At What Cost?: Annuities, Cryptocurrency, and 401(k) Plans

For many people, their 401or 403(b) accounts are their primary retirement savings. So, it’s only natural that they want their 401(k) or 403(b) plan to offer investment options that are truly in their best interests and their beneficiaries’ best interest.

Pension plans are administered by a plan sponsor. Pension plan sponsors are legally fiduciaries. A fiduciary’s duties to the plan’s participant’s and their beneficiaries are the highest duties under the law.

A [fiduciary] is held to something stricter than the morals of the marketplace.  Not honesty alone, but the punctilio of an honor the most sensitive, is the standard of behavior….1

Fiduciary law is a combination of three types of law–trust, agency and equity. The basic concept of fiduciary law is fundamental fairness.

The Supreme Court has consistently recognized the fiduciary principles set out in the Restatement (Third) of Trusts (Restatement) as guidelines for fiduciary responsibility, especially for plan sponsors.

ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.2

Under the Restatement, loyalty and prudence are two of the primary duties of a fiduciary. A fiduciary’s duty of loyalty requires that a plan sponsor act solely in the best interests of the plan participants and their beneficiaries. A fiduciary’s duty of prudence requires that a plan sponsor exercise reasonable care, skill, and caution in managing a plan, specifically with regard to controlling unnecessary costs and risks.

Against that backdrop, plan participants and their beneficiaries are now confronted with the potential issues of being offered annuities and crypto currencies within a 401(k) plan. I believe that both assets are inappropriate for 401(k) and unnecessarily expose plan participants and their beneficiaries to unnecessary risks, including excessive costs, consistently underperformance and the possible loss of a significant portion of their entire pensions account to insurance companies, rather than intended beneficiaries

While an exhaustive analysis of annuities is beyond the scope of this post, I want to address three of the most common types of annuities and the fiduciary issues involved with each. One of the fiduciary issues involved with annuities is their complexity. The analyses herein will be based on the simple, garden variety of each of the three annuities.

1. Immediate Annuities (aka Income Annuities)
These annuities are often recommended to provide supplemental income in retirement. In most cases, immediate annuities can be used to provide income for life or for a certain period of time, e.g., 5, 10, 15 or 20 years.

The key question in evaluating annuities, or any other investment, should always be “at what cost?” With annuities, you generally have annual costs as well as additional optional costs for various “bells and whistles.” While costs vary, a basic average annual cost for immediate annuities seems to be 0.7 percent. The average costs for various additional options with all annuities seem to be an additional 1.0 percent. However, it is a plan sponsor’s duty to always ascertain the exact costs.

Plan sponsors need to always remember this mantra – “Costs matter.” Costs do matter, a lot. The General Accounting Office has stated that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a twenty-year period. 3

Peter Katt was an honest and objective insurance adviser. During my compliance career, he was my trusted go-to resource. While he passed away in 2015, the lessons I learned from him will always be invaluable. I strongly recommend to investors and investment fiduciaries that they Google his name and read his articles, especially those he wrote for the AAII Journal.

Katt’s thought on immediate annuities include:

The immediate annuity is for people who want the absolute security that they can’t outlive their nest egg. The problem is that there is nothing left over for your heirs.4

While annuities often offer options to address this issue, such options often result in reduced monthly payments and/or additional costs.

Katt always said to get the annuity salesmen to provide a written analysis providing the breakeven analysis for an annuity, the estimated time that would be required for an annuity owner to recover their original investment in the annuity. He told me that breakeven periods of twenty years or more are common, making it unlikely that the annuity owner will ever recover their original investment. And remember, with a life-only immediate annuity, once the annuity owner dies, the balance in the annuity goes to the annuity issuer, not the annuity owner’s heirs.

He also told me to always ask the annuity salesman for the APR that was used in calculating the breakeven point. The APR is the interest rate that annuity issuers typically use in determining an annuity’s payments.

One of the drawbacks with immediate annuities is that once an interest rate is set, that will be the applicable interest rate for the period of the annuity. Again, some annuities may offer options to avoid this inflexibility…at an additional cost.

The inflexibility of an annuity’s interest rate results in purchasing power risk for an annuity owner. This risk increases as the period of the annuity increases. Purchasing power risk refers to the risk that the annuity’s payments will lose their buying power over the years due to inflation. Some annuities provide for “step-ups” in rates…at an additional cost.

