In our discussion of annuity products yesterday, we considered reasons why annuitization could be a good decision for some investors; we also looked at reasons why annuity products are often a bad idea; and we then brazenly tried to reconcile these two hostile camps - by underscoring the value of a steady income while eliminating or mitigating the real-world downsides investors cope with in obtaining that income.
As a reminder, we raised three objections to annuity products: a) potential insurance company perfidy - we argued that that problem is likely exaggerated; b) high fees - we recommended finding low-fee products; and c) tying up one's capital - we argued that one can minimize this problem.
I believe the biggest downside by far is b) high fees. As is so often the case on Seeking Alpha, along comes one of our crackerjack contributors with some valuable amplification of this idea in a newly published article on our site. Kudos goes to Bruce Miller with "Retirement Portfolio Cancer: The Destructive Effect of Expenses on Building Retirement Savings."
Bruce's article is not on annuities per se, though he definitely addresses the topic. Bruce looks at the retirement plan market, segmenting these plans into a low-cost group, a median group and a high-cost group. For good measure, he examines a fourth category of variable annuity-funded retirement plans (spoiler alert: this is the super high-cost group). He then measures the performance over time of all these groups against a fictional no-cost group (akin to a stock index that has no costs, but cannot be purchased by a consumer as it is a benchmark rather than a product).
As we would expect, the low-cost category has a low effective expense ratio, in this case, .22%. Most retirement plan participants are not in this lucky group, but those who are see tremendous earnings grow out of their contributions over time. An employee with a starting salary of $46,000, an 8% income deferral and a 7.5% annual rate of return would end up with over half a million dollars over 30 years and over a million dollars over 40 years. (Bruce stresses the enormous value of that extra decade in allowing the retirement savings to really ferment!)
For an average 401(k) plan, using the same assumptions as above, the plan participant is paying an effective expense ratio of 1.32%. Measured against our fictional no-fee plan, Bruce writes:
Over one quarter of the total plan's expense-free value will be lost to total expenses over 40 work years. This is more than most employees realize is being given up from their savings plans."
As to the high-fee group, Bruce writes:
With expenses running 1.81% in the 'high expense' category, over one third of the 'high expense' portfolio is lost as compared to the zero expense portfolio over the 40 work years. Most employees will consider this excessive, particularly when there are much less costly alternatives available to the employer."
Finally, Bruce tabulates results for the insurance company-run plans that are funded with variable annuities:
Nearly 60% of the 0% expense portfolio is lost to expenses, based on a total average account expense rate of 3.85%. By anyone's tape measure, this is egregious."
Please read Bruce's article for the whole story. For my part, I will add a few thoughts. I looked up some annuity sales statistics. I am not an expert in this area, so please view this as a gross generalization. There are lots of room to quibble with my approach. But to get a quick grasp of things, I looked to group annuity sales in the categories of deferred annuities and immediate annuities for the perhaps overly simplistic reason that the former (while they often have their justification) are where one usually finds high fees and the latter tends to be thought of as consumer friendly (though, again, there are cases where deferred annuities are of greater value to a particular consumer). Using these proxies, I was hardly surprised to see that deferred annuity sales in 2015 totaled close to 500 times that of individual immediate annuity sales. My point: Some products really are sold more than they are bought.
As I noted yesterday, it's quite possible somebody who overpaid for such a product will nevertheless have achieved higher "utility maximization." I would not be surprised to find that annuities owners are happier than non-annuity owners, if such a study existed. Peace of mind counts for a lot in the happiness equation, just as worry, fear and dread tend to detract from happiness. That said, a smart consumer can purchase that peace of mind for less.
Finally, getting back to Bruce's article, it seems to me that a smart employee can request information about the costs of his corporate plan. If they're high, as is usually the case, that employee - perhaps together with other employees - can respectfully request that the employer find ways of bringing down those costs by adopting a more consumer-friendly plan. All it takes is an e-mail or two, but the result can be tens of thousands (or maybe six figures!) of extra retirement income.
As always, we welcome your thoughts in our comments section. Herewith, today's advisor-related links:
- Marshall Jaffe: History suggests the indexing bubble will eventually pop, and the result will not be benign.
- Eric @ Servo debates AQR's Cliff Asness on the value of alternative investments.
- For more content geared to FAs, visit the Financial Advisor Center, sponsored by Franklin LibertyShares ETFs.