Earlier this year I wrote 3 Financial Products to Consider Avoiding. This was not intended to be a complete list so here are three more financial products to consider avoiding.
High Cost Variable Annuities
Though I’m not a huge fan of variable annuities, my issue is not with the product but rather with the high fees associated with far too many of the variable annuities sold in the market place. A variable annuity generally entails a lump-sum or a series of investments into sub-accounts, which are somewhat like mutual funds. There are equity sub-accounts, bond sub-accounts, and so on.
Variable annuities are contracts offered by insurance companies. After an accumulation period the insurance company guarantees a minimum payment which can vary based upon the withdrawal term (single life, joint life, period certain, or others). Alternatively the owner can choose to take the payment as a lump-sum or as needed over time, in this case there is not insurance company guarantee.
The expenses generally include an expense ratio for the various investment sub-accounts plus insurance expenses called mortality and expense charges. These are the fees collected by the insurance company in exchange for their guarantee of a payment later on. Some VA contracts also include surrender charges by which the insurance company penalizes you for withdrawing your money before the passage of a set number of years. The surrender charge usually declines over the surrender period.
I’ve seen contracts with annual expenses well over two percent. In my mind this is beyond outrageous and really eats into your ability to accumulate money for retirement. Contrast this with a low-fee (and no surrender cost) option like Vanguard where the expenses are generally about 1/3 as much. Believe me your insurance agent or registered rep isn’t going to show an option like Vanguard or other similar low-cost, no surrender fee providers.
Levered ETFs
A number of ETFs use derivatives and other devices to amplify the performance of the underlying index, such as the S&P 500. There are ETFs that seek to provide 2 or even 3 times the return of their index both long and short (inverse). Again here there is nothing inherently wrong with these ETFs as a product, but my reason for including them is that they are not appropriate for most investors in my opinion. They are wonderful when the market is moving in the right direction and things are clipping along well. But when the market turns in the other direction and the negative returns are magnified 2 or 3 times, your losses can really mount. Additionally these levered ETFs do not track the index that well on a longer-term basis, they are generally designed to follow the daily changes. These can be great vehicles for professional traders and money managers, again in my opinion they are too risky for most individual investors.
Self-Directed IRAs
Technically this is not a financial product, but rather a type of account. Self-directed IRAs are offered by a number of custodians and are accounts that allow investment in a number of alternative investment vehicles that are prohibited by more traditional custodians.
In a July 12, 2012 article USA Today columnist John Waggoner said of self-directed IRAs: “Just because you can do something doesn’t mean that you should. You may be perfectly capable of cross-breeding trout with electric eels, for example, but you probably shouldn’t do it unless you’re very angry at fishermen. You can invest in a wide array of things via your individual retirement account, aside from the usual stocks, bonds and mutual funds. Office buildings? Sure. Small businesses? Check. Unregistered securities? Yep. And you can invest in all of these through self-directed IRAs. Should you? For most people, no. But for a few people, it can make sense.”
Fraud is not uncommon here and the SEC has issued this investor alert about Self-Directed IRAs.
There are certainly legitimate providers and custodians of these accounts. For some investors this might be a legitimate route to go. For most investors, in my opinion, this is a slippery slope at best. Real estate investments in your IRA, do you not remember the recent financial crisis? Using your IRA to fund a business? While no businessman starts a business thinking about failure it is a reality. If you use your IRA to fund a business and it fails, you now have a failed business and no retirement account.
Let’s use some common sense folks. Don’t be swayed by the hype of most of the folks peddling these accounts and the allure of the sometimes exotic investments that often are used to fund these accounts.
Please feel free to contact me with your financial planning and investing questions or to discuss your retirement planning options.
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As long as variable annuities use an inverse pricing approach in assessing annual fees, they will never be in a customer’s best interests, so they will meet the fiduciary standard.
Thanks for your comment Jim. My use of VAs is generally when a client brings one onto our relationship. When possible I try to do a 1035 exchange to a lower cost product. One a couple of very rare occasions we have used them, but always with a low cost, no surrender product.
Love your insight as always Roger. I could not agree more on #2. For those that know what they’re doing, they can potentially be a very apt investment to use. I’ve seen way too many retail investors get into these leveraged ETFs and try and hold them long term only to see significant issues come into play. They can be good if you’re looking at daily swings, but few should really be actively using them. They should be left largely to the professionals and money managers.
Thanks for the comment John. As the columnist I quoted in the Self-Directed IRA section said “… just because you can doesn’t mean you should…” Pertains to leveraged ETFs for most individual investors as well, though an excellent tool for professional traders and money managers.
Roger,
Thank you for sharing your opinion on variable annuities. For many years much like you, I was very down on the use of VA’s, but I became a true believer over the past ten years given the early 2000’s and again in 2008. As you know, Moshe Milevsky was one of the harshest critics of VA’s throughout the 1990’s, however Professor Milevsky as noted in a WSJ article dated July 22, 2009, made two key points, first insurance companies may not be charging enough, given the cost of risk management and secondly that given the reality that most Americans no longer have defined benefit plans to rely upon, VA’s with their built in guarantees can provide an individual their own “personal defined benefit plan.”
In regards to cost you’re correct that with M & E charges, investment management fees and Living Income Benefit riders, total expenses can run in the area of 3.30%, where in a managed retirement portfolio, between investment management fees and advisory fees the total can run in the area of 2.5%, with no downside protection. I would argue that most, but not all, individuals given these two choices would prefer paying an added 80 bps or perhaps more to be protected on the downside.
