Guaranteed Annuities and other Three-Legged Chickens


One of my first Accountable Update posts was about Three-Legged Chickens. I was reminded of this recently as one of my clients dealt with a complicated Guaranteed Minimum Withdrawal Benefit (GMWB) variable deferred annuity that a “friend” sold him for his IRA several years ago.

As is usually the case with products like this, it sounded too good to be true when it was sold to him. He could invest in the stock market but have a guaranteed minimum return of 7%. If only it were so simple.

Long story short, after over a decade, the value of the underlying funds were not much more, if any, than his original investment. After a few years, he decided to transfer the account somewhere else, but had been discouraged from moving it due to surrender penalties that were as high as 7% of his account balance. While market conditions and fund selection contributed to the dismal performance, the fact that he was paying over 2% in annual fees was the primary culprit.

We ultimately found a solution for him after carefully reading his annuity contract. The insurance company now sends him a check each year for the rest of his life and we deposit that into his IRA within 60 days of the distribution so it can continue to grow tax deferred. If you want to hear all of the details, or if you have a similar product and feel stuck, get in touch to discuss.

If you are considering any new investments, especially those touting guarantees, let me tell you a story about a chicken…

Three-Legged Chickens

Did you hear about the Aggie scientist that developed a three-legged chicken? Apparently, executives from a big chicken outfit offered a large grant to modify a chicken’s genome so that they would grow an extra leg. Seeing as to how the drumstick is the most popular part of a chicken, they figured they could lower their production cost by 33% if such a feat was possible.

So the Aggies got to work on it, and lo and behold, they were successful in creating three-legged chickens in a relatively short time. The chicken folks were very excited to hear this and immediately brought a delegation down to College Station to see for themselves.

When they got to the facility where the chickens were being kept, the Aggie in charge, Rocky, greeted them at the front gate. “Howdy!” he said.

“Well hello,” said the head chicken man they referred to as Colonel.

“How’s everything going,” he asked?

“Well, there’s good news and bad news,” said the Aggie.

“What’s the good news,” asked the Colonel?

Rocky answered, “We've got about 1000 three-legged chickens over there in that barn.” 

“That’s great!" the Colonel replied, "How do they taste?”

“That’s the bad news. We don’t know,” said Rocky, looking down at his feet. “You see, with that extra leg, they run so darn fast that no one can catch one!”

You may be asking yourself what that has to do with investing. As it turns out, quite a lot. You see, investors put an incredible amount of effort into chasing three-legged chickens themselves. The three “legs” they are after are high returns, predictability, and liquidity.

The problem is that these three characteristics are almost certainly mutually exclusive. High returns are the potential reward for taking on higher volatility. Predictability, or lower volatility, equates with lower returns. Liquidity can vary widely based on an investment's characteristics or current market conditions, but generally is highest on the least volatile types of investments.

The investment sales industry has a long history of trying to convince people that they have created investments that have all three legs. Some of the worst offenders of the three legged marketing game are variable annuity companies. On the surface, they can be as appealing as a barn full of three-leggers to the Colonel himself. Potential high returns coupled with guaranteed future income and even the ability to make withdrawals along the way are all touted as legs of these chickens. (Yes, tax deferral is another frequently touted benefit of variable annuities but the “tail that wags the dog” is a story for another day.)

Questions for the Annuity Salesperson

If you find yourself cornered by a salesman of one of these frequently foul products, ask the following:

  1. What are the mortality fees and what do they cover?

  2. What are the underlying expense ratios of the investment options?

  3. How much MORE do I have to earn in the annuity just to break even with a similar taxable investment?

  4. If the product guarantees a future amount or payment, what is the Return on Investment (ROI) of that benefit?

  5. What are the surrender penalties if I need to withdraw funds?

  6. How will I be taxed when I make withdrawals?

  7. How will my heirs be taxed when they inherit the proceeds?

  8. Are you paid more to sell me this product versus other solutions?

In most cases, once you add up the cost of that extra leg, it will be obvious that there is a very low chance the annuity can outperform more straightforward and practical approaches.

So if three-legged chickens are as hard to catch in the investment world as they are in the barnyard, what should you do? Choose investments for their obvious characteristics and hold them in reasonable proportions in line with your tolerance for risk.

Stocks offer the potential for high returns, but are very unpredictable in the short term. Bonds offer higher predictability at the cost of offering lower returns. Alternatives, such as hedge funds and private equity, may offer high returns but liquidity can be very low. Cash may offer the most liquidity and predictability in the short term, but the returns are usually very low and are frequently negative with any inflation figured in.

Having a diversified approach can’t guarantee that you will make money or avoid losses, but it is a lot more likely to help you find success with your portfolio than chasing a three-legged chicken.