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Wholesale Rip-off Part 7: The High Cost, Low Return, Bend Over and Kiss Your Money Goodbye Fund

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Today continues a series, to appear roughly once per month, on the main ways that the financial system rips off the average worker and investor.  This is based upon my nearly decade-long tenure in the financial services industry.

Financial Junk Dealers

So, what is it that we sold?  Crap for the most part.  I mean no product is without some redeeming features and that was true of the products I wholesaled.  One should in this industry never say never and never say always.  We primarily sold deferred variable annuities, so we tended to see the world through that lens.  When you sell hammers, everything looks like nails.

As I indicated previously, deferred variable annuities are cost-laden products.  Costs of course tend to hold back performance as every dollar of expense is not able to be put toward your investment return.  Let’s look more closely at the fee structure of these products.

The base set of fees in every deferred annuity product is called the mortality and expense and the administrative fee (M & E and Admin).  The M in these fees cover the cost of the death benefit of an annuity (which usually gives back the initial investment minus withdrawals regardless of the current contract value).  The E is the expense of the contract.  The Admin. is the costs of administrating and servicing the contract.  Why is this separate from the expense portion of this?  Just because, that’s why.  The total for these fees can range anywhere from 1% to 2% depending on the type of annuity contract it is.

On top of these fees are the costs of the “sub account” management.  Sub accounts are just mutual funds that sit inside the annuity.  These can range anywhere from .30% to 2% depending on the type of fund and the strategy employed.

In addition to these fees there are extra charges if an “optional benefit rider” is purchased.  This is an added provision that can provide features not part of the basic annuity.  The most common is a “Lifetime Income Rider”.  These riders provide a set percentage of the benefit base to be withdrawn annually for life if the first withdrawal is taken after a certain age, usually 59.5 or 65.  These can cost from 1.5% to 3% depending on the features.

Another type of optional benefit rider provides a guaranteed return of principal after a set time, usually 10 years.  If for instance you invest 100K and in ten years, the value of the account is 90K the insurance carrier will make up the difference and pay you out 100K.  These riders typically cost around 2%.

The other main type of optional benefit rider is an enhanced death benefit rider.  This will provide for an increase in the death benefit over and above the contract value minus withdrawals feature that comes standard.  There is normally a somewhat complicated formula to all of this, but the upshot is that a client can increase the amount that their heirs can receive.  These typically cost .5%.

Note that these cost percentages are either calculated on the amount of the contract value, usually at contract anniversary or on the value of the “benefit base” (which makes it more expensive). 

I have not yet mentioned the “surrender fees” which I touched on earlier.  These are incurred only if the client surrenders the annuity and walks away with their money before a pre-determined time, normally 3-7 years.  The “surrender charge” drops a bit each year until the money can be removed free of any fees.  It is not fair to fold this into the annual fee structure, but it does factor into how clients get screwed.

One can immediately see a built-in risk in all of this.  I have not even scratched the surface of the complexity of these products and most investors have already had their eyes glazed over.  Any product not fully understood has an inherent risk to it and a client is therefore more easily ripped off.  If it is any consolation, most advisors don’t understand these products either, except that the commissions are very high.

Added all up a client can expect to pay (for a base annuity, including sub account fees, with one rider and the enhanced death benefit) from 3.5% on the low end to 7.5% on the high end.  That means that a money manager would have to produce a decent return of 4-7% before the investor sees any increase in the value of their annuity.

The (Small) Non-Junk Features

Now as I said, no product is without some redeeming features.  If a client bought the lifetime income option, they did get to receive an income that they cannot outlive regardless of market performance.  The way this optional benefit works is that you start off with an investment, say 100K.  That amount becomes your “benefit base”.  If you are waiting to take income, which most are, then you get to increase that base.  This increase in your benefit base occurs either through market growth or by a fixed percentage under the terms of the rider, usually 5% simple interest.  So, let’s say the market was flat your first year.  The 5% credit feature would kick in and your new benefit base would be 105K the next year.  Suppose that year two the market popped.  The new contract value goes to 115K by the end of the next contract anniversary.  That becomes your new benefit base and the contract “resets” so any applicable 5% credits will be calculated on this amount.  This process continues until either 10 years of credits are applied since the last reset or until the client takes income.  At that point the client can take 5% of whatever the benefit base is for life, assuming the first withdrawal was after a specified age (either 59.5 or 65 depending on the product). 

