retirement Archives - Bankers Anonymous

August 25, 2022June 14, 2023

Social Security – The 50 Year View

In the beginning of June, Social Security issued its annual Summary Report noting that the primary trust fund for paying reserves will run out in 2034. Twelve years.

Also, I was reading this past week a book by Peter Ferrera published in 1980 called Social Security: The Inherent Contradiction.

In 1980, Ferrera forecast the trust fund would run out in 2030, to which I have two reactions. First – that’s some amazingly accurate forecasting of a complex actuarial system over the span of 50 years! Well done, actuaries. Second – you Boomers have had at least 42 years to fix this. Like, what the heck? I am first eligible for Social Security retirement payments in that same year, 2034. Coincidence? I’m a Gen X kid, I’m used to this kind of treatment by now. It’s fine. Really. I’m fine.

More seriously, the real thing we should understand about the trust fund is this: It’s a useful fiction.

The trust fund isn’t particularly important.

Benefits get paid from current Social Security payroll taxes. The government is not actually investing our dollars. Technically, yes, a partial and temporary surplus of payroll taxes gets parked in low-interest Treasurys, but by no means is this the real source of our Social Security payments. It’s a pay-as-you-go system. Current workers pay for past workers.

In fact, understanding this is a fiction is the key to remaining calm about Social Security. Rather than panic, we should take comfort. The trust fund has never particularly mattered.

As Ferrera wrote in 1980, the idea itself of a trust fund is “a carefully contrived deception meant to mislead the public.”

Ferrera continued, “the entire purpose of this deception is to hide the welfare elements in the social security system and attempt to create the impression that social security is simply insurance without any welfare elements.” I agree.

Whenever I write about Social Security I receive panicked (or conversely, overly certain) emails asking – or informing – me about the Ponzi scheme underlying our biggest government program. This is neither true nor helpful. Ponzi schemes are not backed by mandatory payroll taxes. Social Security is.

I 100 percent do not worry about Social Security running out of money. It’s never been a true trust fund. Rather, it has always been primarily “pay as you go,” transferring tax dollars from current workers to current retirees.

Ferrara’s big idea from 1980 was that Social Security has two functions, insurance and welfare. Most Americans focus on the insurance aspect, in which they think they pay into the system during their working years and they think they get a return on investment back in retirement years. That insurance function is the fakery, and the trust fund a symbolic misdirection to assist in the legerdemain. The true function of Social Security is a welfare transfer.

Although I haven’t spoken with Ferrera, I’m certain we disagree on whether the welfare element is good. I think it is. He thinks it is not.

A not-sufficiently-understood aspect of Social Security benefits is that it deeply favors modest lifetime incomes over higher incomes, when it comes to benefits. This is partly accomplished through “bend points,” which mean Social Security pays based on 90 percent of an extremely modest lifetime salary, 32 percent of a medium lifetime salary, and only 15 percent of higher earnings. I’m simplifying the language around these “bend points,” but the idea is that the welfare benefit of Social Security favors the neediest. To match this focus on welfare, annual income above a certain amount ($147K in 2022) is not taxed for Social Security.

I am confident that in my own life, under reasonable assumptions, I would have achieved a greater net worth if I had never been taxed for Social Security and instead had invested those funds myself. The “welfare” part of Social Security will turn out to be a net loss for me, personally.

For most of my fellow citizens however, the welfare benefit of Social Security is a net gain. And that’s fine by me. This is socialism and should be understood as such.

I say that not as a diss of Social Security. In fact, ninety-six percent of adults polled consider Social Security an important government program. I mean to point out to a Texas readership with all of its preconceptions that a little bit of socialism can be pretty comfortable. Very popular and indeed, necessary. Not having elderly people die of starvation for example is a win in my book.

As for Social Security staying solvent, the real key is in understanding that this is solved with just a series of technocratic tax rule adjustments. The issue is not running out of money in the trust fund (again, the trust fund is largely irrelevant) but rather what small adjustments to delay and diminish benefits or boost taxes will be made to render the entire system solvent.

