I was listening to an interview with Chuck Schwab (the founder of Charles Schwab) on a podcast earlier this week and he mentioned a phrase when discussing why and how he set up the business that is today Schwab. He said he felt that brokers were “conflicted” when selling securities to clients, as it was not an advisory business, it was a sales business.

I’ve argued for years that the term Financial Advisor is misleading and should be targeted only towards those that actually provide advice rather than be a generic term given to anyone who passes a series 7 exam.

An advisor is described as a person who gives advice in a particular field, and you would be well served to believe that an Advisor, charges a fee for the advice he or her provides. However, that is not the norm. The largest majority of so called “Financial Advisors” work for the largest brokerage houses.  These advisers today charge a fee “based” on your assets, and in addition may have the capacity to receive commissions based on other products that are sold.

Fee Graphic

Now, in general I’m fine walking into to someone’s office and determining whether that person has the skills and experience to assist me in achieving my goals. I don’t expect anyone to work for free, and in fact, if I cannot make sense of how they’re being compensated, I usually walk out. It is exactly this example that leads me to discuss annuities.

Annuities are a product, and although I personally despise them, it doesn’t mean that they don’t have a place for some investors. (However, I argue way less than the amount that have been and continue to be sold).  

Annuities are sold by a person that’s licensed to sell them. The license that is required is an insurance license, that is due to it being an insurance product. I feel that when any investment is “sold” to an investor (where commissions are being earned), the sale by nature puts the person selling them on the opposite side of the investor, and that in my eyes is a conflict. Meaning that the salesperson receives a commission for selling them (which can be substantial).

What you are essentially doing when you are buying an annuity is selling the investment risk of your funds to an insurance company. And aside from the fees you pay for this product, there are also other costs that may be not “understood”. I say understood, as I’m hesitant to say not fully explained or disclosed.

For example, it can cost you the following:

Access to your funds, or what we call giving up liquidity. Whatever return you have been promised is based on a future date and time, and in the case of variable annuities, your guarantee is only on an income benefit over a period of time, not immediate access to your cash.

Dollar sign price tagYour ability to leverage capital gains. Now if you purchased an annuity in an IRA this point may be somewhat moot. However, if you purchased outside an IRA, then any and all gains that you receive will be taxed as ordinary income, and it starts from the first dollar you pull out. Meaning if your $100k went to $200k your taxed on the first $100k that comes out.

Your ability to receive a stepped-up basis on your death. On individual securities (stocks, bonds etc.), if there is a gain, the beneficiary receives a stepped-up basis at the death of the owner. Meaning if they purchased securities that had a value of $100k and grew to $200k then the new cost basis for the beneficiary would be $200K meaning they would not owe any tax that growth. In relation to an annuity, if the $100k investment grows to $200k that growth for non-spouses, is likely taxed at the income tax rate to the beneficiary.

Your sanity. Each of the annuity contracts I’ve reviewed for clients have differences. They change with the times to offer more features and benefits to attract more customers. This usually means each time they give you this, you lose that. The devil is in the details, and nobody who wasn’t president of the chess club would be able to understand some of the language.

Look, my beef is not with the annuity company, or even the guy trying to buy his next Porsche by selling them. It’s the fact that the Financial Industry regulators have allowed the industry to use the term “Financial Advisor” so broadly that it’s hard for investors to tell the difference between when they are paying for advice as it relates to their overall financial plan, or when they are simply being sold something.

Car salesWhen you’re in the market for a new car, you’ll do a mountain of research and narrow down your options to a select few. Then you will visit the dealership and negotiate what you want and what you’re prepared to pay for it. You go into that negotiation understanding that the person on the other side of the table is making a commission on the sale of that car. You understand their motivation.

On the other hand, we have seen occasions of people who end up owning annuities, that have gone into the meeting with their “financial advisor” believing that they’re getting advice. It would never occur to them to treat that meeting the same way they do a new car purchase, nor should it.

Now nothing I say is going to change anything in this argument. I just hope that I get the message out enough that the people in my community hear it and before committing to a long-term contract. My goal is for them to get a second opinion from me or any of the other advisors around town. 

I’ll finish up my rant by saying that I’d like to see how many annuities would be sold if the fees were not paid up front and were based the same way their advisory accounts are paid. I’ll take the under!!!>

Opinions expressed in this article are those of Mick Graham and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation.