Financial Planning

Gas Guzzling Investments

Variable annuities and other excessively expensive investment products are often like my full-sized pickup. They are really only necessary for one or two specific duties, and fuel economy isn’t one of them! If that is the case, why do so many people own variable annuities? Why do so many people drive gas guzzling full sized pickups? We have been sold on many features and benefits that we’ll rarely ever need, and likely never use!

Would You Buy the Least Fuel-Efficient Vehicle All Other Things Being Equal?

Many automobile manufacturers are striving to produce vehicles that will go further on a tank of gas as consumers demand more fuel-efficient vehicles. While many folks don’t make fuel economy their sole determining factor when car shopping, it may rank somewhere near the top of the list when making a purchasing decision. Put another way, given the choice between two vehicles of near identical style, comfort, and price, few folks would purposefully choose the vehicle with poorest gas mileage.

The fuel efficiency of a vehicle is a result of a combination of many variables. The engine’s ability to turn fuel into usable energy, as well as the mass of the automobile, the number of moving parts in the drive train, any power robbing accessories driven by the serpentine belt, and friction caused by the contact with the road surface all play a role.

If we measure fuel efficiency by how far a vehicle can travel consuming a unit of fuel, miles per gallon of gasoline (MPGs) for example, a vehicle that travels further on a gallon of fuel is considered to be more fuel-efficient.

Des Moines To Denver: Your Time and Money

Let’s assume for example that one vehicle (a hybrid car) can travel 40 miles per gallon of fuel consumed, and another vehicle (full sized pickup) can travel 20 miles per gallon. Now let’s assume each has a tank with a limited capacity of 10 gallons of fuel (Let it be known that we understand a full-sized pickup most likely has a tank with at least twice that capacity in real life). Which vehicle do you expect to go further? Which vehicle do you expect to be more fuel efficient?  

The more fuel-efficient hybrid car should travel somewhere around 400 miles on 10 gallons of fuel, and the lesser efficient pick-up truck should only travel about 200 miles. If I was traveling from Des Moines to Denver, about a 10-hour trip at 670 miles one way, I’d have to stop to fuel up once with the more efficient vehicle, and 4 times with the lesser efficient vehicle. The full-sized pickup would also cause me to increase travel time as a result of its fuel inefficiency.

Every time I’d have to pull off the interstate to fuel up I’d kill 15 to 20 minutes. My trip becomes more expense and takes nearly an hour longer than if I’d chosen the more fuel-efficient vehicle.

Knowing what we have just covered, if your ultimate goal is to get to Denver in the shortest amount of time and spend the least amount on fuel, which vehicle is the logical choice? If you happen to have both vehicles sitting in your garage, which one would you grab the keys for to take on your trip if you were trying to be as time and fuel efficient as possible?

We concede there may be other reasons to choose a less fuel-efficient vehicle. For example, if you want to tow a 6,000lb travel camper you will have to give up some fuel economy. A hybrid car won’t get the job done. In that case a full-sized pick-up with the gas guzzling V8 might be your better option.

On the other hand, driving the full-size pick-up as your daily driver will consume far more fuel over a years’ time than driving the fuel-efficient hybrid car. If you track the average of how much you spend on fuel each month you’ll notice the shocking difference in your pocket book.

Choosing the Fuel-Efficient Investment Vehicle

Much of what we’ve just shared is common sense. When choosing an automobile, it is wise to estimate how many miles you average per year, what you will actually use the vehicle for the majority of the time, and what the fuel economy of the engine and drive train set up is. You will want to weigh the cost of ownership to the likely benefits you will enjoy. That will allow you to get a good idea of home much of your hard-earned financial resources will go up in flames and out your tailpipe!

These same logic-based principles may be applied to your investment and retirement planning decisions as well. However, it is often very difficult for folks to compare the relative fuel economy of their investment portfolio. Many investment fees, administrative charges, and advisor commissions are hidden and nearly impossible to spot. 

It’s unfortunately all too common for folks to own the equivalent of gas-guzzling investment products. They own very inefficient costly investments with features and benefits that they don’t even need, and will likely never benefit from. These expensive features result in additional friction and poor fuel economy.

It’s like they were sold the equivalent of full-size pick-up as their daily driver to get to and from the office. They were hoping to get as far as they can with as little fuel as possible, and were perhaps convinced that they might need to haul a couch or tow a trailer they don’t own. They have no intention of carrying a heavy load hooking up to a travel trailer, but perhaps they were convinced when asked “what if you need to?” by the sales person.  

The end result, they own a less fuel-efficient vehicle to get them from point A to point B each day. They shell out more money for fuel each year than necessary. They may even change their driving habits as a result when they realize that their monthly fuel expenditures jump by 60%-100%. Not because the vehicle is bad, but because of the drastic difference between how it is being used and how it was engineered to be used.

Would You Choose To Pay More?

