Thursday, March 20, 2014

A New Twist on Guaranteed Income or More Shenanigans?

As mentioned in my book, Meet Wally Street. The Reason You're Stupid, I talk about my dad's favorite saying when it comes to insurance companies. "That was the old deal. This is the new deal." Generally, as my dad and I were keenly aware, insurance companies often come out with new products that for a time are good for clients. Their typical modus operandi is to make the new product very appealing to clients. Further, they make sure the compensation appeals to the insurance agents who sell it. Both of these factors are the key to the product's development. Later on after they have clients on the books, they jack up the fees that they charge, because you failed to read the fine print. With this in mind, let's delve a little deeper here, shall we?

Most RIA firms like mine are totally against Variable Annuities that are loaded down with commissions and fees. Therefore, insurance companies realize that they are missing out on the cream of the crop of financial advisors which are these RIA firms. So, they got their actuaries to design a product that would appeal to RIA's, or at least that is what they think. What they are really going after are the dually registered representatives who are also registered as an investment adviser with their broker-dealer's RIA firm.

Totally independent RIA's are not easily swayed by a new product from an insurance company. However, you cannot blame the insurance companies for trying. The goal of the insurance company is to put in place a disruption in the marketplace where those advisors who do not fall in line with the herd will be left out in the cold. That's the thought process anyway.

Here comes a new twist on a guaranteed income rider for RIA firms and their clients. Normally, these guaranteed income riders are attached to Variable Annuities. However, now you can attach them to any account with some limitations. You can have an account at your favorite custodian, like Schwab, TD Ameritrade or Fidelity and attach the rider to your brokerage or IRA type accounts. You can invest the account with a select list of no-load mutual funds or ETF's by popular fund families like Vanguard, Schwab, DFA, iShares and others. The taxation of those accounts stay the same. The guaranteed income rider does not change their existing tax status.

The supposed appeal is that you can add this guaranteed income rider to your account or accounts and then you are guaranteed an income stream no matter what happens to your account during the withdrawal phase. Well there are a lot more details to it than that simplistic explanation, but in a nutshell this will work for explanation purposes.

Let's take an example to make some more sense of this strategy of adding a guaranteed income rider to your brokerage account or IRA type account. Assume for a moment we have $500,000 in our brokerage account. The first mistake in making future assumptions is that returns are not consistent. In other words, if we assume a 5% return, then this is something that will never happen. Some years there will be negative returns and others there will be positive returns. No one can accurately predict the return of a $500,000 account over the next 20 years. So, what people do is just assume a flat number like 5%. With this awareness in mind, we will go ahead with the faulty 5% assumption.

$500,000 at 5% per year growth (net of advisor fees) will grow to $1,356,320.14 at the end of 20 years assuming monthly compounding. Let's assume that at the end of that 20 years, we will now turn on the income stream to provide us with 5% in income per year. We continue to earn 5% on the account, but since we are taking out 5%, this means we have a net growth of 0%. The amount we pull out each year will be $67,816.01. We can pull this out for 20 years before we run out of money. So, we grew it for 20 years to $1,356,320.14, then we pull out $67,816.01 for an additional 20 years until we are out of money. This is 40 years of use for the original $500,000. This is what you can assume WITHOUT the guaranteed income rider.

Now let's look at what happens when we add the rider. What will be the benefit of paying the extra fee for the rider? Let's give the fee for the rider the lowest available amount. At $500,000 you eligible for a 0.05% fee reduction from their lowest fee of 0.95% making the fee for our assumption 0.90%. The maximum rider charge could be as high as 2.35% depending on your financial advisors choice and the insurance company guarantee.

Let's take a look shall we? We start with $500,000, but because of the fee, we must subtract 0.90% from our 5% growth which nets us 4.1% per year. (Keep in mind that I am assuming the absolutely lowest fee.) At the end of 20 years, at 4.1% our $500,000 has grown to $1,133,664.34. We want to pull out the same that we grow each year so, pulling out 4.1% will net us $46,480.24 per year making our money last 24 years. However, we are already short $21,336.61 per year in income ($67,816.01 - $46,480.24) just for paying 0.90% for the rider.

The rider guarantees your ability to pull out 4 - 5.5% for the rest of your life if you are age 60 at the time you lock in the rider guaranteed. If we assume 5.5% withdrawal rate, then this would up our guaranteed income stream to $62,351.54. We are closer to our WITHOUT rider annual withdrawal of $67,816.01, but still $5,464.47 per year short. Of course, this assumption assumes that at age 40, you had $500,000 to grow for 20 years. Typical insurance company shenanigans. How many people do you know that have $500,000 at age 40 that they can invest for 20 years with no withdrawals allowed? No withdrawals allowed?

Yes, no withdrawals allowed or your guaranteed income amount is reduced. Also, that fee of 0.90% can be increased by another 0.75% to 1.65%. This knocks our annual income down to a 3.35% withdrawal rate if they raise the total rider fee to 1.65%. As I say in my book, "Remember what my dad said about insurance companies? That was the old deal. This is the new deal."

What if you were 60 years old when you invested the $500,000 and bought the annuity? It would grow as normal, but you can pull out more money in 20 years with the guaranteed income rider. Now that you are 80 years old (typical life expectancy for most people) you can pull out 7.5%. Well, if you are changing the assumption from age 60 to age 80 for the guaranteed income rider, then you have to do the same for WITHOUT the rider. At age 80, do you really need to pull money out for 20 years or more. You are already at life expectancy. The insurance company wants you to believe that you will live to age 100 and you can pull out 7.5% each year guaranteed no matter what. That $1,133,664.34 will last for 13 years pulling out $85,024.83 (7.5% per year), so what your guaranteed rider is assuming is that you will live past age 93 and they will agree to pay that $85,024.83 for the rest of your life. What is the rest of your life assuming you live to age 93? What is the insurance company's risk? Not much in my opinion.

WITHOUT the rider, if at age 80, we pull out the same $85,024.83, then our money will last to age 96. So, our $500,000 grew to $1,356,320.14 at the end of 20 years and we made it to age 96 by withdrawing the same $85,024.83 per year. Why do we need the rider again? We gave up a minimum of $222,655.58 in account growth over 20 years and have to cross our fingers that we never take a withdrawal, plus hope the insurance company doesn't raise the cost of our rider. Plus this also assumes that we do not want to leave our heirs a penny. Idiotic assumptions, are they not? Typical insurance company shenanigans. Since the whole driving force behind this is the guarantees, how good of a deal is this? Damn it man. I got you again, didn't I?

My dad always said, "You're like an Airedale dog. You are a whole lot smarter than you look." That goes for the people who read my book, by the way.