Over my 10 plus years in the insurance and financial services industry one of the most constant issues in selling variable annuities is the ability to overcome the high fees typically associated with them. In most cases and when advised effectively, the client will benefit greatly from the guaranteed lifetime income or tax deferral features of these products and will easily outweigh the downside of those higher fees. All this has changed in recent years with the introduction of the Investment Only Variable Annuity or IOVA for short and these products have carved out a niche in the market place that when used effectively can offer a rather unique solution to some specific situations.
IOVA’s have stripped out all of the typical “expensive” components to the traditional variable annuity. Components such as guaranteed lifetime income, guaranteed death benefits or downside market protection. The result has been a simple one, lower fees (some are just a flat $20/month plus advisor fees) and a more simplistic tool to help clients in certain situations. What IOVAs have left is the important tax deferral feature that is often overlooked by the general public. This remaining tax deferral feature can be a powerful resource to those that have substantial assets in non-retirement accounts. Let’s look at some examples of where IOVAs may be beneficial to use:
Example 1: Trusts
For some of our more affluent clients interested in leaving assets to their heirs, a typical strategy will be to use a trust. A trust in the eyes of the IRS is seen as its own individual and as such must pay income taxes every year. The kicker here is that the taxable rates are far higher than they are for an actual person. In 2018 the tax rates for a trust are as follows:
Meaning that if a client has a $1,000,000 trust that they plan to gift to their heirs and they invest conservatively it is very possible that they have received 3% in dividends or $30,000. That trust would be responsible for $9,486 in income taxes ($3,011 plus 37% of $17,500). The result is that a trust that should be worth $1,030,000 is now, after taxes, worth $1,020,514. This tax liability comes due every single year. This client may benefit from using an IOVA because this product is still an annuity and will not have to pay taxes every year and instead will only pay taxes once it is cashed out. In years when the market performs very well it would not be unreasonable to see a $1,000,000 trust have a capital gain of $100,000 or more. The result of a $100,000 taxable gain would result in a tax liability of $35,386. A fairly large tax bill to swallow.
If this same client were to employ a traditional Variable Annuity to try and mitigate tax liability they would still be responsible for the fees of the annuity. While these fees are not typically a line item, they still will have an adverse effect on growth. For example, a typical variable annuity may have fees and expensive of 2.5% resulting in expenses of $25,000 a year for a $1,000,000 account, regardless of performance. The trade off is that the traditional annuity may offer a guaranteed death benefit whereas the IOVA will only pass on the account value.
Example 2: High Income Earners
For individuals with high levels of income there may present a desire to save for retirement above and beyond the limits the IRS sets on retirement accounts. For example, a client has annual income of $500,000/year:
The IRS will put a limit on the amount this client can put into their 401(k) of $18,500/year and their income will far exceed the IRS income limit to contribute to a Roth IRA ($189,000). For this individual should they want to save say 10% of their income ($50,000) this would leave a gap of $31,500/year in savings. What are their options if they are tax conscious? They could purchase a permanent life insurance policy, which will have very high fees and may have a longer surrender period, they could invest in municipal bonds or they could look to an IOVA.
Again, because the IOVA is still an annuity, premiums invested in the IOVA will grow tax deferred until they are withdrawn. Meaning these funds will grow similarly to the client’s 401(k) with the difference being premiums will not be a tax deduction in the year they are made. Additionally, unlike the permanent life insurance option, the annual amount you decided to invest in the annuity can be variable. One year the client may decided to save $30,000 and the next only $10,000. There is not a minimum or required amount needed to save every year. Unlike the life insurance option, there also is no concern of this product becoming a modified endowment contract which could have negative tax consequences later on down the road.
A note of caution. IOVA’s still have to play under all the rules of variable annuities, including the 59 ½ year old rule. This rule states that if funds are withdrawn from any variable annuity prior to age 59 ½ then any gains are taxable at ordinary income plus a 10% IRS penalty. Furthermore, the first dollars out are considered a taxable gain until the client reaches their cost basis, or premium, deposited into the product. This may not be the best solution available to individuals that are planning on taking income from these assets prior to turning age 59 ½. As always you should consult with your personal tax advisor to help determine the appropriateness of this product and should recognize that IOVAs do not have guarantees associated with them and as such are subject to investment risk, including loss of principal. If you feel like you may be a good fit to use one of these IOVAs please contact us to discuss the pros and cons for your individual situation.