Katt’s advice-anyone considering an immediate annuity should first build a balanced portfolio consisting of stocks and bonds to ensure flexibility, and then invest augment that portfolio with a reasonable am0unt in the immediate annuity. While some annuity salesmen will argue for an “all or nothing” approach in order to maximize their commission. Prudent investors will follow Katt’s advice.

Perhaps the strongest argument against including immediate in 401(k) and other pension plans comes from a study by three well-respected experts on the subject. In analyzing when a Single Premium Immediate Annuities (SPIAs), probably the most popular type of immediate annuity, would make sense, the three experts stated that

Results suggest that only when the possibility of outliving 70 percent or more of a cohort exists, and then only at elderly ages. For ages younger than 80, assets are best kept within the family, because both inflation and possible future market returns have time to do better than SPIA lifetime sums.5

Based upon my experience, very few 401(k) plans have plan participants aged 80 or older. I predict that plan sponsors who decide to offer immediate annuities, in any form, in their plans can expect to see that quote again, especially if I am involved in the litigation.

2. Fixed Indexed Annuities (fka Equity Indexed Annuities)
From what I have read and heard, the annuity industry’s plan to focus on including annuity options within 401(k) plans by imbedding fixed indexed annuities options within target data funds.

Target date funds are controversial investments that attempt to create investment portfolios that are appropriate based on the investor’s estimated retirement, or target, date. Target date funds have typically designed portfolios consisting of equity and fixed income investments.

From the reports I have read, the annuity industry plans to imbed a fixed income annuity aspect into target date fund, and then gradually increasing the percentage of the allocation to the annuity sector within the target date fund. When the target date is met, the annuity issuer would reportedly offer the plan participant the option to actually purchase the fixed indexed annuity.

So what would be wrong with that? Dr. William Reichenstein, finance professor emeritus at Baylor University sums the primary issue perfectly.

The designs of equity index annuities (EIAs) and bond indexed annuities ensure that they must offer below-market risk-adjusted returns compared with those available on portfolios of Treasurys and index funds. Therefore, this research implies that indexed annuity salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.6

While EIAs/FIAs are technically insurance products, not securities, Dr. Reichenstein’s analysis is still applicable with regard to a fiduciary’s duties of loyalty and prudence. If the design of these products ensures that they cannot offer competitive returns to those of alternative investments, then how does a plan sponsor, or any fiduciary for that matter, plan to meet their fiduciary duty of loyalty and prudence?

As regulators emphasize, before an insurance agent can sell an annuity, he or she must perform due diligence to ensure that the investment offered ex ante competitive returns. Therefore, it is appropriate to compare the net returns available in an equity-indexed annuity to those available on similar-risk investments held outside an annuity.7

[By] design, indexed annuities cannot add value through security selection ….[T]he hedging strategies [used by equity-indexed annuities] ensure that the individuals buying equity-indexed annuities will bear essentially all the risks. Conseqently, all (ital) indexed annuities must (ital) produce risk-adjusted returns that trail those offered by readily available marketable securities by their spread, that is, by their expenses including transaction costs.8

The reference to design refers to the fact that managers of indexed annuities buy Treasury securities and index options, but do not engage in individual security selection. Furthermore, indexed annuities typically impose restrictions on the amount of return that an investor can actually receive. Therefore, the combination of the design of these products and the restrictions on returns typically imposed by EIAs/FIAs ensure a fiduciary breach.

So, even though the annuity industry markets these indexed annuities by emphasizing stock market returns, the majority of fixed indexed annuity owners are guaranteed to never receive the actual returns of the stock market. While some annuity firms are marketing so-called “uncapped” fixed indexed annuities, they may still impose restrictions, and such “uncapped” returns…come with additional costs.

The restrictions and conditions that fixed indexed annuities naturally vary. During my time as a compliance director, the fixed indexed annuities I saw imposed an 8-10 percent cap and a participation rate of 80 percent. What that meant was that regardless of the applicable market index, with a cap of 10 percent, the most the annuity owner could receive was 10 percent of the index’s return.