That was addressed in another 1980s throwback way this past week by former Senator Rudy Boschwitz (R-MN).

While serving in the Senate (1978 to 1990), Boschwitz had written a key memo in 1982 with proposals for shoring up the program. Yes, it is clear folks were worried back in the 80s about the issue.

Last week, in the Wall Street Journal, he listed the various ways to do it again.

Raise the “full” retirement age to beyond 67.

Raise the “early” retirement age to beyond 62.

Fiddle with the “bend points” so that payments are even less generous to higher earners.

Slow the rise in benefits by linking to a different, probably better, inflation index.

Slow the rise in benefits for higher earners.

Make inflation adjustments less frequently.

Tax Social Security income more heavily for higher earners.

Raise the payroll tax slightly to bring in more revenue.

This can all be phased in with many years’ lead time, in a boring, technocratic way. No need to panic. Which again is why I don’t worry about the so-called trust fund running out of money in 2034.

Big thanks to reader Steven Alexander who contributed data and analysis to Ferrera’s 1980 book, crunching numbers on computers back in the 1970s that accurately modeled things like return on investment and the end of the trust fund in the 2030s. I was reading his copy signed by the author.

A version of this ran in the San Antonio Express News and Houston Chronicle.

Please see related posts

My nerdy Social Security Spreadsheet, Part I

My nerdy Social Security Spreadsheet, Part 2

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September 16, 2020September 16, 2020

Social Security in COVID – Research and Ideas

Adding to a vast ocean of unrelenting bad news, let’s explore some troubling research into the fine print on Social Security benefits.

Andrew Biggs, a resident scholar of the American Enterprise Institute, has two papers out this Spring with interesting implications on our most important safety net for retirees.

One paper has bad news for a particular cohort of soon-to-be-retirees. The other explores an idea for helping with current financial distress. I personally think his proposal is wrong, but worth discussing.

Biggs wrote in a recent paper that for a group of soon-to-retire folks – specifically those born in the year 1960 – the COVID recession could be very hurtful to their benefits claimed in 2027, at full retirement age.

In his paper, Biggs assumes the 2020 US gross domestic product (GDP) shrinks by 15 percent in 2022, and that average wages also drop by a similar amount. The net effect of this drop in average wages – as a mathematical input into the Social Security benefits calculations for people born in 1960 in particular – will drop benefits by 13 percent overall. If that happens, for a medium-wage worker born in 1960 in particular, Biggs calculates an annual and ongoing hit of $3,900. For that same medium-wage worker, lifetime social security benefits drop by a present value of $70,193 due to the 2020 COVID effect.

The math justification behind Biggs’ claim isn’t obvious unless you enjoy building your own Social Security benefits spreadsheet.¹

The math trick to know is that before calculating your first benefit check, Social Security indexes your annual earnings to a national wage index – rather than an inflation index, as you might expect.

If the wage index declines by 15 percent in 2020 (Biggs’ assumption), then this national wage indexing of 2020 earnings has a substantial negative impact on your benefit checks starting at age 67. Subsequent retiree benefit checks do increase according to inflation, known as the Cost of Living Adjustment. But if benefits start at a low base, for example, they will remain permanently lowered, even as they move upward with inflation over the years.

An economic recovery may mean later cohorts do not suffer this same temporary drop. Biggs recommends Congress consider interventions to protect this specific born-in-1960 cohort.

The COVID recession – depending on its duration and lasting effects on national wages – may also affect near-retirees born in 1961. So that’s your not-so-great news of the day on COVID.

Biggs also has written another paper in April 2020 which should be filed to the “interesting, but bad idea” pile. In the midst of our national discussions around stimulus payments, Biggs and his co-author Stanford Economist Joshua Rauh propose allowing pre-retirement individuals to take loans from their future Social Security benefits, which could be paid back at retirement age.

