“The magic of compound returns is overwhelmed by the tyranny of compounding costs”
The sub-headline of this post is in quotation marks because it’s a direct quote from John Bogle, the father of the index investing strategy and the founder of The Vanguard Group. Bogle is a role model for me and many others who believe passive investing in index funds will always beat managed funds because, as Bogle said in the recent PBS special The Retirement Gamble: “The magic of compound returns is overwhelmed by the tyranny of compounding costs.”
We’ve discussed the tyranny of fees and commissions in the first two posts in this series on the new pyramid scheme, but perhaps the greatest of tyrannies comes in the form of one of the most popular types of investment vehicles being sold today: the Fixed Annuity.
As with any investment, if the value of the investment you select for your annuity goes up, your investment grows. And, if the value drops, you investment shrinks along with your eventual payout. But it gets much worse.
You will pay taxes on the gains made by your variable annuity when you withdraw funds. If you withdraw early (before the age of 59.5 years), you’ll also pay a 10% penalty. The capital gains you acquire are taxed as ordinary income under a variable annuity. So, you are taking earnings that would otherwise be taxed as capital gains and treating this investment earnings as earned income, which is taxed at a much higher rate.
This should be more than enough to steer you away from variable annuities, but we haven’t even discussed fees yet. The typical variable annuity has sales commissions of 4%, management fees of 1%-2% and insurance charges of 1%. All of this is docked at the beginning of each year, so you open your annuity with significantly less than you actually put into it.
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