More on surrender charges and the negative compounding effect caused by "lost" money.
In April's column, I wrote: "Large insurance companies that offer annuities [in 403(b) plans] charge schoolteachers unconscionable fees ranging from 200 to 500 basis points in exchange for poorly performing investment products and services provided by salespeople disguised as 'financial planners.'"
Since one reader characterized that range of 200 to 500 basis points as a "gross misstatement," I set out to show in May's column that 403(b) plans not only have explicit costs but also implicit costs, which such readers seem to outright ignore as if they don't exist.
But alas, all those costs (and more) do, in fact, exist: 1) explicit costs (for variable annuities only), which can range from 250 to 335 basis points (or more if a rider for living benefits is added, for example), are composed of mortality and expense fees of 100 to 185 basis points and a mutual fund annual expense ratio of 150 basis points, and 2) implicit costs, which can range from 125 basis points to more than 1,000 basis points, are composed of brokerage commissions of 45 basis points paid on transactions, bid-ask spread costs of 40 to 1,000 basis points and market impact costs of 40 basis points. Based on this, I came up with an estimated grand total of 375 to 460 basis points (or more) which, though I didn't advance beyond 10th grade algebra, I believe is in the more expensive part of the neighborhood of that gross misstatement of 200 to 500 basis points.
"Per Head" Administrative Charges
But wait (as the infomercial goes), there's more! The "more" is an annual administrative charge of $25 or $30 borne by a teacher's 403(b) account (which ends only when an account grows typically to $30,000). This kind of charge has a particularly lethal effect on school teachers who are in the early stage of their careers and therefore are not usually deferring a lot of money. For example, suppose that a teacher defers $100 per month into its 403(b) account for five years, the account grows at 8% per year and the teacher is assessed an annual per head charge of $25:
Year 1: $25 ÷ $1,200 = 2.08%
Year 2: $25 ÷ $2,496 = 1.00% ($25 ÷ $1,200 + year 1 plus earnings)
Year 3: $25 ÷ $3,896 = 0.60% ($25 ÷ $1,200 + prior two years plus earnings)
Year 4: $25 ÷ $5,408 = 0.40% ($25 ÷ $1,200 + prior three years plus earnings)
Year 5: $25 ÷ $7,040 = 0.36% ($25 ÷ $1,200 + prior four years plus earnings)
The average annual administrative charge comes to 91 basis points (2.08% + 1.00% + 0.60% + 0.40% + 0.36%) ÷ 5 = 0.91%. That is, nearly one additional percentage point of costs--in addition to something within the range of 375 to 460 basis points--must be borne by teachers least able to afford it in the early stage of their careers. The addition of 91 basis points increases the range to 466 to 551 basis points. You can bet that the insurance companies following such a wonderful business model are thinking only one thing: "Cha-Ching!"
I mentioned, but didn't discuss, the costs of surrender charges in last month's column. These charges, more formally known as "contingent deferred sales charges," are imposed by insurance companies when a person decides to terminate an annuity. A surrender charge is normally expressed as a set of percentages of account assets that declines over time. For example, a colleague informed me last month that he had recently run across a defined benefit plan in which a doctor was sold a variable annuity by a (young) agent of a very large and well-known insurance company. The annuity featured a nine-year surrender period with declining charges of 8%, 8%, 8%, 8%, 7%, 6%, 5%, 4%, and--Ta Da!--only" 3% in the ninth year. Oh yeah, the costs of this particular gem of a product amounted to nearly 500 basis points.
The Negative Compounding Effect on Accumulating Wealth Caused by "Lost" Money
I also mentioned in last month's column, but didn't discuss, the negative compounding effect on accumulating wealth caused by "lost money." It should be readily apparent to anyone that sundry costs, expenses, charges, commissions and fees (whether totaling 200, 300, 375, 460, 551, or more basis points) are damaging, over time, to the accumulating wealth of a 403(b) account. Few are aware, however, of the additional yet invisible damage to that wealth inflicted by the negative compounding effect of money used to pay for these costs, expenses, charges, commissions and fees.
This money can be thought of as "lost" because it is immediately gone forever and can never join its brethren in helping compound the future wealth of a 403(b) account. The total adverse impact of such costs, expenses, charges, commissions and fees is therefore composed not only of their immediate visible blow on current wealth but also their invisible blow on future accumulating wealth. Consider how the terminal wealth of a current $50,000 403(b) account growing at 8% annually can be dramatically different due to costs:
|403(b) Costs||20 years||30 years||40 years|
Notice that over 40 years, a 403(b) account with low costs (1.25%) generates nearly $500,000 more than one with high costs (4.00%). Even in some parts of California that's considered a lot of money. And who do you suppose that $500,000 goes to in the high cost account?