For context, private lenders do not make loans specifically collateralized by future social security payments. But Biggs and Rauh propose the federal government become that type of lender.

If a not-yet-retired individual decided to take a $5,000 check now, the authors suggest, the borrower could pay that loan back at retirement age by simply delaying owed benefits until the loan is repaid.

Part of the benefit to borrowers, Biggs and Rauh argue, is that the federal government could offer extremely low interest rates, knowing that it can recoup the money at the individual’s retirement date. This low interest rate helps the individual who could not otherwise borrow cheaply. In addition, warming the cockles of an economist’s heart, this cash infusion can be made budget neutral. Money paid out today during the crisis will be repaid, with low interest, by the worker at retirement.

In their scenario analysis, they show that most workers 45 or older who borrowed this way would likely only delay taking their social security benefits by three months, based on a $5,000 loan made today.

In simplest terms, Biggs proposes a mechanism for financially-strapped workers during the COVID recession to access their social security benefits early, with the obvious implication that they will have less later on, in retirement.

If enacted, (Narrator: this won’t be enacted) this form of pre-retirement loan would clearly impact the most vulnerable folks – people who have no other source of savings.

In general, I like considering any so-crazy-it’s-possibly-good wonky financial idea. But this is more like a so-crazy-its-possibly-terrible financial idea. I can’t endorse robbing future Peter to pay present Peter as a humane way to solve a short-term financial crisis.

When I am declared the National Personal Financial Benevolent Dictator (NPFBD) sometime in the future, I have a few different plans for Social Security. Different from both the current plan and Biggs’ suggestions.

My plan eliminates the need for complicated math and indexing as mentioned by the first Biggs paper. In my plan, basically, everyone gets the same amount of money. It doesn’t matter what your average 35 best earning years are, indexed for wages, then further adjusted for cost-of-living, then made progressive by counting different percentages of a specific workers’ earned wages. That’s a description of the current complicated math, simplified.

Instead, in my simple plan you get, say, $32,000 a year. Or whatever flat amount we choose. Everyone gets the same amount. No math. Congratulations, you’re 67. End of story.

If your lifestyle is above that cost, so be it. You should save some money now so you can maintain your lifestyle. If your lifestyle is below that cost, so be it. You’ll feel rich in retirement.

The complicated math we currently do for social security benefits is a very convoluted way to express a couple of wrong ideas. By wrong ideas, I specifically mean the ideas that:

1. We ‘earned’ our social benefits by a lifetime of working, and

2. If we worked more or harder or got paid more, then we should get a bigger chunk of cash in retirement.

I understand the implications of not doing any tailoring of benefits to individual workers and retirees. I understand why the current system feels “fair” to many. But I think the benefits of simplicity outweigh those implications, leading to a fairer outcome overall.

A spokesperson for the Dallas office of Social Security Katrina Bledsoe said they do not comment on projections or proposed policies, so declined to respond to my query about Biggs’ ideas.

Biggs responded to my query that he is very confident about the math behind his warning about the cohort of near-retirees born in 1960. His biggest doubt is whether the national wage index will actually fall by the estimated 15 percent – a sharp decline – or whether that’s too steep an assumption. At this point – not yet halfway through 2020 – we just don’t know yet.

A version of this post ran in the San Antonio Express News.

Please see related post:

Running for Personal Financial Benevolent Dictator

Building Your Own Social Security Spreadsheet

Building Your Own Social Security Spreadsheet, Part 2

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Whoops, guilty as charged! ↩

November 20, 2019November 20, 2019

FIRE Part III – The Role of Frugality

I’ve recently written about the Millennial trend known as FIRE (Financial Independence, Retire Early), in which people in their 20s and 30s strategize and save and aspire to be able to retire from work very early in their life. While complex planning is interesting one thread links the people I know who successfully retired early: They are super frugal.

