Variable annuities have some unique benefits. Many also have significant costs that can hold down the growth of your portfolio. In this episode we review what kinds of expenses to look out for that can hold you back.
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Speaker 1 (00:07):
Welcome back to 30 Minute Money, the podcast that delivers action-oriented smart money ideas and bite-sized pieces. I'm Scott Fitzgerald from Roc Vox Recording and Production here in Bushnell's Basin. Joining me in studio for another podcast, Steve Wershing, from Focused Wealth Advisors. Gonna gonna throw down the, the info
Speaker 2 (00:26):
, we're gonna throw it down, down. Nice to see you, Scott. Nice to be back.
Speaker 1 (00:29):
Throw it down. Yeah, I'm, uh, I'm excited. I'm always excited to, to when we get to studio because, uh, I'm gonna learn all kinds of cool things, and I'm sure you are excited too. So the question, I'm sure you haven't heard that often, but you may hear, is why aren't my accounts going up?
Speaker 2 (00:46):
Yes. Well, specifically we're gonna talk about one specific thing about that, and it, and it has to do with variable annuity expense charges. So, um, you know, that, that question came up from a client recently. This is, you know, we've talked about talking about this for a while. And so I decided this is, this is a good time because I had somebody come in just a couple weeks ago and said, you know, we're pretty happy with our advisor, but I'm really, I'm frustrated because my, my, my accounts aren't going up. And we've been in an environment where accounts have been going up. So that was a little confusing to him and it piqued my interest. So we wanted to look into it, and it turns out it's because, um, of what was going on in a bunch of the annuities that they have. So I wanted to talk a little bit about that today. We've talked about a couple different aspects of annuities. We're gonna talk about expenses this time. Okay. And you know, the, the short version of the spoiler alert here, um, you know, what we'll get to is that he was, you know, that his, the, the, the expenses were high enough in some of those contracts that they were just crushing his return. And that's ultimately why it was. So, you know, so you like crush, crush your portfolio. . That's an, that's an old, that's an old reference. Sorry about that. I crush your portfolio , um,
Speaker 1 (01:58):
Kids in the hall,
Speaker 2 (02:00):
Right? Yeah, kids in the hall. Exactly. Yeah, . So, um, so let's, so let's back up for just a second. Talk about what, what variable. We won't talk about all annuities. We're gonna talk about variable annuities. And variable annuities are a particular kind of annuity that, that, that, um, what you earn in it is not stated by the insurance company. It's got a bunch of investment options in the annuity. So they look like mutual funds. Sometimes they're called the same name as mutual funds. They're not actually mutual funds. We'll talk about that in a minute. They're called sub-accounts. Um, but, but it's the kind of an annuity contract that you can get into and then you can sort of manage a portfolio within the annuity. And so it's an annuity with lots of different options in it. And there are some benefits to those. Some of the benefits include, you know, annuities or tax deferred vehicles.
So if you're taking after tax money, if you're taking money out of your taxable bucket and you're putting it in there, you know, as it grows you can get deferral on those taxes. Um, there are death benefits that can come with it. There's a little insurance component. So if your account goes way up and then it drops back down, but then you pass away, you might be able to get the high watermark for that as a death benefit to your heirs. And some of them, and this is probably the, one of the things that's most compelling about some variable annuities, is they have something called living benefits, which will, can give you where they'll guarantee you a certain amount of income that you can take out of it, uh, per year. And that's very popular and, and it, and it can be a really, a really good benefit.
Those are some of the reasons why people would do it. There's a downside to that of course. And the big downside is expenses. And so one of the, one of the principles that we manage portfolios by is managing expenses because we don't know what the market's gonna do, but if you have expenses on your portfolio, we know that's gonna put a drag on your portfolio and the higher the expenses go, the higher the drag on the return and the harder it is to make money in the end. So the expenses is ultimately one of the biggest reasons why you would not wanna get into a variable annuity. And so I wanted to break some of those down and, and list out what some of them are. So first one, most common one and one of the significant, uh, ones is called mortality and expense charges.
