probably under-perform the market.  You the client in either situation are stuck in a lousy product that is expensive; however the firm has an incentive to sell one over the other, even if the other isn’t in your best interest.  The separate account sale earns the firm 50% more revenue and the broker 70% more revenue – which product do you think will be presented?  Each firm has their own system and they are all different, but the mechanisms are in place to manipulate the broker into selling what makes the firm and/or the broker more money.

In addition to higher revenue on proprietary products, the broker many times is under tremendous pressure from management to sell you the latest mutual fund offering from that brokerage.  Branch manager compensation is determined in part by the amount of proprietary products his branch sells. His interest is in getting the highest bonus possible, so he in turn puts the pressure on the brokers to “pound the phones,” and sell their “latest offering.”  The brokers are enticed by management with trips, dinners, and a host of other items. It goes unspoken that if a broker does not participate in selling the new offering then things will not be easy for him/her.  I know of one broker who was told, “I don’t think this firm is the right place for you,” after the broker refused to sell the new fund offering.  It turned out that he was the only one to not succumb to the pressure, he eventually left that firm.  I can’t begin to tell you how many voice mails & e-mails I received from management to ‘sell’ the “new” offerings, I never succumbed because it was not in my client’s best interest. Be aware that the pressure is on your broker to sell certain products or else he/she risks losing their job.

Conclusion

Brokerage firms (wirehouses) train (brainwash) recruits in sales techniques and product knowledge, not portfolio management and financial planning. They use carrots and sticks to influence brokers to recommend investment products that are profitable to the firm.

According to William Bernstein, brokerage firms target how much they are going to earn from clients’ accounts.

At the end of the day, most wirehouses operate on the “2% rule” – collect 2% in fees and commissions, overt or hidden, on your clients’ assets, or you’re out.

My experience is that the 2% figure is extremely conservative – it is not unusual to see accounts from which as much as 5% annually is extracted.

You will not see these fees and expenses outlined, because they are not easy to discern. Unless you are a detective, they will be hidden from your view.

Is there a better way? Certainly. It is choosing a fee-only financial advisor, who acts in your best interest, as a fiduciary.

To be continued.

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