“Never invest in any idea you can’t illustrate with a crayon.” – Peter Lynch’s Principle #3 of Investing
While this is an article about annuities and their many potential pitfalls, this must be taken in context and prefaced with some important background information. As participants in the City of LA’s Fire Police Pension System (LAFPP) we are blessed with a very generous retirement system. Now of course, we have to “put our time in,” but if we choose to go the distance we can receive 50% – 90% of our Final Average Salary (FAS). To put this in some historical context, up until 2002 the maximum pension benefit was 70% of FAS for 30 or more years of service. It can safely be said that our standard of living in retirement has drastically improved.
…the proposition that someone suggests you purchase an annuity with your DROP or DC assets seems very suspect…
For most firemen or police officers, the current pension payout will usually provide sufficient income to support a comfortable retirement. In addition, most pension plan participants are contributors to the City’s Deferred Compensation Plan (DC) and the vast majority also participate in the DROP Program. So a healthy pension, plus DROP and DC assets may add up to an income level that can equal or exceed your FAS. This leads us to the point I’m trying to convey in this article. Given these conditions, the proposition that someone suggests you purchase an annuity with your DROP or DC assets seems very suspect. Sales techniques used to push annuities can vary from “you could lose your pension if the city goes bankrupt” to “an annuity can be used to diversify your portfolio.” In reality, after careful scrutiny, both fear-based scenarios are very unlikely and inaccurate.
To further support the statement that annuities usually aren’t best suited for investors like ourselves (and this goes for most individuals with a substantial defined benefit pension) some basic annuity information is in order. Annuities are insurance products that broadly fall into two categories: fixed and variable. Within these two groups they are typically either immediate or deferred. This is where confusion gains momentum and the financial wordsmiths come out in full force. Salespeople often use terms like Variable Annuity, Equity Indexed Annuity, Life Annuity and Indexed Annuities with potential investors. Understanding exactly what you are being sold is critically important. The majority of annuities sold are some variant of a Variable Annuity. This is an insurance contract you buy from an insurance company.
If annuities aren’t best suited for someone with a large defined benefit pension, who are they good for? An investor with a substantial amount of assets that are not within tax deferred accounts (for example our deferred compensation plan, a 401k, or 403b plan are all tax deferred) may want to use an annuity’s ability to have assets grow tax deferred. This brings up an important point. May peddlers of annuities will state “your investment grows tax free.” First point is – our DC assets also grow tax free (we are only taxed when we pull the assets out). So the selling point that an annuity has certain tax advantages is irrelevant if you are using DC or DROP assets to fund this purchase. An annuity might be good for a business owner who has sold their enterprise and has a large asset pool subject to ordinary investment income and capital gains taxes. Another beneficiary could be someone who has sold a large real estate holding and seeks to diversify their income stream with an annuity. But again, for the most part, keeping assets with the DC plan or utilizing an IRA rollover when you retire is preferred to locking up assets in an annuity.
Annuities have been subject to a fair amount of regulatory scrutiny due to marketing techniques that haven’t been exactly accurate when comparing them to other investment options. FINRA (the Financial Industry Regulatory Authority) has issued an “Investor Alert” regarding Equity-Indexed Annuities (EIAs) titled Variable Annuities: Beyond the Hard Sell. Further, the SEC’s Office of Investor Education and Advocacy has weighed in also with an “Investor Bulletin” on Indexed Annuities. This bulletin outlines many factors that are typically not discussed with prospective purchasers of these insurance products. Annuities have been able to gain popularity after investors have witnessed two significant bear markets in recent years. But, most individuals who are sold these insurance products are frequently not informed of an annuity’s high commission sales fees, lockup periods and from FINRA “a variable annuity within a tax-deferred account . . . may not be a good idea.”
Before you consider any investment make sure you fully understand what you are buying. Ask about lock-up periods, surrender charges, Contingent Deferred Sales Charges (CDSC), and the overall fees to manage the annuity (this can be as high as 3% per year).
Kurt Stabel is the founder of Andorra Investment Management, Inc and an active LAFD member. You can reach Kurt at kurt@ai-mgmt.com or (562) 433-1400
* Peter Lynch ran Fidelity’s Magellan Fund for many years and coined the phrase “invest in what you know.”
Information for this article was gathered from various independent sources. For more detailed information please visit:
- FINRA: http://www.finra.org/web/groups/investors/@inv/documents/investors/p125846.pdf
- SEC: http://www.sec.gov/investor/alerts/secindexedannuities.pdf
- American Association of Individual Investors: http://www.aaii.com/journal/article/the-costs-of-owning-an-annuity?adv=yes