Elizabeth

My friend Elizabeth Morse lives in rural New Mexico. Now 48, she retired at age 42. She had previously earned close to $40,000 per year through work, mostly at a private school. Her income spiked to approximately $80,000 for just four years prior to retirement when she worked in the development office of her school. She was pleasantly surprised to be earning that much in those years, but soon realized – by around age 38 – that she could retire very early. She didn’t do any fancy math or tax-savings tricks to plan her FIRE.

Instead, she realized she and her husband Alan could live on around $42,000 per year. Between his pension and their joint savings, they have that covered.

I asked Elizabth about her keys to retiring early.

Elizabeth and her husband, a retired math teacher, previously lived in the faculty housing of their private school, taking financial advantage of that, plus free cafeteria food. Living that way, they saved 25% of their pay every year.

“If I’d had kids or divorced, I wouldn’t be able to do it,” she acknowledged.

Her hobbies come straight out of the 19th Century. They frequently walk in the national forest land that abuts their property. She reads constantly. She knits constantly. She makes her own yarn for knitting, with a spinner. In fact I learned from Elizabeth the origin of the word “spinster.” (Look it up!) As she says, “If your hobbies are free, the money just accumulates.”

knitting — If you make your own yarn, you may be a spinster

They are too far a drive from the nearest town to buy coffee from somewhere else, or to go out to eat much. She bakes her own bread and almost always cooks at home. She recently bought a half-cow and a whole lamb from a nearby ranch, from which they’ll derive 2 years’ worth of meat. By her estimation they will pay $1.12 per pound of grass-fed meat for that privilege. She adds that this quickly justifies the cost of their chest freezer.

Her husband’s tastes and hobbies are similarly modest. Although he loves stamp collecting, he recently scratched that itch by organizing and disposing of someone else’s extensive stamp collection. Which, as Elizabeth explained, provided all of the fun with none of the expense! Philately, I gather, may be pursued either expensively or frugally.

Elizabeth wasn’t always this way. “I grew up as an American in the 1980s, where going to the mall and shopping is recreation.” But as her twenties became her thirties and forties, she figured out what she really liked doing with her time. Which turned out to be shockingly free or frugal. And although she jokes that her non-participation in consumerism is ‘counter-cultural,’ she also sees it as a key to her early retirement.

“Everybody who wants financial independence has to be somewhat counter-cultural. We live in a culture that pushes instant gratification.”

As old-school as this life seems, they aren’t shut off from the world. She’s on Facebook. She and her husband listen to radio and podcasts. Their internet plan at home doesn’t have enough bandwidth to stream video, so they still do the old-school Netflix CDs through the mail. (I thought Netflix CDs through the mail ended in in the 1950s, but that just shows what I know.)

Gerald

Gerald Van Den Dries, now 59 and living near Lake Medina, Texas, retired at age 53 from teaching at public school.

In his highest earning years as a teacher he made less than $55,000 per year. He lives partly from his Texas teachers retirement pension, partly from investments, and partly from part-time work that he and his wife still do – work they do more for stimulation than for the money. Gerald emphasized to me, however, that he and his wife never let their part-time work get in the way of their extensive travel schedule.

Gerald and his family were featured in a newspaper article in 2005 about how frugal they are. This isn’t his first frugality rodeo.

Now in retirement, it’s not that Gerald avoids spending money on meals out, or on travel. On the contrary, he provided to me extensive details of his planning a 66-day trip to Asia. He says he and his wife travel so much they are running out of places to go on vacation. They’ll go out to a steak dinner, if he can get a 30% discount. But if there’s no discount, there’s no eating out.

Gerald takes the cruise ship in the ‘repositioning leg’ of the journey to save money

Just as exciting as the trips and the steak, it seems, are the cheap deals he gets.

They travel off season, picking up flights, hotel, and cruise-ship rides at crazy-bargains. A big part of the joy of travel for Gerald is in the steal he gets by using websites like groupon.com for travel, golfnow.com for recreation, and mindmyhouse.com to save on hotels.

