Case Study: Scotty Gets a Variable Annuity




A young adult quit his job after six years and rolled his 401(k) worth $42,000 into a variable annuity because a financial advisor, who was also a family friend, recommended the investment. After three and a half years, this investment was worth $45,700; however, if this money was invested in a diversified portfolio of three low-cost index funds, his investment would have been worth $54,000. This large discrepancy was due to the variable annuity's fees and poor performance of its investment.


Anytime I hear the words “variable annuity,” I can’t help but think of The Big Short, Michael Lewis’ book about the infamous stock market crash of 2008. Lewis detailed the methods and madness behind newly created financial products (and lax regulation and unscrupulous lenders and banks charged with fraud and minimal consumer savings and etc!) that led to the second largest stock market crash in US history.


These newly created products - in this disaster they were called mortgage backed securities, collateralized debt obligations, and CDO squared - had vague names, prospectuses that were hundreds of pages, top-tier credit ratings, all sorts of fees, and investments within the investment. Just like variable annuities.

Explain That To Me

Although variable annuities have yet to be blamed for a collapse in the stock market 1, they are a complicated financial product sold on their “guarantees” and “benefits” while covered in fees and conflicts of interest. Variable annuities also cannot be sold without paying a hefty penalty for seven to ten years.


Add in the fact that variable annuities are a cash cow for the financial industry (variable annuity sales of $235 billion in 2014) and its brokers (commissions on variable annuities are generally 7% = $16 billion in payouts to brokers in 2014), we have ourselves a financial product that may not bring the financial world to its knees but will continue to bleed its consumers dry with complicated financial jargon that makes an expensive investment sound like a good one.


Advocates of variable annuities will argue there are benefits to variable annuities, such as tax-deferred growth, death benefits, and guaranteed income, and I will say that there are much cheaper products that will create the same benefits for a fraction of the cost, like a 401k or IRA, a term life insurance policy, and a bond fund, respectively.


Then I’ll put a study from the US Senate in front of those advocates: Villas, Castles, and Vacations: How Perks and Giveaways Create Conflicts of Interest in the Annuity Industry. I’d ask how financial advisors manage conflicts of interest given the lavish trips and prizes provided for recommending such a product. I’d ask why advisors recommend a variable annuity from a specific company. I’d wonder who this product really benefits and how often all the presumed benefits are actually received.


(For more information on a variable annuity, please see the SEC’s explanation of the product and its risks and benefits.)


To put this all in perspective, I wanted to present a case study I had with a friend of mine:

Scotty Gets a 401k

Over the course of six years at his first job, Scotty contributed a percentage of each paycheck to his 401k, accumulating $42,000. When Scotty changed jobs in 2013, a family friend who was also a financial advisor recommended Scotty rollover the 401k to his firm. The advisor/family friend said he would find a good long-term investment for Scotty.

Scotty Gets a Variable Annuity

Since the broker was a trusted family friend, Scotty agreed, and the broker invested the entire $42,000 in a variable annuity under the auspice that Scotty would not need the money for a long time and was able to be a more aggressive investor at such a young age. Scotty did not understand what a variable annuity was nor did he know how his advisor would be compensated. Scotty said he basically just trusted his advisor’s expertise.

Scotty Doesn't Know

Fast forward to 2017. Scotty gives me a shout. He’s aware what I do for a living and asks me what I think of variable annuities. I give him an ad-libbed version of what I said above. I ask what kind of fees he’s paying annually - he said he has no idea. I ask if the annuity has any riders - he doesn’t know what a rider is. I ask Scotty what the annuity’s surrender charge is - he said he doesn’t know what a surrender charge is.


Based on my experiences, Scotty’s answers were not unusual. The majority of people do not fully understand the characteristics of their variable annuities, particularly the total fees being charged and the commissions and trails2 their broker was making. There are so many different aspects to these investments that clients typically drown in the information and cling to the word “guarantee” and “benefits” in hopes of a good investment.


I asked Scotty what his current account balance was. It was $45,700. I gasped. I made sure I understood him correctly - that the variable annuity was purchased in December 2013 for $42,000 - and now (March 2017), three and half years later after the market performed well, the account had only increased by $3,700 (a total return of 8.8% or roughly 2.6% annual rate of return after fees over 3.4 years)?


Scotty didn’t understand, he thought making over three grand was a great return! I explained to Scotty that no matter the increase or decrease in value, he needs to compare his returns with the returns of a comparable or replacement investment to understand how his investment is doing. In industry terms, this is called “benchmarking” your performance.


Compare the dismal increase in his variable annuity to a $42,000 investment Scotty could have made in a diversified basket of three low-cost index funds during the same time3. His $42,000 would have now been worth $54,045, (a total return of 29% or roughly 8% annual rate of return after fees), or $8,300 more than his variable annuity before surrender fees.