Imagine you are considering two investment vehicles with virtually the exact same investment options. One investment vehicle has an expense of 1%. The other investment vehicle has the same 1% expense for investments, and an additional 1.3% charge unrelated to investment performance for a total of 2.3% annually.

Which investment vehicle do you think would have a better performance overtime? Which vehicle would you rather have in your portfolio?

You may be asking, “does this actually happen in real life? Are there really examples of two similar investment vehicles with such drastically different expenses?”

The answer is a resounding “YES!”

An easy to pick on example of overly expensive investment products would be many of the variable annuities sold to investors by commission-based brokers.

First of all, let us be clear that we think all products have appropriate uses and poor uses. To say an entire class of financial products is bad is to generalize and be ignorant. All financial products and instruments are just tools. It’s up to the craftsman to know which tool to grab to best handle a specific job.

However, we often see variable annuities sold to folks within their IRA’s.

What’s Wrong With That?

You might ask, “What’s wrong with that? Why not use a variable annuity within an IRA”

Deferred annuities, both fixed and variable, have special preferential tax treatment under the Internal Revenue Code (IRC). Interest is deferred; thus, you don’t have to pay taxes on the earnings at the time you receive them. Distributions are taxed as regular income and distributed on a last-in first-out (LIFO) basis. This tax treatment is not applied to most other investment options, and could have a positive effect if you goal is to strategically deferred taxes on your after-tax accounts until a later date.

However, IRAs are already tax deferred!

Using a variable annuity as an investment vehicle within an IRA doesn’t provide any additional tax related benefits. However, they often end up costing the policy holder significantly more to own than other investment options available. It’s like owning a full sized gas guzzling pick-up truck as a daily commuter.

It’s not uncommon for a variable annuity to have insurance and administrative charges that exceed 1% of the contract account value. In addition, the sub-accounts, or mutual fund-like investment options inside of a variable annuity typically have expenses ranging from 0.50% to over 1.5%. It’s not uncommon to rack up investment related fees of 1% on the combined selected sub-accounts. When totaled with the insurance and administrative charges, many policy holders are paying fees of over 2% annually.

Many folks are also sold living benefits along with their variable annuity. Living benefits sound good. We all want to live, and we like benefits. However, these additional insurance features such as guaranteed income benefit riders have their own expenses often tipping the scale at 1% of the benefit base.

Add all of the fees and charges up and you have 3% or more of your account value going out the door each and every year.

Transparent as Bubble Wrap

Unfortunately, it is not common practice for insurance carriers selling Variable Annuities to disclose these fees on your quarterly or annual statements. You have to be able to read the prospectus and know how to interpret the legal language in order to know what you are paying and what you are receiving in return. It’s not uncommon for a prospectus to contain 150 to 300 pages of intimidating hard to understand language about the legal contract you purchased.

Imagine for a moment that you had a choice between an investment account with a 1% investment fee structure, or a variable annuity with a 3% expense structure when everything is totaled. In addition, you have an IRA, so there’s no tax related benefit for using a variable annuity over a less expensive option.

If you have a $500,000 account you might pay $5,000 annually for the lower cost investment option. On the other hand, you may pay $15,000 for the variable annuity. Over time do you think this might have an impact on the overall performance of your retirement funds?

Questions to Ask Before You Buy!

Variable annuities may be useful tools in a few very specific situations, but are rarely the most cost-effective strategy. Since they are sold by commissioned brokers, there’s often a conflict of interest that should be questioned before making any purchases.

Before you buy a variable annuity do yourself a favor:

  1. Be sure that you understand ALL of the applicable fees and charges.
  2. Separately apply those fees and charges to the money you plan to invest
  3. Then total that actual cost in dollars that you will pay to own it
  4. Lastly ask about other possibly more cost-efficient vehicles to get you from where you are to where you want to go.

Seek Advice From A Fiduciary

If you are feeling over whelmed or confused you are not alone. Our financial industry is often as transparent as bubble wrap. It’s OK to ask questions, and get unbiased answers before making a costly decision.  

If you have questions about a variable annuity that you have been sold, or one you are considering buying, or other investments without clearly stated transparent fees, seek the opinion of a fee-based client-first fiduciary advisor. He or she would be able to conduct a cost benefit analysis.

We would specifically caution you to consult an advisor who doesn’t also operate as a commission broker. You see, there are financial professionals who operate as both a fiduciary advisor, and a commission-based registered representative of a broker-dealer effecting the sales of investments for a commission.

It may be hard to believe, but our financial regulatory system allows it. Although, we’re not sure how the dually registered advisor chooses which hat to where each morning; fee-based fiduciary who charges a fee for advice or commission-based representative of a broker-dealer who receives commissions for the sales of investment products.

Seeking a fee-based fiduciary who isn’t also employed in a sales capacity by a broker-dealer may help avoid receiving conflicted advice.  

“Investment Adviser Representative of and advisory services offered through Royal Fund Management, LLC, a SEC registered investment adviser.”

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