The Most Hated Investment In An IRA

Ugh….

….when I was a financial advisor, there was one investment that always drove me crazy. it was frustrating for two reasons:

– It had huge expenses (and, not-shockingly, high commissions to the person who recommended it).

– The client rarely knew they had it and how it might actually be “good” in their IRA (the only reason to actually have this product).

What am I talking about?

An annuity.

To be clear: I’m not talking about the recent developments from the Treasury that you can now have a deferred late-life income annuity inside of an IRA or 401k and avoid tax penalties. That’s a whole different ballgame, and can be a huge win for investors worried about running out of cash.

Nope, I’m talking about a variable annuity inside of an IRA.

Lots of people have them.

According to ThinkAdvisor, as many as half of all annuities sold end up in a rollover IRA. Considering how many people roll over their 401k to an IRA each year, that’s a huge number of annuities.

I just wish I could say most people knew the benefits and problems with this approach.

Problems with an annuity in an IRA

Let’s start off with the question of variable annuities. You’ve probably heard of them, but how do they really work? Variable annuities are “variable” because they have many different savings options. When I first became a financial advisor (about the same time dinosaurs went extinct) it wasn’t common to see annuities with five or six options. Today, most annuities have well over forty options, and some have hundreds. Big name providers like FranklinTempleton, American Funds, T Rowe Price and Fidelity all have accounts inside of many annuities. Many of these accounts have the same name as a popular mutual fund, but the fee structure is completely different.

An an example:

The Dreyfus Stock Index fund is used in many annuities. According to the prospectus (don’t bother flipping…we did it for you and the fee is on page 8) is 0.28%. That seems pretty good until you realize that the Vanguard Index 500 fund does the same thing for 0.17%….or 36% less money.

But that’s not all.

When you open the annuity prospectus/contract specimen, there’s more fees. To give you an example, I found an annuity co-run by Dreyfus on the internet and pulled up their expenses. You’ll find (on page 9) a whole host of additional costs:

Transfer fee (if you’re transferring from another place): $0 – $10
Special Service fee (what the hell is that fee about?): $0 – $25

Annual Service Charge (for what?): $0 – $30 per contract
Mortality and expense risk fee: 1.15%
Administrative charge: 0.15%

Optional annual step-up death benefit (in my view one of the few GOOD reasons to have an variable annuity inside of an IRA): 0.15%

Total additional expenses: 1.45% (plus the dollar expenses listed above AND the 0.17% for the Stock Index fund you chose).

Confused? This makes a mortgage look easy, doesn’t it?

Oh Yeah….and there’s more

Check out page 18. You may pay surrender charges if you decide the annuity isn’t for you. The maximum surrender charge is 7% of the amount you paid in (called the premium), while the smallest is 3% in year six.

If you leave your money in this account for seven years, there’s no additional fee to withdraw your own money.

That’s Just the Variable Part – Now Let’s Talk “Annuity”

An annuity is tax deferred. You don’t pay taxes until you take money out. You also have the ability to withdraw your annuity as a stream of income similar to a pension rather than to take the accumulated value. Why would you want to do this? If you’re someone who’s conservative you might love this benefit….imagine a stream of income you can’t outlive!).

So what’s the problem?

Remember how I said an annuity is tax deferred? Guess what an IRA does? it’s a tax deferral shelter. By buying an annuity inside of an IRA you have a tax deferred savings vehicle inside of a tax deferred shelter.

Ouch.

You could have chosen the cheaper Vanguard mutual fund, paid much lower fees, and ultimately had more money.

So, the point?

If you’ve bought a variable annuity inside of an IRA and you aren’t worried about streams of income you can’t outlive or guaranteed gains in your account, you’ve paid for a whole lotta tax shelter you aren’t getting the benefit of.

….but the person who recommended the annuity is getting the benefit of a big commission for selling it to you.

Questions? I’m happy to answer in the comments!

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When he’s not begging “the man” at All Things Finance to let him post more here, Joe Saul-Sehy is the co-host of the popular Stacking Benjamins podcast.

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