Just Say No to Variable Annuities

Variable annuities are private financial contracts that provide income for a specified period of time, such a number of years or for life, and are tied to the investment performance of the mutual funds held in the contract. While the promise of a fixed income stream is enticing, I’ll level with you about the many downsides. In short, variable annuities are expensive, restrictive, and unnecessarily complicated financial products that offset any financial benefits they claim to offer.

Caveat emptor (“Buyer beware”). The salesperson pushing a variable annuity is largely motivated by the high commissions they will receive from selling it. I belong in the camp where if you are a financial professional, your fiduciary duty is implicit and paramount, and the client’s best interests always come first. The financial professional should never be incentivized to undermine the client’s best interests for their own gain. However, in the case of variable annuities, there couldn’t be a more egregious conflict of interest.

Here is a plethora of reasons not to buy one:

Commissions. Annuities are primarily front-end loaded, commission-based products. When a salesperson tries to sell you an annuity, don’t be afraid to ask about the commission they collect by selling it to you. Annuity firms can pay out commissions of 5% or more. Reality check: for each $100,000 you plunk into the annuity, that’s $5,000 or more in commissions. Furthermore, the mutual funds held in the annuity charge commission-like fees in the form of front-end loads, back-end loads, and 12b-1 fees.

Surrender charges. Most annuity firms charge a hefty surrender fee, usually on a seven year scale. For example, a $100,000 investment could cost you $8,000, or 8%, in surrender charges if you take your money out in the first year. The surrender charges usually go down 1% per year until reaching 0% at the end of the surrender period.

Fees. Additionally, there is a raft of dubious fees that may be charged by the annuity firm. This can include, but is not limited to, any of the following: asset fees, management fees, annual fees, quarterly transaction fees, withdrawal fees, rider fees, administrative fees, mortality and expense fees. With fees in aggregate costing between 2-4% annually, it’s difficult for investors to make money. At best, stated interest rate contracts (often called “guaranteed” interest rate contracts) may end up only paying out the stated rate (like 2%) because the rest is negated by fees. At worst, the fees negate any profits whatsoever.

Risk. The value of a variable annuity goes up and down with the market, so growth is not assured. Consider what would happen if the annuitant were to die prematurely. If the annuity has not been annuitized, the beneficiaries receive the value of the account. Depending on investment performance, this could be significantly less than what was originally invested. Or, if the annuity has been annuitized, all payments cease, even if only one payment has been made.

Irreversible consequences. Once you annuitize, you give up the ability to recover your lump sum or pass it on to beneficiaries. For example, if you put $250,000 into an annuity at age 60 and agree to receive a monthly income for the rest of your life, it could take 25 years to break even. It’s worth belaboring my last point as well – all payments cease at the death of the annuitant.

Poor tax planning. Once you put after-tax dollars into an annuity contract, withdrawals are taxed as ordinary income rather than at more favorable long-term capital gains rates.

Inflation. Rates are currently at historic lows, and will increase in the future. Over time, the purchasing power of fixed annuity payments is greatly reduced by inflation.

No socially responsible choices. Most annuities do not have any environmental, social, or governance screens that measure sustainability and ethics in regard to investments. As such, your investments may be supporting companies not aligned with your values.

Intentional derangement. Annuity contracts seem to be complex on purpose and the salespeople who tout them seem to skimp on disclosure. If the annuitant doesn’t fully grasp the terms of the contract, this benefits the salesperson, who likely doesn’t fully understand it either. Numerous clients have come to me with annuity contracts from other financial professionals and they can’t make heads or tails of them, and they certainly aren’t aware of all the limitations. Older retirees in particular are vulnerable to this dishonorable practice.

These myriad pitfalls of variable annuities add up to a vehement Do Not Touch With A Ten-Foot Pole rating.

To Lend or Not to Lend – That is the Question

There are times when lending one’s ear to a friend or family member going through a difficult time just isn’t enough. What they need the most is an infusion of cash. Should you or shouldn’t you reach into your pocket and help them out with a good-faith loan? While this intrepid financial planner cannot advise on relationship dynamics and how they might be detrimentally affected with a personal loan, I can tell you how to protect yourself if you do decide to go ahead with one.

Draw Up a Promissory Note
Despite everyone’s best intentions at the outset, a handshake is not enough to seal the deal. The best thing each party can do is protect themselves with a written contract called a promissory note. Basically, the promissory note is a document wherein the borrower promises to pay the lender back. It should state the loan amount, the interest charged, the repayment plan, the per diem for any late payments, and be signed by both parties. Once you have agreed on the interest rate, you can use an online calculator to calculate the amount of each payment over the term of the loan. Regarding repayment, you can arrange a lump sum payment (most common), an installment payment plan, or even a balloon payment plan (rare). Each party’s signature makes the promissory note an unbiased document that can be used as a gentle reminder, a means of exerting pressure, or evidence that will hold up in court (heaven forbid it comes to that).