As if that was not unfair enough, that 10 percent return was then further reduced by the annuity’s participation rate. So, with a participation rate of 80 percent, the maximum return an investor could receive in our example was 8 percent.

Reichenstein points out even more inequities, noting that  

Because interest rates and options’ implied volatilities change, the insurance firm almost always retains the right to set at its discretion at least one of the following: participation rate, spread, and cap rate.9

The one question that I always asked of fixed indexed annuity wholesalers, but still remains unanswered, was what happened to the excess return generated from the index options after the caps and participation rates were applied. Still waiting for an answer 

And finally, a simple explanation of how fixed indexed annuity companies further manipulate returns to ensure that they protect their interests first.

From AmerUS Group financial statements, ‘Product spread is a key driver of our business as it measures the difference between the income earned on our invested assets and the rate which we credit to policy owners, with the difference reflected as segment operating income. We actively manage product spreads in response to changes in our investment portfolio yields by adjusting liability crediting rates while considering our competitive strategies….’ This spread ensures that the annuity will offers noncompetitive risk-adjusted returns.10

Equity-indexed annuities generally do not credit owners with the dividends paid on the index used in calculating equity returns. Many indexed owners are not aware of this fact, or its significance. For example, historically over 40 percent of the S&P 500 Index’s compounded returns has come from dividends paid on its underlying stocks.

I could go on to discuss additional issues as single entity credit risk and illiquidity risks, but I think investment fiduciaries get the picture. The evidence against fixed index annuities establishes that they are a fiduciary breach simply waiting to happen. I strongly recommend that plan sponsors and other investment fiduciaries read Reichenstein’s analysis before deciding to offer fixed indexed annuities, in any shape or form, in their plans or to clients.

3. Variable Annuities
Any fiduciary that sells, uses, or recommends a variable annuity has breached their fiduciary duty…period. Katt summed it up perfectly:

Variable annuities (VAs) are flawed because they covert capital gains into ordinary income and have considerably higher expenses compared with comparable mutual funds. For this reason they are quite unsuitable for most investors.11

Exhibit A
Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.

[T]he fee [for the death benefit] is included in the so-called Mortality and Expense (M&E) risk charge. The M&E risk charge is a perpetual fee that is deducted from the underlying assets in the VA, above and beyond any fund expenses that would normally be paid for the services of managed money.12

[T]he authors conclude that a simple return of premium death benefit is worth between one to ten basis points, depending on purchase age. In contrast to this number, the insurance industry is charging a median Mortality and Expense risk charge of 115 basis points, although the numbers do vary widely for different companies and policies.13

The authors conclude that a typical 50-year-old male (female) who purchases a variable annuity—with a simple return of premium guaranty—should be charged no more than 3.5 (2.0) basis points per year in exchange for this stochastic-maturity put option. In the event of a 5 percent rising-floor guaranty, the fair premium rises to 20 (11) basis points. However, Morningstar indicates that the insurance industry is charging a median M&E risk fee of 115 basis points per year, which is approximately five to ten times the most optimistic estimate of the economic value of the guaranty.14

Excessive and unnecessary costs violate the fiduciary duty of prudence. The value of a VA’s death benefit is even more questionable given the historic performance of the stock market. As a result, it is unlikely that a VA owner would ever need the death benefit. These two points have resulted in some critics of VAs to claim that a VA owner needs the death benefit like a duck needs a paddle.”

Exhibit B
Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.

At what cost? VAs often calculate a VAs annual M&E charge/death benefit based on the accumulated value within the VA, even though contractually limit their legal liability under the death benefit to the VA owner’s actual investment in the VA.

As a result, over time, it is reasonable to expect that the accumulated value within the VA will significantly exceed the VA owner’s actual investment in the VA. This method of calculating the annual M&E, known as inverse pricing, results in a VA issuer receiving a windfall equal to the difference in the fee collected and the VA issuer’s actual costs of covering their legal liability under the death benefit guarantee.

As mentioned earlier, fiduciary law is a combination of trust, agency and equity law. A basic principle of fiduciary law is that “equity abhors a windfall.” The fact that VA issuers knowingly use the inequitable inverse pricing method to benefit themselves at the VA owner’s expense results in a fiduciary breach for fiduciaries who recommend, sell or use VAs in their practices or in their pension plans.