Frugality, for Gerald, is not a cold, joyless existence. It’s a game that he relishes and maximizes. Some people write symphonies. Gerald is the Mozart of saving his money.

Elizabeth’s expressed her counter-cultural philosophy as the commonest of common sense: “The important thing for me is framing my world so that my wants and my needs are not that far apart”

Speaking to Elizabeth and Gerald. the FIRE thing seems to work for a lot longer and a lot more consistently if frugality is not a struggle, but rather an expression of who you are in the world.

As I write this, I see from Facebook that Elizabeth and her husband are in Paris, on a houseboat on the Seine River. Gerald and his wife’s trip to Asia will happen in February.

Their day-to-day frugality and early retirement has led to some pretty big perks.

A version of this post ran in the San Antonio Express-News and Houston Chronicle.

Please see related posts

FIRE Part I – A Taxonomy

FIRE Part II – Doing it The Complex Way

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September 24, 2019September 24, 2019

Running for Benevolent Dictator

Following the Democratic presidential debates, I feel like I could have qualified for a spot among the 20 or even 10-person debate stages, if I’d only rolled out my platform sooner.

I know we can do better on the personal financial policy side. Here are my three big ideas on retirement.

Oh and by the way I’m not running as a Democratic Presidential candidate per se. Rather, I’m declaring my candidacy for National Personal Financial Benevolent Dictator – or NPFBD, which just rolls off the tongue nicely – a position that happens to also include extraordinary legislative power needed to pass my most important ideas.

My first three policy ideas deal with the crisis of retirement.

This is the crisis: About half of American households have zero net worth, and 29% of older Americans have virtually no retirement savings. The returns on Social Security savings are low, the enrollment in workplace retirement accounts is weak, and the costs of investing are too high. As NPFBD, I will solve all this.

I’m not a member of a party. Rather, as NPFBD I’m embracing “Paternalistic Capitalism” as my ideological mantle. For you fervent capitalists, very little will change under my dictatorship – you can continue to save and invest as you always have, and the program is revenue neutral. Read my lips: No new taxes. For you budding socialists, I think you will find my benevolent dictatorship addresses the problem of poverty and financial insecurity at retirement through important government interventions.

Policy #1 – Automatic enrollment in workplace retirement accounts.

About once a day I remember that not every single person with a job is enrolled in a their workplace tax-advantaged retirement account – like a 401(k) or 403(b) – and then I get heart palpitations and red in the face. Gah! Why is this still allowed?

As benevolent dictator, my fellow Americans won’t be able to make that mistake. The day you start your job is the day the HR department at work directs a portion of your paycheck to a retirement account. No ifs, ands, or buts. You’re also automatically invested in an age-appropriate investment fund. You can improve upon that fund choice later by taking charge of your investments, but the default fund will be thoughtfully chosen (by me, your NPFBD, according to your age, and adjusted annually).

Policy #2 – Private market investing of federal payroll deductions

In addition to automatic enrollment in a workplace tax-advantaged defined contribution plan, I’m going to reform the nation’s primary defined-benefit plan for retirees.

So part of every paycheck you receive will be withheld by the federal government, and you get the money back at retirement, but more. Through the decades of your working life this money will be invested by the federal government in private high-return assets, like diversified stock mutual funds.

Now, you’re probably thinking, “So, let me see here…the feds take part of every paycheck throughout my working life, and then I get my money back in retirement…Well um, that’s…that’s Social Security!…This blogger thinks he’s just invented Social Security.”

And fine, yes, there’s a resemblance. But the improvement I’m highlighting as NPFBD is that the money taken throughout our working life is actually invested, under my plan. Like, invested in stocks and mutual funds and stuff that grows in value over time.

