Evil Commissions vs. Noble Fees

Not too long ago I saw a column entitled, “As Seen on TV: Financial Products You Should Avoid – Ty J. Young,” by Robert Huebscher. Now, normally I would not publish the author’s name, but he went out of his way to someone in his title, so I figured he’s asking for it. Also, there was much to object to in the column, but I will stick with what they always like to hit: those evil commissions.

The thing that struck me was Huebscher’s obviously biased takedown of the product Mr. Young focuses on, the Fixed Index Annuity, a.k.a. the FIA. From Huebscher’s column:

The concept behind an FIA is simple: the investor gets a portion of the upside returns from the stock market, along with downside protection against market losses….

The first thing you should recognize is that this is not an annuity. It is a vehicle that can grow in value over time, but pays no dividends and offers no income. Income comes only if the investor withdraws money. The product is more like a zero-coupon bond, with returns linked to the equity market, than an annuity.

There are options to annuitize the accumulated value of the FIA, but I did not analyze those.

Okay, let’s stop right there. If there are options to annuitize the accumulated value of the FIA, then it is, by definition, an annuity. It is a deferred annuity, not an immediate annuity. But deferred annuities are real, genuine, honest to gosh, authentic annuities. So if Mr. Huebscher is so wrong about a basic fundamental fact, what else is he wrong about? He goes on to say:

There are no fees for this product in the traditional sense. The product is constructed in such a way as to ensure it is sufficiently profitable for the insurance company and for the IMO, which pays a commission to its “advisor.”

Well, yes. It is sufficiently profitable so that the insurance company and its sales force to make a living. That’s a good thing. If the insurance company isn’t making money, it will fail. If it fails, the policyholders will be left holding the bag. We want a robust, profitable, and strong retirement industry.

Still, it always bemuses me how an industry that charges fees around 2.5% – 5%, year after year after year, whether you make money or not, can get so worked up about a commission-based product that doesn’t even come out of the client’s pocket. According to the Center for American Progress (CAP), a typical worker earning the median income and paying the average 401(k) fees over their lifetime, will pay a total of $138,336 in fees in a world where the average 401(k) balance is under $100,000! If you are a high earner, with a starting income of $75,000 or more at age 25, the CAP estimates you will pay $340,000 over your lifetime.

To find out for myself what the impact of that would be, I assumed a 25 year old contributes $6,000 a year to her 401(k) for 40 years, until age 65, and then lives 30 years in retirement, to age 95. Assuming the 7% average rate of return Wall Street advisors like to quote, her balance at the end of 40 years when she begins income would be $1,281,657. Now, assume fees of just 1.5% per year. Her net balance: $864,713. That means that “reasonable” 1.5% annual fee cost her $416,943. A 2.5% fee would cost her $610,577. Remember, this is assuming a constant 7% rate of return with no risk, and no market losses. We are discussing fees only. Not even mentioning the fees beyond age 65.

We also haven’t addressed the most important aspect of income planning, the actual income that can be derived from an account. For decades now, the Wall Street income planning formula has used the “4% Rule,” meaning you can start by taking 4% income a year and adjust it upward by 3% for inflation each year, and expect your money to last for 25-30 years around 90% of the time. However with the fluctuations in the market since the turn of the millennium, that number has now been reduced to 2.8%. That means income in the 1.5% fee example above would start out at $24,211 a year, and in the 2.5% scenario, would start at $18,790. With a 90% chance of success if you actually got the promised 7% returns from the market.

Now compare that to a FIA which has no fee, but in the words of Robert Huebscher, “is constructed in such a way as to ensure it is sufficiently profitable for the insurance company and for the IMO, which pays a commission to its ‘advisor.’” Something Mr. Huebscher fails to mention about the FIA is the nearly ubiquitous availability of the income rider which sets these remarkable products apart from nearly everything else in the industry. The income rider provides the benefits of annuitization, i.e., guaranteed lifetime income, without the main drawback of a traditional annuity – the requirement to give up control and access to your money, beyond the income generated.

Most of these riders have a guaranteed “roll-up rate” of around 6%-7%. Let’s split the difference and make it 6.5%. Using the same scenario as above, that roll-up rate would generate an income fund of $1,1222,287, but there is more. Since the insurance company knows your money isn’t at risk in the market, and since it also uses actuarial-based risk management as an asset class, it can pay you a much greater income and guarantee it for life. That means the FIA will provide, in the above scenario, $50,503 a year in income for two spouses as long as either is alive. If there is money left in the account at the end of the second life, it goes back to the estate, not to the insurance company.

And the agent’s commissions for helping the client into a plan that is going to double or triple their lifetime retirement income? $14,400. Total. For your lifetime, and never from your pocket. Figuring 40 years of saving and then 30 of retirement, that works out to about $205 per year, as opposed to an average management fee of $11,149 for the Wall Street “advisor.”

So is this what Mr. Huebscher is objecting to? That you can purchase a safe product that generates two to three times the income with guarantees: as much as $1.1 million or more if you live into your 90s? That somehow you are being ripped off because there is an annual commission of around $206 paid to the agent? Or is he perhaps objecting to something else? Maybe the fact that if you were to go with the FIA, Mr. Huebscher or his “advisors” would be losing somewhere around $780,000 in fees over the 70-year investment lifetime?

 

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