Chicken Salad?

I have a lawyer-friend who periodically asks for input on various topics. He sent me an email a month or so ago, that generated some thought about annuities. I thought I would share our comments:

Gil:

Greetings from Downtown Houston.

A few years ago, whilst my bride and I were having a great time in The City (New York City), we passed a person in a subway station who was holding a sign that said “I’m begging for money, which I will use to buy booze. Hey, at least I’m not bull-shi..ing you.” The dude was doing very well. Why? As you know, most folks appreciate honesty.

So, here we go.

Annuities.

Bad? Good? Maybe?

So I come across this article (in “The Trust Advisor”).

I know you’re busy. But the article’s short and not very deep (sort of like me), and I bumped up the font size to make it even more reader friendly.

Your thoughts: Chicken Sh.t, or Chicken Salad?

[sic] The annuity article goes on to say how Peyton Manning wins games by avoiding taking hits, and correlates that mindset to annuities purported to do the same thing for investors. The question also comes from a self-effacing and wise investor with 30 years invested in Johnson&Johnson (JNJ) shares with 15x returns.)

Long time no see–

The answer to your question is far more complicated than it might appear. I think the answer is 90% chicken sh.t, and 10% chicken salad. There is an old saying that goes: “Annuities are not bought, they are sold”. Hence, 8% commissions will get a salesman’s attention. My firm can’t earn commissions and our annual fees are less than a tenth of that. Hence your suspicion I will give an honest answer. Seminars spreading the annuity gospel are motivated by that commission, and it can cloud some people’s judgment.

In the case of variable annuities, the annuity sales rep will still see the benefits of tax deferral, despite the alternative choice of a dormant portfolio of JNJ shares also being tax deferred. But there’s no commission in that good advice. JNJ shares with dividends reinvested will likely run circles around annuities for several reasons, but mostly due to taxes and fees. You see, the annuity game ends in ordinary income taxation, while JNJ shareholders have capital gains taxes forgiven at any owner’s death. This makes all of the future JNJ profits tax free to the surviving spouse. Not so with an inherited annuity. This is before you consider staggering cost issues, and commissions aren’t the only cost in an annuity. All in, the fees would likely consume a third of the annual return you might get in stocks (3% annual cost in an 8% return world). And of course, the carry cost of letting JNJ shares sit and reinvest is zero. The JNJ is potentially so profoundly advantageous (or substitute an index ETF for similar effect) it’s not worthy of further discussion.

HOWEVER, annuities have a unique set of benefits that cannot be matched by other vehicles. It is this side benefit that is worthy of further discussion. Annuities that provide lifetime income benefits can encourage risk taking (either inside the annuity or with other money) that an investor short on retirement funds cannot replace. The peace of mind one gets from an income source that cannot die before you leads to risk taking that may prosper an investor greater than the increased cost of the annuity. This same under-saved investor might not get harmed by ordinary income taxation due to relatively low tax rates.

The side negative to that is a greater certainty that heirs receive less or even nothing in residual. Those higher annuity costs as compared to JNJ (let’s says 3 points of annual carry vs. 0) will necessarily increase the odds that a 5% distribution rate will kill the annuity contract prior to the annuitant’s death since it would take 8% returns to keep from exhausting the principal. While this provides income for life to the annuitant regardless of principal remaining, this leaves little to nothing for the heirs.

But what if this income certainty gave an investor the opportunity to own stocks and take principal risks that would otherwise be off the table? Without that certainty, stocks would be too risky to own, since a 40% decline along the way might cause an inopportune reflex liquidation to ease the agony. But by owning stocks alongside or even inside an annuity, excess returns could replenish the account by more than the annuity cost. How many sellers from 2009 today regret that decision, and might not have done that if they had a guaranteed lifetime income (even if small)?

So to me it’s a behavioral issue, not an investment issue. Does the annuity provide an under-funded retiree an opportunity to take risks beyond their scope simply because they have a permanent source of income that makes periodic losses irrelevant? To that case, it’s chicken salad. In the case of an abundant saver, say you for example, total chicken sh.t. I cannot envision a circumstance where you might benefit.

  • Sincerely,
  • Gil Baumgarten
  • President
  • Segment Wealth Management
  • 3050 Post Oak Blvd #1680
  • Houston, TX 77056
  • 713-800-7151
  • gil.baumgarten@segmentwm.com

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