Currently, our Social Security taxes are not invested over decades. Rather, our money is either transferred to retirees or loaned to the federal government and earns a very low rate of return. Actually investing our money over decades would, under many scenarios, grow tremendously over forty years of compounding returns. My own calculation recently was that I would have a monthly income about 2.7 times larger if my specific Social Security taxes in my lifetime had been invested, rather than simply earned a low government loan interest rate.

Ok so yeah, it’s a partial privatization of Social Security. Deal with it. You elected me to be NPFBD for a reason.

Also, In order to make this partial privatization the best deal possible, we have to roll out policy #3 at the same time.

Policy #3 – Universal access to the Thrift Savings Plan (TSP), currently only open to federal employees

Even as you read my third policy, the investment management industry (aka Wall Street) is already typing up its response to me. Something along the lines of “Shhh…Shut Up!”

Now, I sense your instinctual suspicion about expanding government-managed retirement funds like TSP. Something like “Gub’mint git yer gosh-darned hands off my mutual funds,” or whatever.

But firstly, private sector managers actually run most of the money, subcontracted by the TSP. Currently, BlackRock is the manager for the TSP stock funds. The federal government just did the important work of simplifying and driving down costs, a major part of successful investing.

Anyone who is a federal worker with access to TSP retirement accounts already knows that these funds are amazing. Amazing – not because they employ brilliant managers of money, as brilliance in money management is over-rated – but because they offer some of the lowest cost funds in the world. All I can tell you – if you haven’t experienced it – is that the TSP is a delightful program, and we should all be so lucky as to have access to it.

As my campaign for NPFBD continues to gather momentum, I will release further plans in the future. In the meantime you are welcome to send me your own crazy-but-good ideas for me to roll out, as your benevolent dictator.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

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July 8, 2019July 8, 2019

Annuities Rant Part III – Moderating my Complaints

I spilled considerable ink this Spring bashing all manner of insurance products peddled as investment products. I base my un-sell of insurance products on their complexity, illiquidity, mediocre returns, and high costs. Now I will pull some of my punches and give a more moderated view of some annuity products.

The summary of my more moderate views: Some people are happy with their variable annuities and have had good returns, without paying excessive fees. If you already own an annuity product, I don’t think you should necessarily sell it right now, or right away. Finally, fixed rate annuities are at least simple. I like simple.

Don’t get me wrong. I don’t actually endorse these things.

Annuities generally put me in a dark place.

Other than their complexity, illiquidity, mediocre returns, and high costs, I like annuities just fine.

It’s like that awful joke: “Other than that, Mrs. Lincoln, how did you like the play?”

I’ve received numerous responses from insurance salespeople this Spring about how weak my arguments are regarding annuity products. I read their responses and think of Upton Sinclair’s wisdom: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” Occasionally, when feeling cheeky, I respond to those emails, with Sinclair’s words.

But a thoughtful column-reader recently responded to my variable annuity-bashing by sharing his carefully kept spreadsheet of his variable annuity with Vanguard, which he bought in 2004. Quite frankly, he’s has been happy with it ever since.

His annuity owns a mixture of seven different equity-based Vanguard mutual funds. Whereas most variable annuity funds I’ve seen charge 1.5 to 2.5% management fees, his funds average 0.55% management fee, which I find utterly reasonable. In addition, the “mortality and expense risk charge” accompanying variable annuity funds – which typically runs from 0.4% to 1.75% across the industry – is a mere 0.17% at Vanguard. Again, quite reasonable.

Not coincidentally, he’s happy to report, his returns since 2004 have been quite competitive.

With a starting value of $110 thousand in early 2004, his funds grew to $340 thousand by mid-May 2019. That’s a 7.7% annual return over a little more than 15 years.

That compares pretty well with an 8.7% return including reinvestment of dividends of the Wilshire 5000 Index of the broad US stock market, or an 8.3% return for the S&P500 index of large US companies. Given mutual fund management costs, I’d say his 7.7% annual compound return on his variable annuity is as good as one could reasonably expect.