The industry is well aware of this inequitable situation. John D. Johns, a CEO of an insurance company, addressed these issues in an article entitled “The Case for Change.”

Another issue is that the cost of these protection features is generally not based on the protection provided by the feature at any given time, but rather linked to the VA’s account value. This means the cost of the feature will increase along with the account value. So over time, as equities appreciate, these asset-based benefit charges may offer declining protection at an increasing cost. This inverse pricing phenomenon seems illogical, and arguably, benefit features structured in this fashion aren’t the most efficient way to provide desired protection to long-term VA holders. When measured in basis points, such fees may not seem to matter much. But over the long term, these charges may have a meaningful impact on an annuity’s performance.15

In other words, inverse pricing is always a breach of a fiduciary’s duties of both loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without any commensurate return, which also violates Section 205 of the Restatement of Contracts.

Exhibit C
Benefit – VAs allow their owners the opportunity to invest in the stock market and increase their returns.

VAs offer their owners an opportunity to invest in equity-based subaccounts. Subaccounts are essentially mutual funds, usually similar to the same mutual funds that investors can purchase from mutual fund companies in the retail market.

While there has been a trend for VAs to offer cost-efficient index funds as investment options, many VA subaccounts are essentially same overpriced, consistently underperforming, i.e., cost-inefficient, actively managed mutual funds offered in the retail market. As a result, VA owners’ investment returns are typically significantly lower than they would have been when compared to returns of comparable index funds.

Exhibit D
Benefit – VAs provide tax-deferral for owners.

So do IRAs. So do any brokerage account as long as the account is not actively traded. However, dividends and/or capital gain distributions are taxed when they occur.

The key point here is that IRAs and brokerage accounts usually do not impose the high costs and fees associated with annuities. This is especially true of VAs, where annual fees of 3 percent or more are common, even higher when riders and/or other options are added.

Remember the earlier 1/17 note? Multiply 3 by 17 to see the obvious fiduciary issues regarding the fiduciary duties of loyalty and prudence. 

Although not an issue for plan sponsors, another “at what cost” fiduciary issue has to do with the adverse tax implications of investing in non-qualified variable annuities (NQVA). Non-qualified variable annuities are essentially those that are not purchased within a tax-deferred account, e.g., a 401(k)/403(b) account, an IRA account.

When investors invest in equity investments, they typically are not taxed on the capital appreciation until such gains are actually realized, such as when they sell the investment or, in the case of mutual funds, when the fund makes a capital gains distribution.

In many cases, investors can reduce any tax liability by taking advantage of the special reduced tax rate for capital gains. However, withdrawals from a NQVA do not qualify for the lower capital gains tax. All withdrawals from a NQVA are considered ordinary income, and thus taxed at a higher rate than capital gains. An investment that increases its owner’s tax liability by converting capital gains into ordinary income is hardly prudent or in an investor’s “best interest.”

Bottom line – there are other less costly investment alternatives available that provide the benefit of tax deferral. While they may not offer the same guaranteed income, they provide other significant benefits, while avoiding some of the risks associated with VAs, e.g., reduced flexibility, purchasing power risk, higher taxes.

Exhibit E
Benefit: Annuity owners do not pay a sales charge, so more of their money goes to work for them.

The statement that variable annuity owners pay no sales charges, while technically correct, is misleading. Variable annuity salesmen do receive a commission for each variable annuity they sell, such commission usually being in the range of 6-7 percent of the total amount invested in the variable annuity.

While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through a variable annuity’s various fees and charges, particularly the M&E charge.

To ensure that the cost of commissions paid is recovered, the insurance company typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for an initial surrender charge of 7 percent for withdrawals during the first year, decreasing 1 percent each year thereafter until the eighth year, when the surrender charges would end. There are some surrender charge schedules that charge a flat rate, such as 7 percent, over the entire surrender charge period.

Fidelity Investments recently announced that it would begin offering a new fund that would allow 401(k) plans to offer a cryptocurrency option within the plan. The reaction was immediate and divided. And now news that Bitcoin and other cryptocurrencies have suffered a cumulative $200 billion dollar loss.