From time to time I visit the websites of other advisors in the Charleston area and every once in a while I will come across a website that has something other than the usual generic information that you may have seen during your search for an advisor. This other than generic information is more times than not found in a page titled "Newsletter" or "Blog." It is our goal to have our newsletter section to be not only accurate but also relevant to the topics that you, the general public, are wanting to learn more about. In the upcoming months we will cover the following topics:
The one thing we would like to make clear, this section of our website is for you. If there is a specific topic you would like to learn more about please feel free to comment below and we will do our best to address all questions and topics people may have.
-Andrew R. Reina
One of the most common questions we get when potential new clients are interviewing us is "what are your fees." A fairly straight forward question on the surface, right? Not so fast. For such a generic question that should yield a simple response, the financial services industry has done a fantastic job making the answer to that question more difficult than it should be. All too often, depending on the recommendation, the advisor themselves may not know exactly what all the fees are within an investments. Even worse than that sometimes they truly do believe they know only to find out later they were mistaken. One of our goals at Veritas Wealth Management LLC is to help educate the general public on topics such as this to help them navigate the constantly changing world of financial services. Even more important to us is to not just give you the answer as it applies today but give you the tools necessary to find the information on your own as it changes.
I can vividly remember like it was yesterday, I was home for Thanksgiving back in New York, my first one back home since I had made the move the Charleston. I was sitting on the couch with my former step father watching football and talking about the usual topics when we started talking about work. I had recently took his advice and started my career in the financial services industry with New York Life Insurance Co. on Meeting St. in downtown Charleston. I did so largely because of him, after all at the time he was and still is, a VP for Morgan Stanley. We started talking about all of the different paths that one can take when attempting to start a career of giving strangers financial advice and believe me the options are seemingly endless. My stepfather had been pressing pretty hard to have me take a position at Morgan Stanley because of the opportunity I would immediately have because of the work he had done. I wasn't interested but that is a story for a different day. My stepfather was and still is an asset manager, meaning he is compensated a percentage fee for the money that he manages. The reason this particular conversation stands out in my memory is because of how high I perceived that fee was. He actually went on to tell me about how his office tracks which advisors revenue the highest fees based on a percentage of their assets. Meaning there was an award if one advisor managed to charge his clients on average a fee of say 2.5% vs his office average of 2.0%. Can you believe that? That notion of rewarding higher fees made me uncomfortable then and now with close to a decade of experience that uncomfortable feeling has morphed into downright anger.
The anger stems from understanding that there are very few things that advisors have actual control over when it comes to managing your money so they really have to excel at those things. The things advisors can actually control are:
1) How much we expose your account to taxes
2) How much general risk we expose your assets to
3) How much we charge in fees
The first two are fairly well regulated. For example tax exposure inside of a retirement account is non-existent until withdraws are taken. How much risk your account is exposed to is generally determined by a standard risk tolerance questionnaire to determine the amount of stock and bonds a client owns. However, the third one, the fees advisors charge is more like the wild west with the differences between advisors being greater than one may believe. What's even worse is that some companies don't necessarily disclose that information and instead allow each individual advisor to make their own fee schedule. For example, I use to own a Voya franchise on Broad St. in Charleston and at my office we had a completely different fee structure than the Voya office in North Charleston and Mt. Pleasant. This makes finding fee information more difficult. You, the client, undoubtedly signed an agreement at one point but years later do you really remember what those fees are? Did you even pay attention when you were signing off on fees? Are you aware of what the range in fees are and the effect they have on the growth of your portfolio? While we can't answer the first two questions we can at least give insight on the last question.
For the purposes of this post I will focus solely on a standard Managed Account, one were you have an old IRA invested in stocks, bonds, mutual funds or ETFs. We will tackle the topic of things like Annuities and Life Insurance at a later date.
Is There a "Standard" Fee?
