Breaking-Down the Annuity Expense Criticism

Coverage of annuities by the broader financial media tends to be negative, with much of the criticism focused on annuity expenses.

The criticism is typically accompanied by a blue-sky investing scenario that makes the case for annuities that much less compelling.  The theoretical retail investor in such a blue-sky scenario invests with perfect discipline, efficiency and rationality in the lowest cost index fund over some absurdly arbitrary time-frame.

The problem is that the average retail investor’s reality is quite different, and the data is clearly there to support this alternative reality.  

In fact, one could argue that the drag on retail investment performance that is encountered in real life is equal to or greater than the fee structure of some of the most expensive variable annuities with living benefit features.    

Consider one such blue-sky investment scenario that has a 20 year time-frame starting in 1983 (the beginning of the bull market).  During the period beginning in 1983 and ending in 2003, the S&P index delivered an annual return of 13 percent.  

Pretty hard not to make money in such an ideal environment, right? Just buy and hold a simple (and inexpensive) S&P index fund and watch your wealth double every 5-6 years.

Not even close.  As discussed in a previous post, Vanguard founder John Bogle has demonstrated that during this same 20 year period, the average return of actively managed equity funds is 7.8 percent--a 5.2 percent difference.  Factors contributing to this drag include under-performing fund managers, fund management fees and taxes.  Toss-in a 3 percent rate of inflation (the average during this period) and the average return is reduced to 4.8 percent, creating a lag of 8.2 percent.

This isn’t the end of the story.  What is likely the greatest performance drag, cost or expense for the average retail investor is their own decision making.

Wall Street Journal columnist Brett Arends discusses this issue in an article titled “You Should Have Timed the Market.”

Arends cites a study from TrimTabs Investment Research that suggests poor investment decisions cost retail investors $39 billion over the past decade.  Poor decisions boil-down to buying and selling at the worst possible times.  The TrimTabs study indicates that the investing public bought the S&P index at an average of 1,434 (close to the record high of 1,565).  Random purchases over the course of the decade would have resulted in an average purchase point of 1,171.

It is probably safe to assume that, on average, retail investor decision making adds a meaningful amount to the 5.2 percent nominal (and 8.2 percent real) drag referenced above.  In any event, the total is far and away greater than the total expense structure of any annuity.    

What is also worth noting is that the annuity buyer is receiving something in exchange for the expense--namely insurance guarantees. In contrast, the retail investor who purchases a mutual fund or ETF receives zero guarantee in exchange for the very real costs they incur.