Scotty Needs To Know

How is it possible that Scotty’s variable annuity performed so poorly in comparison? His fees for the variable annuity were high and ate away additional returns, and his actively-managed investments were inexplicably invested heavily in bonds.


Scotty was paying approximately 2% in fees annually (or $1,000 per year) in fees on his variable annuity (approximately 0.9% for his investments, 1.1% for a Guaranteed Minimum Income Benefit rider4, and a $30 annual fee). For comparison, one of Scotty’s hypothetical index funds, SPY, charges 0.04% in annual fees, or 50 times less than this variable annuity.


To make matters worse, tucked deep into the variable annuity’s prospectus, Scotty’s Guaranteed Minimum Income Benefit rider was required to invest in a smaller subset of investments that were less risky (more heavily weighted in bonds) because the variable annuity company stated they had to protect themselves from market fluctuations in order to provide the guarantee.


The variable annuity not only charged Scotty for this guarantee but required which investments he could make. For a 27 year-old like Scotty, investing wisdom states his investments should not be heavily weighted in bonds because he has so much time before he retires and therefore can take more risk to achieve a higher return, and therefore, invest more in stocks (as the benchmark “three index fund” investment shows above).


Furthermore, Scotty’s financial advisor said Scotty could be more risky with his investments, but Scotty ended up primarily invested in bonds. There’s really no explanation or excuse for this.  

Scotty Gets Upset

After speaking to Scotty about all of these factors, he was not pleased. He wanted to sell his variable annuity and move his money elsewhere. But there’s a catch.


Remember earlier when I asked Scotty if he knew what his surrender fees were? Basically, you have to keep your money in a variable annuity for six to ten years or else you will incur a significant surrender fee for selling your variable annuity. Scotty’s surrender fee - after holding it for more than 3 years - was over $2,000!


Even more perverse, and a practice many unscrupulous financial advisors take advantage of, is called a 1035 Exchange. This allows you to exchange your current variable annuity for a new variable annuity with no tax implications. Advisors will make another 7% commission on the exchange and will likely sell this new variable annuity because they say it has better riders, guarantees, and investment options. You’ll also have to pay surrender fees if your old variable annuity was still within the surrender fee window, and the new variable annuity resets your 7-10 year holding period begins anew.


In my time as a regulator, I never saw a client request a 1035 Exchange, I only witnessed financial advisors recommending these exchanges to their clients. Fortunately, Scotty did not have a 1035 Exchange.

Scotty Sells His Variable Annuity

Despite the surrender fee, Scotty sold his variable annuity and moved his money away from the family friend. All in all, Scotty ended up with $43,700, or a $1,700 gain (or a depressing 1.2% gain per year), in the midst of one of the best bull markets ever. Including the surrender fee, Scotty’s hypothetical three index fund investment would have returned $10,000 more than his cost-heavy and terribly invested variable annuity.

Gray Area

After reading all this, you might wonder how a financial advisor could get away advising Scotty to invest in something like this. Seeing as most investors are not financial professionals, they tend to rely on the advice of their broker. Unfortunately, the broker himself relies on the “suitability standard,” the lowest common denominator of standards in finance. Refer to my blog post - A Pro Athlete’s Advisor: Broker or Investment Advisor - for more information on this.


Was the broker’s investment in a variable annuity suitable for Scotty? It’s a gray area and arguments would be made on both sides. Scotty signed the documents to invest in a variable annuity which had disclaimers about the risks and surrender fees and was provided the prospectus which had the investments and riders explained. The product did have beneficial aspects to it, it’s just that Scotty chose to sell the investment and forgo those benefits. That’s what the defense would probably say, and that might be enough to sway an arbitrator to their side. Scotty’s side would be compelling as well. Either way, it’s gray.


This gray area is where a lot of finance operates. Read Matt Taibbi’s brilliant historical retelling of how Goldman Sachs exploited crisis after crisis, and you may believe Goldman was either brilliant, professional, immoral, illegal, or gray. It’s rarely black and white, and even when that happens, we’ve had too many instances to show us money prevails over regulation.


This is my way of saying that individuals have to look out for themselves or have an advocate who will ask the questions that need to be asked in their defense. If you do not have the ability to be your own advocate, contact BrightLights to help.


1 - Though we certainly can't say that about the insurance companies


2 - After a broker is paid his commission on a variable annuity, he/he typically receives an additional 1% “trail” of your investment each subsequent year that you hold the variable annuity. The broker can also take a larger up-front fee on the initial sale and forgo yearly trails.


3 - 70% S&P 500 Index Fund (SPY), 10% Vanguard Total Bond Fund (BND), and 20% Vanguard Total International Fund  (VXUS).


4 - Riders are basically add-ons to a variable annuity that guarantee to pay you more at a later date but charges you extra fees to compensate for those payouts. This benefit - referred to as a “GMIB” - provides a guaranteed payout of approximately 5% per year of the future value of the annuity after you hold the variable annuity for 10 years.