I was taken to task by one reader for suggesting that fixed annuities have up-front commission sales charges and bear other costs. The reader is technically correct that fixed annuities don't have fees (other than an annual maintenance/administration/contract fee of $20-25). But since we're dealing with reality, let's stick with that for now. And the reality is that even though fixed annuities don't have explicit fees, they sure do have implicit fees, which are called "spreads" in the industry.
Consider an investor earning 2.5% in a fixed annuity during a period when short term interest rates are 5%. That investor wouldn't be getting a good deal since there is an implicit fee (i.e., the opportunity cost) of 2.5%. In fact, many products in the 403(b) world start out with high teaser rates which are then dropped quickly to the minimum guaranteed rate, all the while using an investor's money to earn about 2% to 2.5% over and above what the insurance company pays to the investor. I think that any economist worth its salt would call that (i.e., the spread of 2% to 2.5%) a "cost," and so would any investor if it were disclosed to the investor in an understandable way.
As for the (apparent) lack of an up-front commission sales charge, does anyone seriously believe that a fixed annuity is sold without the insurance company compensating the salesperson who sold it? In fact, the insurance company recovers those "phantom" commissions via the series of surrender charges imposed by a fixed annuity. The fact that an investor "technically" doesn't pay up-front commission loads in a fixed annuity is merely a distinction without a difference, as my law school professors were fond of saying.
Investing Directly in Mutual Funds in a 403(b)(7)
In 1974, Congress began to allow participants in 403(b) plans to invest directly in mutual funds without bearing the second layer of fees imposed by an annuity. About 20% of assets in 403(b) plans are so invested today. The problem is that many of these assets are invested through brokerage firms which pose their own problems because they generally have high cost products as well.
A provider such as a low cost mutual fund company would seem to be a plausible option for 403(b) plans. The problem, though, is that many school districts require such companies to sign agreements with "hold harmless" clauses that respectable companies simply won't be a party to. (There are even some school districts with contracts that hold them harmless even if they happen to abscond with 403(b) money.) Any provider that would sign such an agreement is obviously doing so because the profit potential is very high. And that's why insurance companies which can afford to lose billions of dollars sign such agreements and why low cost mutual fund companies which cannot afford to lose such money do not.
Two, Two Tax Shelters in One, Redux
A reader e-mailed me about language in April's column that concerned placing an annuity (a tax shelter) inside a retirement plan (a tax shelter): "[Y]ou make a big point about the wrongness of putting a tax shelter inside a tax shelter. Please, there is no cost to the annuity tax shelter. It is a function of the annuity product, and does not have a cost. It is irrelevant." Regardless of whether or not an annuity loses its tax deferral once it's placed inside a tax-deferred account, the larger point made in April's column is that an annuity sold in a retirement plan creates a double layer of fees. In any event, it seems to me that it would be wrong of a salesperson selling an annuity in a retirement plan to tell a client that the annuity was providing a tax deferral.
Lifetime Income Guarantee of a Variable Annuity
A number of readers asked me why I didn't mention the advantages of purchasing a "living benefit" rider in order to secure the lifetime income guarantee of a variable annuity. After all, who wouldn't want a product guaranteeing them that they won't lose money? The only problems with such "guaranteed" products are that they're quite expensive and, in some cases, difficult to collect on. Where the variable annuity is used for both accumulation and payout, an investor could pay the living benefit rider, say, for 20 years and then die before it ever got to take advantage of the added benefit. The investor gets its money's worth only if it lives longer than the insurance company thinks it will. The investor could, on the other hand, just invest in and accumulate low cost mutual funds and then buy an immediate annuity upon retirement. There's just no need to pay the high costs of a variable annuity during a participant's pre-retirement, accumulation phase to get a guaranteed income payout in retirement.
Another reader e-mailed me about equity-indexed annuities. Oh no, here we go again. Melba! Quick! Get me my blood pressure medicine!
Note: The following sentence appeared in April's column: "Fixed annuities or variable annuities offered as investment options in a tax-deferred retirement plan such as a 403(b) plan (or 401(k) or 457 plans) are typically invested in baskets of a half dozen mutual funds wrapped inside a life insurance policy." A reader suggested that the last three words of that sentence--"life insurance policy"--should be deleted and the words "variable annuity policy written by a life insurance company" should replace them. He is right, and I now stand corrected.
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