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Tax-deferred annuities often a big mistake

Updated: May 3, 2013 12:14PM

Originally published: August 22, 2005

It’s becoming a national financial epidemic: tax-deferred annuities sold to people who don’t understand them, don’t need them, and might even be harmed by their high fees and surrender charges. The people who fall for this trap tend to be seniors, widows and others who have a sum of cash to invest and are seeking security. Instead, they get locked into expensive and ongoing management fees.

And what do the salespeople get? Huge commissions. As much as 10 percent of the initial investment, and ongoing commissions for years after that!

It’s a huge violation of trust because a great number of these tax-deferred annuities are sold inside banks, where the trusting clients don’t realize they aren’t dealing with a banker. They’re dealing with a securities broker licensed by the bank, and paid on commission.

What are tax-deferred annuities? An insurance contract that allows your money to grow tax-deferred until after age 591/2, either in a fixed-rate product or a mutual-fund-like sub-account whose value depends on your investment judgment. There’s nothing wrong with the products if used correctly. But if you don’t understand their costs and restrictions, a lot can go wrong.Unaware buyers

Here are just two examples from e-mails I received in the last few days.

First case: The trusting widow. Sue is a 60-year-old Texas widow, a teacher whose husband died unexpectedly, leaving a substantial 401(k) plan. Sue owned other savings, and eventually would have her own pension, so she didn’t need the money immediately. She went to her bank for advice.

Sue told me that her “banker” suggested a tax-deferred annuity, and helped her move the $206,000 that was in her husband’s retirement plan at Fidelity.

What’s wrong with that? As a widow, Sue could have simply rolled over her husband’s retirement plan into her own IRA at Fidelity without incurring any tax liability. There it could have continued to grow tax-deferred in similar, but less costly mutual funds, until she reached age 701/2, when she could start taking at least minimum withdrawals. There would have been no surrender charges, and much lower annual fees.

Sue’s “banker” was a securities salesperson licensed by the bank’s securities division. Instead of giving unbiased advice, she received a sales pitch. And her broker received a big commission.

Second case: The busy doctor. Doctors are notorious for being bad investors since they spend so much time focused on patients.

So, one Illinois doctor entrusted his entire pension plan to his “banker.” Yes, you guess it. The “banker” was actually a securities broker licensed by the securities broker-dealer.

Ten years ago, the doctor invested nearly $1 million of his pension fund in tax-deferred annuities. And every year, his additional pension fund contributions were placed into the annuity. Now he’s 70 years old, about to retire and take withdrawals. But a good portion of his retirement plan is tied up in annuities. Surrender charges have expired on some of the original deposits, but remain on newly committed funds.

The doctor wrote me because he had just figured out that he was paying a 1.7 percent annual management fee on top of an 8 percent sales charge, while his investment itself was only earning 3 to 5 percent! Worse: He didn’t need the tax-deferral in the first place, because a pension plan is already tax-deferred!

Some people buy annuities in their retirement plans because of a guaranteed death benefit that comes with the annuity. The “mortality cost” is built into those annual annuity fees. But the death benefit doesn’t replace money lost in bad investments and needed for your retirement lifestyle. It only benefits your heirs, and a traditional life policy would be cheaper.Buyer beware

Some newer tax-deferred annuities offer guaranteed income benefits. No matter how poorly your annuity investments perform, you can withdraw a certain percentage of your initial deposit without running out of money.

That’s an attractive offer, but you might pay as much as 0.70 percent each year for the privilege.

The Securities and Exchange Commission and the National Association of Securities Dealers are considering new regulations to deal with unsuitable annuity sales. But until new regulations are issued, it’s buyer beware. And that’s The Savage Truth.

Terry Savage is a registered investment adviser and the author of the newly published The Savage Number: How Much Money Do You Need to Retire? (256 pages, Wiley, $24.95).

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