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Rolling over your 401k and the Dangers of Variable Annuities

So you’re all excited because you’ve finally landed your dream job. You’re getting paid more, and you’ve met your co-workers. Then, you get approached by your financial advisor about rolling over your 401k.
What should you do?

I don’t give investment recommendations, but I know I’ve really come to love and appreciate Vanguard for their low-cost index funds.

I’ve also learned from years in the financial services industry that variable annuities are the cigarettes of the investment world.

Getting great investment advice is critical in building financial momentum.  I’ve connected with some really great financial professionals in the past, but the financial services industry is fraught with conflicts of interests & rip-offs.  I say this because I spent a short time as an investment advisor, registered representative, and financial advisor with two large firms.

While working as an investment advisor & registered representative with both Mass Mutual & Thrivent Financial for Lutherans, I got to see the opportunities for the industry to be dishonest.  This wasn’t because the people were immoral or anything, but because their income was tied to their ability to sell high-commission products, of which, the variable annuities paid the highest.

First and Foremost, What is a Variable Annuity?

If you really want to know the details, go here to learn.  I’m going to focus on the really basic stuff here that’s most relevant.  Basically, Mutual Funds, Variable Annuities, ETF’s, and other derivatives are like “baskets” of stocks and/or bonds.  Each “basket” can have a whole bunch of different stocks and bonds in them, so you can own like 10-150 stocks in one bundle, rather than having to buy a hundred different stocks.  They make it easy for regular investors to be diversified and own stocks, bonds, or other investments.

Just like a ready-to-buy Easter basket, financial institutions build these “baskets of investments” differently to accomplish diverse objectives, and they charge fees and commissions in order to build these baskets and manage them for you.  These charges are made through internal fees called an “expense ratio” and sometimes up-front commissions called “loads”.  For instance, you might see a Mutual Fund from American Funds have a 5% front-end “load” or initial cost, and then an internal cost of .60% every year.  That means that when you invest, 5% comes off the top right away and reduces your account balance.  Then, as your money sits in the basket, they suck out a small percentage throughout the year totaling .6% in this case.  Prices and the make-up of these investments can vary wildly between companies and products.  Each mutual fund manager works hard to buy, sell, and choose which stocks or bonds they want to hold in the basket so that the returns are good for the investor.  The problem is, picking and choosing has proven to be nearly impossible and the average, non-active investment basket does better over time than an investment that’s swapping things out according to predictions and bets.  

Variable annuities are basically like mutual funds in that they are a basket of stocks and bonds but variable annuities usually have extremely expensive internal fees because they have some faux “benefit” to them.  This benefit is usually a seldom-beneficial “mortality” benefit which will pay you something when you die.  So the variable annuity Easter Basket is like a basket full of stocks and bonds that you pay far more than usual for. (Watch out for the “no-load Variable Annuity Sham”).  So the first point is that Variable Annuities are expensive.

So, all that to say – the first point is that variable annuities are expensive.

When you add the mutual fund expense ratio, the “M&E expense”, and other expenses, a variable annuity will usually cost an investor between 1.5% and 3.5% a year.  That’s extremely high, particularly when the often better performing index funds cost .015% a year from companies like Vanguard or Fidelity.  

variable annuities the cigarettes of the financial services industry
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Not only are the fees extremely high, but most of the variable annuities have what’s called a “surrender schedule” which forces you to keep your money in the variable annuity for a certain mount of time – or you incur a penalty fee.  The fees are high too!  A company I was with had a 7 year surrender schedule, where if you pulled your money out in the first year, a 7% fee applied, a 6% in the next, and it reduced each year until there was no longer a fee.

That means that you are stuck in an expensive product – or you’ll have to pay a fee to get out.

Another problem with variable annuities is that financial advisors get extremely high commissions for selling them.  For example, one company I worked for had a 3.7% payout for putting money into a variable annuity – and the compensation plans rewarded you greatly for hitting certain levels of production.  There are companies that I’ve heard rumors about that will pay out close to 10% commissions for selling their product.  

So not only are they expensive, but the advisor will try to get your to buy them – which seems like a conflict of interest. 

Think of it, if you’re investment didn’t perform well, over 7 years, you would end up paying nearly 14% in total fees just sitting there. (2% total cost over 7 years).  That’s brutal compared to the option of investing in an S&P 500 index fund for a total expense of about .015% a year.

If you are talking to a financial advisor, registered representative, CFP or Investment Advisor and they start talking to you about the great benefits of a variable annuity,  run for the hills because chances are that it’s not in your best interest to buy a variable annuity (there’s almost always a better alternative).

The most common companies that you’ll encounter handing out advice to roll over money into a variable annuity are the large insurance companies that have registered representatives working for them.

How this usually looks is that you will get “comprehensive financial planning” from one of these companies, and then far along in the process, the advisor will present you with a number of “suitable” options to invest your money.  What you will typically see is a couple of things:  

  1. Front loaded, Proprietary Mutual Funds
  2. Variable Annuities
  3. “Wrap Accounts” or “Fee Based” accounts

Each of these is relatively “expensive”, but not as expensive as being a fool with your money.  Great advice is worth paying for, and you will usually benefit more than the cost you are paying – if they are up-front with you about things.  

Be careful about who you trust your money with.

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