You mention the Vanguard VA which could be an excellent choice for the “do-it-your-self investor,” however in the advisor world unless the advisor is charging a flat fee for all services provided, an advisor will undoubtedly charge an advisory fee on the entire portfolio, including the Vanguard VA (thereby raising the total cost to somewhere between 2.5% and 3.00%).
The bottom line on all of this is that no individual or couple are the same. Consequently it’s important for advisors just like doctors, to keep an open mind and never stop learning how best to serve our clients.
Thanks for your comment Scott. As I said in the post its not variable annuities that I am opposed to its the high cost versions that I so often see. I charge most new clients and a fair amount of my existing client base a flat fee so on those occasions when I use a VA it is generally Vanguard or a similar low cost no surrender product. As for the downside protection, I’d like to think a competent advisor is pretty good downside protection. Downside protection doesn’t (in my opinion) mean there will not be periods of losses, but rather that the portfolio and withdrawals will be professionally managed for the client to give them the best shot at retirement success. The investors who fared the worst during ’08-’09 were those who gave into their fears and sold. I do fully concur that no one size fits all with any type of investment, annuity, insurance product, etc. It is nice that there is no shortage of products and providers from which we can choose on behalf of our clients.
I agree with Scott. There’s low cost VAs which provide very solid benefits over a vanguard product at 3ish percent, which is not high cost. When you say 2pcnt, you’re really limited to index investments, and some va’s have great guarantees offered on some pretty volatile asset claases like hedge funds, re, and pe.
Also, there’s a vast world of fixed indexed annuities which offer stellar benefits in the 3pcnt (and disclosed!) all in fee range.
Paul thank you for your comment. I’m sorry but I have to disagree with you when you say that 3ish percent is not a high cost. It is beyond high and I would be hard-pressed to endorse any product that charges those kind of fees. At that point I think the only one making out financially is the rep selling the contract.
Scott,
All across America are advisors using the 2008 market to help them sell high cost annuities to scared investors. Don’t forget, the advisor makes more money selling the VA than they do selling mutual funds. Of course, they can do this under the guise of “protection.”
Thanks for your comment, and you hit the nail right on the head. One of the things I love about being a fee-only advisor is that I don’t have suggest products that I don’t believe in in order to make a living. Don’t even get me started on my thoughts on fear-mongering annuity sales types, especially those peddling index annuities.
One question a friend of mine told me that he asks retirees (a question that I think is highly misleading) is: “How much of this retirement can you afford to lose?” Of course, a retiree hearing this question is going to be set up perfectly for the high-fee annuity pitch. Sad.
IF annuities are that great for clients, then give them the exact same commission structure as mutual funds. If the advisor is really looking out for the best interest of the client, then they will have no problem earning the same commission that they would earn from a mutual fund sale.
That is a really bad question to ask in my opinion. I prefer to gain an understanding of how much cash flow/income is needed to support the client’s desired lifestyle and we work from there. As I understand it annuities are a great payday for many reps and sadly I’m guessing that many are sold for that reason and not because they are the best solution for a given client.
I enjoyed your article. That said, what are your thought on index annuities?
Thanks Brian, please see my last reply to the prior comment. Also under the annuity link in the category section on the front page of the blog there is an article that I wrote in late 2011 about Da Coach hawking index annuities, basically the product and most folks selling them make my blood boil. Hope tax season is going well and I look forward to the opportunity to meet you after April 15.
Roger, I needed updated ammunitition for my dislike of annuities, and your blog and various reader comments provided many for me to use. I just heard one of those sales pitches on Friday saying 1.8% is the stock market gain in the past 10 years, and the VA was going to guarantee 3%. The scare tactics sales people use is working, and it is now more necessary than ever to have fee-only advisors like us available to do what’s best for the client.
Susan thanks for your comment. Scare tactics is sadly a great description for how these products are too often sold. As I often say, I’m not anti-annuity, but I am against these types of sales tactics. Real advisors focus on what is right for the client in looking for solutions, too many financial product sales people take the approach that their product is the solution for any problem.
Hi Roger,
I agree with you on the self directed IRA’s. When I was working with plan sponsors at VG, I tried to dissuade them from offering self directed IRA’s because of the potential damaging actions that participants can take using them. Without experienced advise there are too many investment options that could do very real damage.
Nice post!
Suzanne
Suzanne thanks for your comment. I think you might be referring to the self-directed brokerage option that a number of 401(k) plans offer. Assuming this is the case, your point is well-taken. In the plans that I advise that offer this option it is pretty standard to have the participant sign-off on the risks they are assuming and to require them to attend an orientation session at the front-end as well. The self-directed IRAs that I was referring to in the post were from custodians offering to custody non-traditional and alternative holdings like a business, non-listed securities, real estate, a business and the like. Very risky as well and too often a breeding ground for scams.
Thanks for the article. While VA’s in Australia are in low demand, and Leveraged ETFs are yet to really hit our market, DIY IRAs (we call superannuation) are massively popular here.
It’s the most common structure for retirement savings (by dollar value). I’m unaware of the DIY IRA popularity there bit going on OZ experience, I’d watch this space carefully.
It has opened up new business opportunities via specialised expertise for willing advisers to serve that market. Cheers.
David thanks for your comment. I’ve heard the term superannuation but I have to admit that I am largely unfamiliar with any of the details.