The client can even grow their income while in retirement if the market carries the contract higher.  However, the market would really need to run for this to happen.  Once you add a 5% withdrawal on top of the high fees the client will need a rise of over 10% in the market to get an increase in their income.  Also keep in mind that the contract value would have to rise beyond its previous high point for an income increase, which if the client has been making withdrawals for several years is unlikely to happen.

The client has effectively “annuitized” the contract.  This means that the amount they start withdrawing is the amount they will likely get for the rest of their lives.   An actual immediate annuity would be simpler, cheaper and allow the client to grow their assets before retirement more effectively in lower cost investments.

All that being said, there may be a certain type of client for whom this investment makes sense.  Primarily a higher earning client who needs tax deferral and sees the value in investing in tax inefficient asset classes via a tax advantaged annuity product.  Of course, this type of buyer makes up a small slice of annuity sales.  Mostly they were sold to clients within ten years of retirement who did not know better than to trust their advisor.

Another Line of Junk

Briefly, we also wholesaled crappy mutual funds as well.  Not just any kind of funds, however, but a fund of funds.  A mutual fund is a pool of money that purchases individual stocks and bonds and using some type of strategy, actively trades those stocks and bonds to gain a return.  A fund of funds is a pool of money that invests in a group of mutual funds who then invests in individual stocks and bonds.  This adds another layer of cost onto the client without producing any measurably greater return or risk management.  This fund of funds approach was also the strategy used for the aforementioned “sub accounts” that sat inside the deferred variable annuities.  Remember the higher the costs the greater the fees to the money managers and salespeople.

How to Sell This Junk (Along with Your Soul)

How then did we sell this crap? First let’s look at the normal shtick that all salespeople use.   It does help to have ignorant clients as well as ignorant advisors (more on them later).  But when you add the ignorance of clients and advisors to some good bullshit you have the recipe for some solid sales.

When you are selling an obviously expensive product you must start with a strong value proposition.  The strongest proposition for annuities is their tax advantaged status.  This of course is the whole point of the lobbying done by the industry.  It does make for a nice opening pitch though.  This facet of these products does lower their effective cost; not to the point of making them a smart investment but it does lower their cost, nonetheless.

Once you get past this it starts to get thick with jargon and spin.  Lots of studies and “white papers” are produced and cited as to why these are a good investment.  For our fund of funds our tag line was “double diversification” and lower risk.  We can then go on to claim it raises the “risk adjusted return”, it raises the “Sharpe ratio” or its “correlated” or “non-correlated” (depending on your need at that moment).  There is acceptable “portfolio turnover” or the other guys is too high.  Perhaps the client is interested in low “residual risk” or a low “drawdown”.  How about the “standard deviation”?  What can that tell us?  How about the Greeks: What is the Alpha? Or Beta?  These are terms and concepts that only relate to the fund performance.

There is a whole other set of terms to discuss the features of annuities specifically.  How can you defend your client against an “adverse sequence of returns”?  When will the retirement plan tip out of balance?  What is the proper “withdrawal rate”?  Are the other guys benefit base and credit features better than ours?  Is our 10% simple credit better than the other guys’ 7% compounded? And on and on and on.

I am not expecting anyone to understand any of this.  The point is that the profusion of jargon and gobbledygook is intended to befuddle the advisor, who will almost never admit that they do not understand any of this (trust me, most do not).  It also serves to give the advisor talking points to befuddle a client who cannot reasonably be expected to understand these concepts or fairly evaluate the competing choices before them.  If an advisor can do this, they can get the client to buy almost anything.