Because annuities are, when it comes right down to it, insurance products, insurance companies just can't feel good about themselves unless they build some kind of an insurance cost into everything they do. So in an annuity, it's called a mortality and expense fee or an m and e fee. And the most common one that I see is about a percent and a quarter. Um, so that's one and a quarter percent, that's right off the top for all of these contract oriented expenses. There, there will be some administrative expenses. Um, usually those aren't very big. Um, a lot of annuities cap 'em off at 30 bucks a year, so not really a big deal. Um, then there are the fees of the investment vehicles themselves. And, and those are harder to find. So some people don't realize that they're there because when you look at the expense page, um, in the contract, they don't really break 'em out there because each one is different and you've gotta go searching for 'em.
So in mutual funds, um, there is an expense ratio. So it costs money to run a mutual fund. And so there's a little bit, they take a little bit out of the fund, uh, every day, but it's expressed as an annual number. They take a little bit of money out out of that to run the fund. And one of the things that we look at really closely is how expensive is it? If it's a high expense fund, it's gonna be harder for it to make money 'cause you've got a bigger drag. Here's one of the things that I find really, you know, that surprising and disappointing about variable annuities and that is that, um, within the annuity you have all these investments you can put money into. A lot of insurance companies will contract with outside money management firms, many of them popular mutual fund companies, and they will put sub-accounts in those annuities that are run, like run by the same people look like name the same as the mutual funds that are available to the public, but they're not actually those mutual funds.
And here's the thing, almost always they're more expensive than the mutual fund . So you might have just to pick one at random, you might, you, you could go to Fidelity and you could buy the Fidelity Contra Fund. Very popular fund, very large fund, and you could look at, if you go out to Fidelity and you can look at what the expense ratio is for the Fidelity Contra fund, okay? That's what it is. If you look inside of a contract and the contract says one of the things you can put money into is the Fidelity Contra fund. That's not really, the Contra fund is run by fidelity, run by the same people who run the contra fund. But one of the big differences is it's got a different expense ratio and sometimes that expense ratio can be, can be as much as 1% higher than the mutual fund it's named after.
It's pretty tricky. It is tricky. And that's one of those things that I don't like about insurance companies is, you know, they're really good at burying expenses. So you wanna make sure that you dig into that and find out, you know, what you are paying on a weighted average basis for all of those different sub-accounts. And then here's the, here's the real kicker. I said one of the things that makes variable annuities really popular these days is those living benefits. And those living benefits can be really good. I use them every, I, I think of them as a precision tool. If I have a situation that really needs one, it's great. You know, it like, so I think I've may, may have mentioned this example before I had, I had, you know, a client who really didn't quite have enough, just barely enough to really meet her expenses in retirement.
And I was kind of in a pickle because I wanted to invest in a diversified portfolio, but she was really living on as much as that portfolio could generate. And if we had a really bad market, which happens every once in a while, you know, she could get herself in one of those spirals where, you know, now you're pulling out more than the portfolio can, can return, right? And so you pull that out so the balance goes down and now you're pulling out even more than it can. Yeah. And so you get into this spiral downward. So in that situation, one of those riders was great because if we could just keep to the maximum allowable under that rider, then even if she ran outta money, the insurance company would continue paying that much every year. So it was a great solution, but they're used a lot, they're on a lot of contracts.
And here's the thing about those living benefit riders, I can say two things about them for sure. One of them is they're all different. You know, you could have something called a guaranteed minimum withdrawal benefit, but if you look from one company to the next, sometimes even one contract within a company to the next, the terms are different. And they're, and, and the other thing I can say about them all is they're hideously complex. I mean, you really have to tear these things apart, figure out how they work, you know, so if you want to use it like a precision tool, that's great, but you really need to understand what it costs and you really need to understand how it works. And most people will, would need an expert to go through it with them to figure that out. But here's the thing, those expenses are really high.
