Julie Jason: Don't be afraid to ask embarrassing questions

The backdrop for last week's column on how to read a prospectus is a story a reader brought to me a decade ago. The lessons are still valuable to this day.

On a visit with a family friend who was a broker, "Paul" invested his entire inheritance of $800,000 in a variable annuity. After a few months, he changed his mind. He wanted his money back.

That's when Paul learned that he would receive the value of his annuity, less about $56,000. That came as a surprise. His broker explained that the reduction was a "surrender charge," which was described in the prospectus, a document Paul admitted he had not read.

A surrender charge can be viewed as a penalty for early withdrawal that declines over time. The charge can be as high as 9 percent in year one, declining to zero over a period of up to 10 years.

Paul did not recall speaking with the broker about penalties or surrender charges when he bought the annuity. "Maybe penalties came up in the conversation," he said, "but I looked in my notes after the meeting and I could not find any reference to them. I don't remember discussing them. It was an oversight on my part."

Prospectuses disclose the cost of buying the investment, the internal costs during the time you own the investment, and the cost of selling (or redeeming) the investment. Some also state how much the person making the sale is paid.

In this case, Paul was told that there was no commission to buy the variable annuity. In those circumstances, you might think the broker receives no commission. That's not the case.

In a variable annuity prospectus comparable to the one Paul purchased, a commission of 6.75 percent is paid to the firm employing the broker who makes the sale.

On an $800,000 investment, that comes to $54,000. The broker's share of the commission — his payout — is set by the firm he works for. One determining factor is the broker's production. Brokers who produce greater sales are rewarded with higher payouts. Assuming a 40 percent payout, this broker would have earned $21,600 on the sale.

I asked Paul whether knowing that a sizable commission was involved would have made him a little more curious about the product he was buying. He admitted that it would have been an eye-opener. He said he certainly would have asked a few more questions, such as "How do I get my money back when I decide I want to cash in the annuity?"

Given his experience, I asked Paul if he wanted to share anything with other readers of this column. He said: "Tell them to ask embarrassing questions and read the prospectus before investing."

From my perspective as a professional money manager, I can understand why Paul did not push for more information. But the reality is that this is your money and you need to have answers. When I lecture, I tell my students to blame their embarrassing questions on an "unnamed financial columnist."

From my perspective as an arbitrator of more than 10 years, I need to point out that big disputes start out with small misunderstandings. As a result, it pays to air any concerns early in the sales process.

Finally, as someone who started her Wall Street career as a lawyer who wrote prospectuses, I encourage you to confirm what you hear about a product with language in the prospectus. You also need to check the contract if you are buying a product such as an annuity.

In those documents, you also may find some golden nuggets of information that may come in handy if you want an out. For example, variable annuities may offer investors a chance to back out of the purchase if they change their minds within a short period of time (10 days, for example). Before buying a variable annuity, it pays to search the prospectus or contract to see if you can find a "free look" or "right to cancel." If you have such as provision, you may get a refund of your full purchase price. Free look provisions do vary, so you have to make sure you understand the terms of the particular product you are buying.

Julie Jason welcomes your questions/ comments (readers@juliejason.com).