This fact explains why among the blizzard of concepts rolled out, I did not mention the most basic one of all: return.  Advisors simply don’t really care what a fund’s performance is over time.  Yes, it can be an issue if a fund is performing significantly worse than its benchmark.  This is a crucial concept.  A benchmark is selected to provide a yardstick for comparison.  It may be a reasonable benchmark or not.  One of the bond funds I represented used the 10-year treasury as its benchmark.  This is considered among the lowest risk investments in the world and produced correspondingly small returns.  Too bad our bond fund in question was made up entirely of corporate bonds, which are considerably riskier.  Since risk goes hand in hand with reward it produced stellar comparisons.  It would be like comparing my 100-yard dash time against a quadriplegic’s.

This allows the fund and its managers to be judged and paid on relative performance. It also allows a money manager to explain to a client that the whole asset class lost money so there is nothing to worry about.  It is alright to be wrong along with everyone else.  God help the advisor who is wrong all by themselves.  This concept gets added to the mix of jargon and the advisor can get client buy in to invest in almost anything.  Too bad for the client that you cannot put relative performance in the bank.

So, the day-to-day plan was to reach as many advisors as possible and repeat the talking points ad nauseam.  In short, baffle them with bullshit until they have learned the story well enough to convince a client.  As a famous quote has it “the secret of success is sincerity.  Fake that and you’re in.”

As important as these day to day talking points is, what really makes an advisor commit to selling a fund or annuity; and not care about the expense or performance is not surprisingly…the money.  Commissions and “marketing support”.

Let’s look at commissions first.  Deferred variable annuities are among the most highly commissioned of products.  Upfront commissions can run from 4-7%.  Other options trade a lower upfront commission for a “trail” or residual commission paid out quarterly.  Advisors don’t keep all the commissions of course.  They must share this with their back office, the broker dealers.  Typically, an advisor keeps 60-80% of the total commission.  So, if a client invests 100K and the annuity carrier pays $7000 in commission to the broker dealer.  The agent keeps say 60% or $4200.  Not bad pay for baffling a client.

Mutual funds pay in a similar fashion with one notable difference.  A mutual fund investor will typically pay about 5% in commissions.  However, they pay that themselves unlike an annuity investor, the annuity commission being paid by the carrier (which is why there are surrender fees for leaving early).  So, if a client invests 100K into a mutual fund the broker dealer gets 5%, which they share with the advisor in a similar way to an annuity.  The client then is only investing 95K into the market, which of course instantly drags down your returns.

There is obviously a clear tension between the interests of the client and those of the advisor.  So much so that regulators are on the lookout for advisors who “churn” their accounts by repeatedly buying and selling their clients into different investments.  This does not really apply to annuity sales if an advisor waits until the product is past the point of any surrender fees.  For mutual funds an advisor would have to wait for 6-7 years to amortize the cost of the upfront fees to safely justify a change in investment.  Even if an advisor does not churn their clients’ accounts the tension still exists in that advisors are incentivized to sell expensive financial products that underperform.

The other main type of commission is the “wrap fee”.  This is a management fee, like what a fund manager charges, only it is assessed by the advisor.  This fee can range anywhere from .75% to 2% but typically is in the 1.25-1.5% range.  This fee “wraps” around all the assets that the advisor is responsible for in the client’s account.  If the total account value goes up, then the advisor makes more money.  This facet of the payment arrangement is said to negate the conflict of interest inherent in the payment arrangement detailed above. 

If it seems so, then appearances are deceiving.  Yes, an advisor gets an increase in pay if the assets grow in value.  However, they get paid whether they do anything at all.  Parking the money in a marginally performing investment still gives the advisor his/her management fee.  Also, the products themselves, in addition to the wrap fees, are still overpriced and hence a drag on client returns. 

The only type of investment advice that could possibly be conflict free is to charge a client a flat fee to produce a financial plan based on their needs and resources and then have nothing to do with either recommending, selling, or managing the assets.  But where’s the fun or excessive profit in that?

Neither of the dominant forms of payment arrangements changes the fundamental conflict of interest that exists in this business: that the recommendations themselves are bought and paid for by fund companies and insurance carriers.  It is to this topic we turn to next month.

Praise Be to God

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