Posts tagged ‘annuities’

Paper Cut to Death with 12b-1 Fees

Paying all these 12b-1 fees and other expenses found in the small-print can be a lot like getting paper-cut to death.  The Securities and Exchange Commission (SEC) is looking to put a Band-Aid on the problem by capping these nonsensical fees and proposing more disclosure, albeit three decades after these fees initially got introduced. According to InvestmentNews, the SEC has proposed a .25 percent cap on 12b-1 fees, which may save investors upwards of $857 million per year if the proposal is enacted. That’s all good and great, but aren’t investors already getting pillaged and plundered with load expenses and other investment management fees?

The Original Rationale

The original thought process behind the 12b-1 fee movement was designed to allow the little guys (small fund management companies) to compete on an even playing field against the big guys (think of Fidelity, Vanguard, and the American Funds) when it came to product distribution. The SEC says about 2/3 of the 8,000 mutual funds in the industry charge 12b-1 fees, which reached over $13 billion in 2008. These 12b-1 fees generally account for 18% of the total annual fund expenses (ICI – Investment Company Institute).

Source: ICI. The general trend in 12b-1 fees was upwards until the financial crisis hit.

 So are small fund management companies truly benefitting from the customer kickbacks after 12b1-fees were unveiled in 1980? It appears the small fry fund companies have indeed scraped up some extra fees as ammo to market products against the big guys, but the big guys are receiving the same 12b-1 fees. It’s like giving both me and Alex Rodriguez (New York Yankees) an aluminum bat in the game of baseball. There’s  a good chance I may be able to clear the infield now, but A-Rod will instantly have the power to hit one out of the stadium – I have effectively gained no advantage with my new metal bat.

The Investor Perspective

If I’m an investor, what do I care if my mutual fund company has one investor or one million investors? I just want the best products at the lowest price. Yeah, there are these special items used in other industries that help pay for marketing and distribution expenses…they’re called sales and profits. What a novel idea. 

Deciphering all the mutual fund class flavors is tough enough. Like trading in a used car when buying a new car, the juggling of prices, fees, and taxes can become a head-spinning exercise in discovering the true component costs. The cards become even more stacked against investors, if you consider alternative products like the shady world of annuities (see Annuity Trap article).  If translating 12b-1 and load fees is not challenging enough for you, try digesting a slice of legalese heaven by examining this 259 page annuity prospectus gem.

The Flawed Structure

Unfortunately, the financial industry is rife with conflicts and opacity, with the investor getting the short end of the stick. The industry’s main incentive is all about generating commissions for the broker (salesman) and financial institution – not about generating the best return for the client. Here is how I see a typical conversation playing out between a broker and prospect:

Broker A:  “This is a slam dunk investment with guaranteed returns.”

Prospect XYZ:  “Wow, that sounds great – guaranteed returns in a world that everyone is talking double-dip. How do I learn more?”

Broker A:  “You can sign here on the dotted line, or borrow this forklift and take two months to review this gargantuan 259 page prospectus that I don’t even understand.”

Prospect XYZ: “If I have questions about 12b-1 fees, administrative fees, up-front commissions, management fees, mortality charges, trail expenses, or other costs, can I give you call?”

Broker A: “Oh sure, but I’ll probably be in the Bahamas drinking umbrella-coconut drinks with all the commission dollars I’ve earned, so if I don’t answer, just leave a message.” 

Why do 12b-1 Fees Exist at All?

OK, now that I’ve returned from my annuity rant, let’s get back to the pointless value of 12b-1 fees. I mean honestly, what privileged status does the financial industry have in charging customers for a business’s operating expenses? Why stop at charging customers for marketing and distribution costs…maybe customers can start paying for new fund development expenses or for employee health benefits? What’s more, if the financial industry is going to nickel and dime clients with all kinds of fees, then why not have customers subsidize the marketing and advertising campaigns in other industries, like in the pharmaceutical, tobacco, beer, and junk food industries?