Also, consider what would happen if you were to die before the loan is repaid. Depending on the amount loaned, you may want to add a line to the promissory note that stipulates that the borrower will either pay your estate back any amount still owed, or receive a decreased inheritance based on the amount still owed. This can protect other family members who will receive their inheritance out of your estate and prevent conflict between beneficiaries.

If there is serious concern about repayment, an added layer of protection would be to have the promissory note notarized, which would officially recognize the document and give you increased legal standing in court, although it is not necessary. However, if there is serious concern about repayment, perhaps the loan is not the best option anyway.

Charge a Favorable Rate
If you make a personal loan, the IRS requires you to charge a minimum interest rate, called the Applicable Federal Rate (AFR), to avoid potential income tax and gift tax consequences. The interest you collect is then reported as interest income on your tax return. The AFR is less than what borrowers would have to pay for a bank loan, but more than what lenders could earn from CDs or money market accounts. The AFR you must charge depends on the term of the loan:

Short-term (< 3 years)
Mid-term (3 – 9 years)
Long-term (9+ years)

What if it makes you feel Scrooge-like and ungenerous to charge the borrower interest? You might consider that the function of interest is to fairly compensate the lender for using money that could have been earning interest elsewhere. By lending that money to your borrower, you give up the opportunity cost. That said, you can still go ahead with an interest-free loan if that is most comfortable.

What happens then? If you make an interest-free loan and the IRS discovers it, they can impute the interest and require you to report it on your tax return. The uncharged interest can be treated as a tax-free gift to the borrower as long as it’s under the gift tax annual exclusion amount for the year (it’s $14,000 in 2016). Otherwise, any uncharged interest over the gift tax annual exclusion amount will need to be reported on your tax return. However, only a handful of people ever pay gift taxes in the end. This is because any amount over the gift tax annual exclusion amount reported on your tax return is added to your lifetime exclusion amount free of Federal estate tax (which is a whopping $5.34 million in 2016).

Let Go
With the promissory note in place, let go of any attachment you might have to the borrower’s use of the money. You have made a careful effort to set up an agreement where you are the bank and this should free you (and the borrower) of any emotional tangles or obligations that belong outside of the loan agreement. Ideally, both parties can compartmentalize the loan and resume their normal relationship with one other.

Estate Planning Essentials: The Advance Health Care Directive

If you are a Gen Xer or older, most likely you remember the highly publicized case of Terry Schiavo, a Florida woman in a persistent vegetative state who tragically became the center of a legal battle between her parents, who wanted to keep her alive, and her husband, who wanted her feeding tube removed because he said that would have been her wish. Since Schiavo did not have a living will, her case worked its way up through state and federal courts, eventually landing on the desk of President George W. Bush, and in the end it took seven years for her feeding tube to be removed.

I can’t think of a better example that illustrates the need for everyone to have explicit end-of-life care instructions, just in case. After all, it is your constitutional right to choose or refuse medical care, so why not exercise it? In California, the Advance Health Care Directive does just this, simply and unambiguously. This Advance Health Care Directive combines a living will and a power of attorney for health care, and following are descriptions of both parts of the document. (To be expected, each state uses slightly different terminology for these documents.)

Living Will: This document describes your health care wishes. The Living Will bears no relation to the traditional will or living trust used to leave property to your beneficiaries at death. It’s a document that lets you state what type of medical treatment you do or do not wish to receive if you are too ill or injured to direct your own care. (Among other things, you can use it to be sure that doctors do – or do not – “pull the plug.”)

Power of Attorney for Health Care: This document names someone to make healthcare decisions for you. The Power of Attorney for Healthcare, also known as a medical power of attorney, allows you to name a trusted person to make medical decisions for you if you are unable to communicate on your own. The person you name to make these decisions is usually called your agent or attorney-in-fact. You can give your agent the authority to oversee the wishes you’ve set out in your health care declaration, as well as the power to make other necessary decisions about health care matters.

Procrastinators take note and go-getters take a breather – it is a misconception that this is a costly and cumbersome process. You do not need an attorney to draft the Advance Health Care Directive for you as you can easily do it yourself. Conveniently, the Advance Health Care Directive provided by the State of California Department of Justice Office of the Attorney General is available on this website: https://oag.ca.gov/consumers/general/care#advance. Click on the link to “California Probate Code Sample Form.pdf”, download the pdf, and print. All you need to do is fill out the form, have it signed by two witnesses, and then keep it in your files. Needless to say, for most people this can be a significant accomplishment in estate planning, an oft-neglected subject.