His stated reason for purchasing a variable annuity product, rather than a straight brokerage product, is to simplify passing on wealth to his heirs. His belief is that the variable annuity will pass smoothly to his intended beneficiaries without the risk of going through a probate court. I am no estate-planning expert, but if this gives him peace of mind, then that’s great.

One of the distinguishing characteristics about this variable annuity investor is that he was not sold the product by a commissioned salesperson. That partly explains his low costs.

My second moderating comment about various annuity products is that I would not presume to tell anyone to sell theirs, if they already own one. That’s a question that I get asked whenever I talk about how terrible they are.

So I’ll say it clearly: If you have an annuity already, don’t sell it right away. Often in personal finance matters, inaction is the best course. This is because action is costly, and other alternatives could be worse. Maybe what’s done is done. Maybe your annuity works for you. Maybe you have plenty of money already. I’m mostly talking about what you should not buy in the future.

Without knowing anything about your specific situation, a plausible solution to your problem of “I’m currently paying into a terrible annuity product, what do I do?” is to cease paying in to that product, starting paying for a better product, and then over time evaluate whether and how the existing annuity you bought can play a reasonable role in your long term financial plan.

And then finally, what about a fixed rate annuity?

I recently received a quote from my preferred insurance provider for a fixed rate annuity. I wanted to know, assuming I turned over $100,000, what kind of monthly lifetime income could I lock in? The answer is $391.64 per month, for life. I’m 47 years old. Were I older, the monthly payment would be higher, since I’d be more likely to die quicker.

The expected return on my fixed rate annuity was 3%. I don’t find that sufficient. I would never advise anyone with a net worth less than, say, $5 million, to buy one of these.

On the other hand, it’s very straightforward. We can all have different preferences for risk. Some annuities, especially fixed rate annuities, provide certainty. Fixed rate annuities like this are terrible for growing wealth, but have the advantage of simplicity. I like simple. And no fees. You turn over your $100 thousand. You lock in $391.64 for life. They are easily explained and understood. They never let you down.

Except under conditions of medium to high inflation. Other than that though, they’re safe.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Annuities – Death Eaters

Annuities Rant Part I – Complexity

Annuities Rant Part II – High Fees, Low Returns

Variable Annuities – Shit Sandwich

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July 3, 2019July 3, 2019

Annuities Rant Part II – Low Returns and High Fees

Editor’s Note: Please see Annuities Part I here.

Another reason I don’t like fixed rate, fixed index, and variable annuities is their low returns and high costs. These are directly related. The higher the costs to you, the lower your returns.

To begin with the simplest of the three types, fixed rate annuities are the exception in that they do not charge high fees. In fact, generally they don’t charge you any fees at all. Instead, they offer you very low returns.

I recently pulled some quotes from my preferred insurance company. For amounts less than $100,000 I could earn 2.6% guaranteed on a fixed rate annuity for the next five years, and I could earn 3% if I invested more than $100,000. I checked rates with another provider online and received quotes in the similar range of 2.8% and 2.95% respectively. That rate changes over five years. Mine had a minimum reset rate of 1.3%, after the five year term.

What should we think about these rates?

With a product like this, you should always reasonably expect that the annual return on a fixed rate annuity, adjusted for inflation and taxes, will be approximately zero. That’s not a typo. That’s just a rule of fixed rate annuity products and risk-less products in general.

Now, figuring the returns of fixed index and variables annuities is trickier because they are somewhat market driven and depend on what you pick as underlying investments and risks. But we can understand what the costs are, and therefore their expected underperformance versus comparable assets you could buy from a brokerage company.

With a variable annuity you have the chance to purchase mutual funds similar to funds at a brokerage account. Costs will weigh down your returns, however.

The management fees of mutual funds offered inside a typical variable annuity are typically very high. In the 2018 Brighthouse Financial Life (formerly MetLife) policy variable annuity contract I reviewed, the costs of mutual funds ranged from a low of 1.56% to a high of 2.71%. Hello? 1987 just called, and it wants its mutual fund fees back.