Not all 12b-1 fees are created equally. Many funds do not even carry 12b-1 fees, or many that do carry a much more modest punch. While I respect Mary Shapiro’s courage in addressing the useless 30-year 12b-1 fee structure institutionalized by industry lobbyists, putting a Band-Aid on this paper-cut is only hiding the wound, not healing it.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and mutual funds, including Vanguard and Fidelity, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

September 3, 2010 at 1:21 am Leave a comment

The Annuity Trap

Like the infamous Roach Motel, annuities allow investors to check-in while making it very difficult to check out. In many instances, getting out of annuities can be cost prohibitive (fees, charges, commissions, expenses, etc.), even if escaping these fee-laden products is in the investors’ best financial interest.

In an article dated April 13th, 2010, Jay Peroni warned others by outlining a typical annuity fee structure as follows:

  • Mortality and Expense Charge 1.50%
  • Sub Account Management Fees 1.00%
  • Unreported trading costs 0.78%
  • Annual Administrative Expenses 0.15%


What aren’t included in these numbers above are the surrender charges, which effectively can lock you into the annuity if you are averse to paying hefty surrender charges. Normally, the surrender charges vary from up to a 10% charge for large withdrawals in year one, decreasing to something like 1% in year 10. Worth noting, steep sales commissions can be layered on top of the previous charges or mysteriously embedded in the fee structure categories above.

The Big Sell


Driving the push for these 3%+ annual fees are lucrative financial institutions hiring aggressive salespeople. Typically annuities are sold under the guise of safe tax shelter investments. What the broker won’t tell you is that only a fraction (“exclusion ratio”) of the annuity payments is shielded from taxes, and the rest of the payments are taxed at the higher, unfavorable ordinary income tax rate (relative to qualified dividends and capital gains from other securities). Much of the time, many of the salespeople, who call themselves “financial advisors,” know little about these complex annuity products (see Financial Sharks article). What these brokers do understand are the big, fat commissions they stand to collect upon fleecing unsuspecting investors.

Scores of these so-called advisors are actually “registered representatives” who do not carry a fiduciary duty (meaning they are NOT required to make investment decisions in the best interest of their clients). Certainly, there are some situations where annuities might be appropriate, but from my experience there are very few cases where the egregious charges and expenses outweigh the benefits. I believe the vast majority of brokers/registered reps/salespeople are more concerned about padding their wallets than building and protecting client portfolios.

The Alternatives

If safety and tax advantages are features you are looking for then I encourage you to look at more efficient options such as the following:

  • 401k Defined Contribution Retirement Plan (or other “Qualified Plan”): Allows you to achieve tax deferral often with free money given to you in the form of a match to your contributions.
  • IRA (Individual Retirement Account): Whether you consider a traditional or Roth IRA, there are tax deferral advantages with lower fees.
  • Low Turnover, High Dividend Portfolios: Using a tax efficient management strategy with better tax treatment of income is another approach that I firmly believe will outperform most annuities.
  • Tax-Exempt Muni Bonds or Corporates: The tax-exempt status of municipal bonds affords investors a tax advantaged status. The after-tax yield on corporate bonds can be compared to the returns promised on annuities (AFTER all fees, charges, and commissions). Holding individual bonds until maturity can help avoid interest rate risk.
  • Ladder Zero Coupon Bonds: If safe fixed payments are what you are looking for, then staggered purchases of zero coupon bonds can be purchased as well.

These are only a few options that could and should be considered when reviewing your personal objectives and circumstances. With regard to the insurance component of an annuity contract, there are more cost effective ways of paying for insurance – most notably, term insurance.

At the end of the day, no matter the financial product, it is important you understand the underlying fees charged on any strategy, along with how the person selling you stuff is compensated. If you don’t do your homework on these extremely complex products (many not regulated by the NASD or SEC), then you may find yourself checking into the annuity hotel, but unable to check out.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

June 7, 2010 at 12:10 am 1 comment

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