Those expenses, you know, can be well over a percent. The example that I started with the, the client who came in who said, you know, how come my account's not going up? The rider on one of those contracts, just the rider was 1.6%. Hmm. So in that case, you know, we took the m and e fees, we took the administrative cost, we took the weighted average expenses for the investments in the contract, and we took the cost of the rider altogether. He was paying ready 3.93% per year on the contract. And when we met, the next time I, you know, I, I could tell him I figured it out. I could see why you're not making money, because that's a humongous drag on a portfolio. So, you know, so we wanna be really careful and, and if you've got variable annuities, you know, and one of, one of the things you should look at really closely, and one of the reasons you might be frustrated about the return is because the expenses are really high.
But if you have one, we have a whole episode about this too, right? If you have one, it doesn't mean that you necessarily wanna get out right away. Because one of the other kinds of fees that they have in these contracts is surrender fees. And so, you know, we want, if, if you find that you're in that situation, you, you wanna have a strategy for getting out of it in a way that's not gonna cause you excess taxes. Excess fees. So I'll give you an example of another client. Another client was recommended. One of these contracts, they got into it, they used after tax dollars to invest in it. They invested in it, held it for 10, 12, 15 years, something like that. And we decided he didn't really need it. He didn't really need the, didn't really need the contract. You know, it had one of those guarantees in it for a minimum income, in this case, the minimum income, they would guarantee him 5% per year that he could take out.
Now, the safe rate, what we, in the financial business, of course we are argue about this all the time, but one of the things that is widely considered to be a safe rate of withdrawals is about 4% per year. So if you, if you're pulling out 4%, it's probably gonna last a good long time. If it's, if it's well managed and well diversified, the guarantee was for 5%. So for all the expenses he was paying, he was only getting 1% more. But here's the problem. So we said, you know what, you don't really need this. It's not doing for you what you need. You have more than enough money to meet your plan. You know, you'd better off, you'd be better off if the money were not in this contract, but if we cashed it in, he would've a huge tax problem. And so, you know, we have to consider that too. So, you know, you want to consider all these things, but before you worry about what action you'll take, what you really wanna understand is what are you paying in total inside of a variable annuity that you own? Because it can be putting a real drag on that portfolio and keeping you from really growing your nest egg.
Speaker 1 (12:07):
Well, there's a lot there. That's, that's a lot of tricky information and it's, and like you said, it's all hidden. Yeah. So, you know,
Speaker 2 (12:15):
Speaker 1 (12:15):
What, yeah, what's somebody, what, what can they do? How, how can they find
Speaker 2 (12:18):
That? So this is, this is, yeah, so this is really, this is really not a do it yourself kind of thing. This is, if you have something like this, you probably the best thing you could do would be to, you know, depending on how much you have in there, it may be worth it to go to, to, to an independent, um, an independent advisor and just say, would you analyze this for me and get an, get a third, you know, get a, I had, I hesitate to say a second opinion, get an analysis and, and you know, going back to the person who sold it to you in the first place can be tricky. You know, it's just like, if, if, if I saw a doctor and they said, well, you should have this major surgery, the first thing I'm gonna say is I want a second opinion. Yeah. I just wanna check because it's a big deal. And you know, you can do the same thing here. You can just pay somebody a fee to analyze it and, and they can tell you, I mean, it's um, somebody who understands this stuff, they know how to do it. They can do it fairly quickly. It's really hard to do it yourself if you don't already have that technical background. So I would go to an independent person and have 'em pull it apart for you.
Speaker 3 (13:18):
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Speaker 1 (14:43):
And of course you could check back into our log of Benny podcasts and, and watch and listen to the one that's, what do I do with my bad annuity? That's right. I believe is what it's called. Yep. So what's your 30 minute action item?
Speaker 2 (14:55):
30 minute action item is if you have a variable annuity, take a look, see if you can figure out what the expenses are or find somebody who can analyze it for you and tell you.
Speaker 1 (15:04):
Alright, well thanks a lot for joining us on 30 Minute Money. You can find steve at focusedwealthadvisors.com. I am at rocvox.com and we will catch you next time.