The cheapest 1.56% fund was a stock index fund which low-cost brokerages offer at 0.05% – or 31 times cheaper elsewhere. I really didn’t enjoy the 1.66% fees quoted on the Blackrock Ultra Short Bond Portfolio. That fund has a 10 year return of 0.39% – meaning you could have locked in huge losses after fees for the past decade, on a product supposedly meant to preserve capital. These types of egregious fund management costs are the rule, not the exception, when it comes to most variable annuity fund offerings I’ve reviewed. The Teacher’s retirement System (TRS) in Texas just capped mutual fund fees inside variable annuities at 1.75% following a “reform” in October 2017, to go into effect in October 2019. These fees are, in a word, bad. Even after that “reform.”

Why are the fees so high? I have a theory, and it goes something like this.

Insurance companies can impose huge fees on variable and fixed index annuities because they have selected their customers very carefully. Only people who don’t know what they are doing would select these providers and these products. So in essence they can charge whatever they like.

They employ psychology similar to how the “Nigerian Prince” scam artist who supposedly wants to wire you $10 million will purposefully misspell words in the solicitation email. The Nigerian Prince scammer knows that any target victim who replies has no powers of discernment. The misspelling in the email is a purposeful selection process by which the scammer chooses the right kind of victim.

Similarly, whenever a public school employee sets up a “finance and retirement discussion” meeting with a commissioned insurance salesperson, the salesperson can have high confidence that the teacher has absolutely no idea what they are doing financially. The result: high fees, with impunity!

Of course, there are more fees after that.

Arguably the main service an insurance company provides with variable and fixed index annuities is a lifetime guarantee of payments, because they employ actuarial math that helps them make educated guesses about how long you’ll live. That seems like a service. And the insurance company seems to be taking a risk on you.

Ah, but they aren’t, not really. These complex annuities also charge a fee on your account called the “mortality and expense risk charge” – offloading that specific risk that you live too long – to you.

The 2018 Brighthouse contract I reviewed charged 1.2% per year for this “mortality and expense risk,” and the industry range is an extra 0.4 to 1.75% per year on these products. The lesson: If you charge high enough fees, you don’t end up taking a risk.

Finally, here’s my least favorite of all the low-return/high cost features of fixed index annuities.

This gets a bit technical, but bear with me, because this is really how the sausage is made.

The insurance company calculates the ‘growth’ in your fixed index account value based on the change in value of a stock market index over a year, but does not take into account dividends or the reinvestment of dividends that you would get, were you invested in the market directly through a brokerage account.

Over long periods of time working towards retirement – I’m talking about decades – the growth of your investment may be in substantial part due to dividends. Because of the way the company calculates returns, however, you probably don’t get the return on dividends from a fixed index annuity.

Does this matter? Oh yes.

Let’s say you had $100,000 in an S&P 500 brokerage account beginning in May 1989, held until May 2019. The return on the index over 30 years, considering only index price changes, is 7.7%.

However, the return on the index over 30 years, including the reinvestment of dividends, is 9.9%.

Hmm. Is that annual 2.2% difference a big deal? Yes it is. It’s the difference between ending up 30 years later with $818,000 or $1.6 million. But if you, as a fixed index annuity investor don’t get the credit for dividends or the reinvestment of dividends, who kept that money? Do I have to spell this out for you?

Over a long period of time, you may be leaving half your investment gains with the insurance company.

When you are a hammer, everything looks like a nail. Similarly, when you are an insurance company or commissioned insurance salesman, the investment solution everyone needs for retirement is an annuity. It’s what you sell.

As I do not sell annuities, all I can say is: Don’t buy these.

A version of this rant ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Annuities Rant Part I – The Complexity

Annuities Rant Part III – Condoning in Some Ways

Annuities – Death Eaters

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