The quick answer is no. For a long time the "standard" fee in the industry has been closer to 2% meaning on an account of $100,000 the client would be charged $2,000/year. So if a client's investments experienced a 10% gain the client's account would only see a net gain of $7,800. ( $100,000 + 10% = $110,000 - 2% fee of $2,200 = Net $107,800) However things have been changing in the financial services industry and just like other industries such as Retail, competition is increasing forcing the average fees down. More competition = lower fees. There have also been advisor such as myself or say Vanguard that have been bold enough to challenge the status quo. One such company called Personal Capital has managed to compile a large enough sample size to, in my opinion, adequately compare a number of different firms. For example they have found that on accounts between $100,000 - $1,000,000 The average account fees for each company are as follows:
So how can there be such a large difference between the high side of Ameriprise's 3.00% and the low side of Charles Schwab's .28%? The answer to that question comes down to what you, the client, is looking for. The lowest two firms, Charles Schwab and Vanguard, generally offer advice and portfolios comprised of their own proprietary mutual funds and ETFs. Both also see portfolio management as a secondary revenue source behind their brokerage business. Both will also have limited contact to an actual human that you can look in the eye or shake their hand. On the other side we have the rest of the firms that offer the human touch certain client's are looking for along with an open architecture strategy that allows its advisors to recommend funds or securities regardless of their name. It is fairly common with these firms to have several different fund families such as Fidelity, Oppenheimer, American Funds, iShares or T. Row Price etc. Is that human interaction worth the increase in fees? Mathematically speaking there are far too many variables to answer that question from a numbers stand point so really the answer comes down to the value you, the client, places on that advisor/client relationship.
Where Can I Find Fees From Different Advisors?
All advisors and firms that are registered as Registered Investment Advisors, are required to file a Wrap Fee Brochure with the SEC. In this brochure you will find a breakdown of their fees. In some instances the fees will not be as obvious, for example Voya, does not have an explicit breakdown because it largely depends on the individual franchise owner. In cases such as this you can:
1) Request a copy of the fee disclosure you signed when you opened the account
2) Look at your statements and find the itemized fee, multiple by frequency then divide by value
3) Contact us and we will calculate for you
Personal Capital was kind enough to provide each of the firms Wrap Fee Brochures at the bottom of their study, which again I have attached a link to at the bottom of this post.
Why Do Fees Matter So Much?
As we previously discussed advisor can really only control 3 things about your account. Only fees are a steady constant headwind to portfolio growth. Taxes may go up or down and your appetite for risk may also decrease or increase as time goes on and goals change. However one thing that will never change is the fact that you will be paying fees. Since fees are the only constant they have the unique feature of always being a drag on your portfolio growth. Their effect can be dramatic and at times goes unnoticed. Let's take a look at an example:
Client "A" account size $100,000 with 6% growth for 20 years
It is important to note here that should your actual rate of return differ from the one illustrated above the difference in fees would change as well. If your rate of return was higher, say 8%, the difference in fees would be much greater. In contrast should your rate of return be less, say 4%, the difference in fees would be less.
In order for the client to experience the same end result an advisor from Edward Jones, under these conditions, would have to outperform an advisor from Veritas Wealth Management by .51% annually and Morgan Stanley would have to outperform Veritas Wealth Management by 1.21% annually. The probability of that happening has many variables and is ultimately up to you, the client, to decided if that is very likely or not.
The question really comes down to what type of investor are you? Do you value having an advisor that you can establish a relationship with or do you just want an algorithm (computer) making your investment choices for you? Do you have to choose?
This is the only place you will see us "advertise" ourselves. We don't believe you should have to choose between working with an actual personal advisor or lower fees. We do not, nor do we plan on, ever having clients simply placed into a computer program and live with whatever that outcome is. We believe our fees, found under the Portfolio Management tab, reflect our commitment to challenge the higher fees of our personal competitors while remaining competitive with our computer driven counterparts.
Personal Capital Study can be found HERE
Andrew R. Reina
The views and opinions in this newsletter are that solely of Andrew R. Reina and do not necessarily reflect those views and opinions of Fortune Financial Services Inc. or its affiliates. You should always contact your tax or legal professional regarding your specific situation.