A lot of what we discuss on the show and in the office is theory, albeit well-researched and well-documented theory. But sometimes it is nice to put a real-life example in front of the public. Some people will hear parts of their own situation in the discussion, and may take away some understanding, or at least formulate some of the questions that should ask. There are a lot of lessons here.
So today I am bringing to the show an actual case encompassing many of the aspects of a real-life situation. It involves investment of long-term funds, perceived and actual mistakes, relationships, corrections, and some interesting solutions.
Let’s start at the beginning, just for fun. This case involves a single woman we will call Jane. Jane was a hard worker, divorced, good saver, and has a couple grown kids. A few years prior to retirement she wanted to get started investing her nest egg. One of the "advisors" she met with was an accomplished annuity provider with a large financial institution. Accomplished, that is, if you measure results in terms of annual income.
I once wrote an article about a supposed “great” salesman. He was one of the people I bought out in an acquisition. And he could sell. In fact, people praised him by saying, “He could sell an icebox to an Eskimo.” That became the subject and title of the article.
But the more I thought about that, the more I questioned whether or or not this made him a great salesman. After all, did the Eskimo need the icebox? If not, was this a good sales job, or just another salesman’s commission? And this made me re-think the whole concept of sales.
The wonder of Steve Jobs in his years at Apple was that he could sell us things that didn’t exist, so we didn’t know that needed or even wanted them. He literally created the perceived need and invented the product to fill that need. It isn’t the same thing, and as usual, I digress.
To me, the greatest sales jobs are those that result in everyone being happy. I have an old expression for almost everything. One of my favorites is this: “A good business deal is when everyone walks out smiling, and a good political deal is when no one walks out smiling.” This was business, and Jane very soon was not smiling. Not a good business deal! Let’s see why.
First, Jane and her son told the salesman that they did not like, and did not want, any annuities. He promised to their faces that his investment suggestions were not annuities. Jane bought in, the contracts were drawn, and guess what she purchased – two annuities!
Since this is a learning blog, I’ll start here with the lessons, beginning with Lesson #1. When you receive the contract, READ IT! If it says the word annuity, guess what you have? An annuity. Remember the old addage, “If it walks like duck, and it quacks like a duck……” – you can complete the thought, I’m sure.
Lesson #2. When you receive an annuity, you have a short free look period, meaning that it can be returned within a few days, usually about 20. If you have any doubts, call us, bring it with you, and we’ll tell you what you have and discuss what to do about it. Jane was too late, bringing up:
Lesson #3, which is that annuities have large and long surrender fees. Surrender fees are the way that the insurance company pays the commission to the salesman so that he or she can tell you:
Lesson #4, which is that salespeople will tell you that you don’t pay a commission, because the company pays the salesman. Let me illustrate the absurdity of that statement. Let’s say that you buy an annuity for $100,000. 6 weeks later you believe that you made a mistake, and you tell the company that you want your money back. They will tell you (in my example case) that your account is worth $92,000, which is 8% less that you paid into the account. This brings me to:
Lesson #5, the Surrender Fees. The Surrender Fee is an amount, based on a percentage of the contractual value, that is amortized over a period of years until it eventually disappears. This provision essentially locks you into the annuity for a period of years, at least under penalty of large financial loss from the commission payment. Once locked into the annuities, Jane was eager to get out of the annuity contract, but was under severe penalty for 8 years. So we started to unwind the annuity using the maximum penalty-free withdrawal clause, or:
Lesson #6. Most annuities will allow a certain amount to be taken from the annuity annually without a surrender charge penalty. This is usually about 10%, and while maybe not tax-free, it is free of surrender charges, bring us to:
Lesson #7. The “consumer-oriented” Federal Government has arranged to have you penalized for withdrawing funds from an annuity using a process called “worst in, first out.” Under this provision, funds withdrawn will be taxed at the maximum rate for all the funds in the annuity. It can only be avoided by annuitizing the contract, which is:
Lesson #8. Annuitization is the process of turning a lump sum of money into a streaming cash flow. It can last a set period of time or a lifetime, but in any case it is irreversible. Your money is tied up. Period. Don’t annuitize until you think it over long and hard. Back to Jane. Years have gone by, and her surrender fees have been amortized. They went to zero this year, so we are free to pursue another course. How to liquidate the annuities and start a new program has become our current challenge, and the problems in doing so are represented by:
Lesson #9. It has two parts, as there are two annuities, but the answers are the same. Lesson #9 says that funds withdrawn from an annuity are taxable if either of 2 things is true. First, if the annuity is inside an IRA (Traditional, not Roth), taking any money out of the annuity will make that money taxable at ordinary marginal income tax rates. For a non-qualified annuity, it is taxable so long as there is any investment gain left inside the annuity account. This renders the cash-out option (in Jane’s case) untenable.
On to Lesson #10, this is the annuity in the IRA case. Most of the time I believe that annuities have no place in an IRA. Costs inside an annuity are high. Part of the reason is that the annuity is a tax-deferred vehicle, but so is the IRA. Paying double for tax deferral is usually not a good option. We have discovered a method of creating the best (or, at least, the least-bad) scenario for reclaiming funds from an annuity. It involves a tax-free exchange to another annuity, but one with an entirely different cost structure and investment possibility.
Lesson #11 is the tax-free exchange of one annuity for another. This is called a 1035 Tax-Free Exchange, and is authorized by the U.S. Tax Code. It simply means that an annuity can be exchanged for a different annuity while preserving the tax status quo. It also works for life insurance and real estate, subject to certain limitations. And naturally, this brings us to:
Lesson #12, which is that not all 1035 exchanges are created equally. Normal annuity sales, including 1035 exchanges, generate commissions. For that reason, the consumer must be aware of the possible motive behind a salesman’s advice to do an exchange. In Jane’s case, our solution involves a commission-free exchange, so that concern is nonexistent. Back to our case. Jane has two annuities, and wants to get them out of her life, but the tax consequences dictate that we stay in the annuity arena. So we suggested the newish product from Jefferson National Insurance, which has no commission, and carries with it the benefit of having fees of only $20.00 per month. And naturally, this brings up:
Lesson #13, the investments available inside the annuity ARE NOT all created equal. The beauty of the Jefferson National annuity is that they offer about 380 no-load investment possibilities, all selected from regular mutual funds available to the public. The usually annuity company’s mutual funds are owned and operated by the company itself, and they are usually inferior to, and more expensive than, the publicly-available funds in a competitive environment called the market.
Lesson #14 is simply that the new Jefferson product can be professionally managed, even by fee-only planners. There is no need to go to someone with an insurance license. I suppose you may have figured out that this is:
Lesson #15, the fee-only advisor lesson. Any advisor who accepts commissions opens the door to potential conflicts of interest. Fee-only advisors assume fiduciary responsibility, causing them to have to put the client’s interests ahead of their own. We do that. We are fiduciaries.
Lesson #16 says that 90% of the biggest companies using the term “fee-only” aren’t, according to a recent study. If you are unsure, ASK!
Remember that this is only one aspect of the financial planning process. There are many reasons to use a qualified, fee-only Certified Financial Planner for your long-term relationship. If you aren’t using a fee-only CFP, and if you think that you might want a no-obligation consultation, our number is 904-685-1505.
Van Wie Financial is fee-only. Always.