Since there are still a number of issues that need to be address ed, especially the concerns raised by regulators, including the Department of Labor16 and the Securities & Exchange Commission17, I will simply suggest that plan sponsors and other investment fiduciaries should wait until the regulators have issued guidelines on this topic.

One thing I will address is the notion that because investors may want to invest in cryptocurrency is no reason for a plan sponsor or other investment fiduciary to do so. First, a plan sponsor has no obligation, legal or otherwise, to include an investment option in a plan simply because one or more plan participant wants to invest in such an option. A plan sponsor, a trustee, or any other investment fiduciary has two primary duties, the duty of loyalty and the duty of prudence.

With all the acknowledged concerns about cryptocurrency, from susceptibility to hacked accounts resulting in significant losses, the volatility of such investments, and questions regarding the concept/ structure of such investments, prudence is the best course for all fiduciaries at this point. For plan participants that want to invest in cryptocurrencies, they are free to open up retail brokerage accounts and trade in such investments.

Going Forward
In addition to being a fiduciary, I also represent investors who have suffered losses due to questionable investment recommendations and poor financial advice. Far too often, such losses can be traced to incomplete and/or misrepresentations.

For example, annuity salesmen marketing annuities often stress the “guaranteed income for life” aspect of annuities, without explaining that to receive such guaranteed income, the annuity owner has to “annuitize,” of give up all rights to the accumulated value of the annuity. Simply put, due to the way annuities are designed, the insurance company, not your family or other beneficiaries, will receive the benefit of your lifelong labor.

My experience has been that annuity salesmen often fail to explain such disadvantages to customers, only disclosing the “guaranteed income for life” mantra. As a former securities compliance director, I am well aware of the “sell the sizzle, not the steak” marketing strategy where the salesman focuses on the potential benefits of a product, not its disadvantages. Transparency and full disclosure are the financial services industry’s kryptonite.

However, a plan sponsor’s fiduciary duties are inviolate. There are no “mulligans” or “do overs” in fiduciary law. As the courts have repeatedly pointed out, “A pure heart and an empty head’ are no defense to allegations of the breach of one’s fiduciary duties.18

Plan sponsors have a duty to know every aspect of every product they select to offer within their plan. Unfortunately, far too often plan sponsors ignore such duties and simply rely on the representations of the plan adviser and/or other third parties, whose advice may be tainted by the commissions or other compensation they can generate from a plan. The widespread impact of these failures of sponsors to perform their fiduciary duties, combined with self-conflicted advice from third parties, is the reason there is currently so much litigation involving 401(k) and 403(b) plans.

If anything positive comes out of the current debate over the inclusion of annuities and/or cryptocurrencies in 401(k) plans, hopefully it will be a greater recognition and appreciation of the importance of one’s fiduciary duties by plan sponsors and other investment fiduciaries so as to avoid causing unnecessary losses for plan participants and their families.

There are a number of resources available online that can be used to analyze annuities in terms of breakeven analysis. Google “annuity breakeven analysis” to find them. In my practice, I often use the Annuity Break-Even Calculator — VisualCalc program, which compares an annuity with an alternative equity investment. The graphic makes the results easier to understand.

The article by Frank, Mitchell, and Pfau provides detailed instructions on how to perform annuity breakeven analyses using Microsoft Excel.

1. Meinhard v. Salmon, 249 N.Y. 458, 464 (1928).
2. Tibble v. Edison International, 135 S. Ct 1823 (2015).
3. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”).; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”),
4. Peter C. Katt, “The Good, Bad, and Ugly of Annuities,” AAII Journal, November 2006, 34-39
5. Larry R. Frank, Sr., John B. Mitchell, and Wade Pfau, “Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios,” Journal of Financial Planning, April 2014, 38-47. 8. Reichenstein, 302.
9. Reichenstein, 303.
10. Reichenstein, 309.
11. Katt, 35.
12. Moshe Miklevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126, 92.
13. Milevsky and Posner, 94.
14. Milevsky and Posner, 122.
15. John D. Johns, “The Case for Change,” Financial Planning, September 2004, 158-168.
16. Department of Labor, “Compliance Assistance Release No. 2022-01”
18. Donovan v. Cunningham, 716 F.2d 1455, 1461, 1467; 

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This article is for informational purposes only and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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