Insurance advisors balk at annuity fees

(MoneyWatch) Investment News, a leading publication for financial advisers, recently ran an article headlined "Pru fee hike another nail in VA coffin" that looked at a new Prudential Variable Annuity with fees of 2.45 percent annually. One advisor was quoted as saying "you have to take a look as to whether the cost is going to be prohibitive." The story also reported that the costs were too rich for wealth management company Raymond James Financial, which places a fee limit of 2.35 percent annually.

Can financial advisors selling insurance products set limits on the fees their clients pay?

To answer that question I spoke with Bruce Ferris, senior vice president of annuity sales at Prudential. Ferris confirmed that the 2.45 percent annual fee wasn't the entire charge, as it did not include the costs of the underlying funds in the annuity. I did the math and arrived at a fee of about 3.50 percent annually. Digging a bit deeper, I learned Prudential can unilaterally increase fees further after the fifth contract year. Ferris said that total fees were in line with Prudential's competitors.

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Ferris noted, however, that one has to look at the benefits of the annuity. Their Highest Daily Income product comes with a guaranteed "income" based on age. For example, an annuity with a $100,000 value is assured of paying $4,500 for the rest of the annuitant's life. Ferris referenced a new Morningstar study that indicated a safe withdrawal rate for a portfolio of mutual funds would be 2.8 percent, or only $2,800 annually, so this 4.5 percent income looked good by comparison. He also brought up the low rates CDs were now paying.

I challenged Ferris on terming the guarantee as "income" rather than cash flow. I suggested that most of the cash was actually a return of principal and that comparing the 5 percent distribution to a bank CD was unfair. Ferris disagreed but did admit the return of principal was not assured.

I also noted that the Morningstar study's finding that 2.8 percent is a safe withdrawal rate assumed the annual withdrawal rate would increase each year with inflation. Prudential confirmed their product did not. The Morningstar analysis was also based on funds lasting for 30 years. According to the Society of Actuaries, the average life expectancy for a 65-year-old male is only 20.4 years.

I further looked at the value of the guarantee. At a 4.5 percent payout, it would take 23 years just to get one's money back with no interest. There is only a 40 percent chance of this occurring for a 65-year-old man, meaning that the expected value of this benefit is zero. I checked out the returns for those beating the longevity odds. A 65-year-old male has a 33 percent chance of living 25 years longer and a 17 percent chance of living 30 years, which produce an annualized return of 0.93 and 2.06 percent, respectively.

This is to say that beating the odds wins the jackpot of only a 2.06 percent annual return. That may not even be what a CD earns over the next 30 years.

I ran my numbers by my favorite actuary -- CBS MoneyWatch writer Steve Vernon. Vernon said that for "a competitively priced conventional fixed annuity, my most recent retirement income scorecard shows that you'd get a payout rate of 6.6 percent for a single man." That's a 47 percent higher payout rate compared to the Prudential annuity, though Vernon notes the Prudential annuity may have some value should you die soon afterwards. (If you want to learn more about annuities or making sure you don't run out of money, I recommend Vernon's book, "Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.")

My take is that I'm thrilled to see that financial advisors are finally drawing a line in the sand on high fees. But advisors also should look at total fees and at whether an insurance company can raise fees. In this case, the product has a 3.50 percent annual fee, with Prudential having the right to increase it to 4.50 percent.

The guaranteed payout is not income, and there is only a 40 percent chance that the benefit will be higher than if you stuffed the money under your mattress and took out a constant amount each year. In my view, calling this income, comparing it to CDs and measuring it against a safe withdrawal rate indexed to inflation is misleading. I suspect few would buy this product if they understood the value proposition. Apparently some advisors now do.