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MARCH 25, 2013

Did You Mean to Buy an Insurance Policy?

By Gary L. Hall, 3/25/2013

Insurance is designed to replace something lost—it’s an expense. An investment, on the other hand, is designed to generate added value over time.  It seems to me, though, that deferred annuities often blur the line—blending insurance and investment into some combination of the two; a complicated financial product trying to do too many things–none of them well. Annuities, at root, should be nothing more than longevity insurance. But sales rhetoric claiming they’re a foolproof growth investment—market participation with no downside—is common.

But my experience in analyzing annuities leads me to believe that the combination doesn’t result in this fairytale investment—but much more often, poor performing investments combined with inefficient insurance.  Can you imagine insuring a $30,000 car by giving the insurance company $30,000? I can’t. So why do people insure a $500,000 retirement by giving the insurance company all $500,000?

Variable annuity investments are stock and bond mutual funds called subaccounts. Independently, these are legitimate mutual fund-like investments that can create wealth over time. Variable annuities’ insurance component comes in the form of death benefits (life insurance…sort of) and income benefits (longevity insurance) and are often hooked on the word “guarantee.” Some benefits are included in the basic variable annuity contract while others can be added for additional fees.

Fixed-indexed annuities (previously called equity-indexed) are even more insurance and less investment. These are variable interest rate products based on the stock market price and don’t have any base fees. Sounds great! And that is why they sell so well. But because they charge no fees, insurer profits are dependent on your contract returns being lower than the insurer’s underlying investment returns. And insurance companies prefer to put their money in predictable investments like intermediate US treasuries or something with a similar risk/return profile. In case you missed that: indexed annuities must more or less systematically underperform a relatively conservative bond portfolio.

There may be value in that type of financial product –your principal is very safe, returns are relatively predictable, and lifetime income is a great piece of the retirement puzzle. But it’s not a comprehensive solution for most investors, especially those that need growth to support an ever longer retirement. Do most people buy the product with that understanding? There is reason to be skeptical. And I wonder if investors are ultimately disappointed with indexed annuity returns? Seems possible, given how these have been marketed.

Insurers are profit seeking corporations so the insurance piece needs to be profitable. This requires that fees collected be higher than expenses and net payouts over time. On average there must be more principal lost than gained by contract holders as a group.

And from the perspective of an individual contract holder, it’s alarming how difficult it is to keep the insurance aspect in your favor—contracts often allow increases in fees and reductions in benefits at any time, buyout offers may not be a good deal, not to mention the counterintuitive income riders. It’s a tough position to find yourself pitted against the actuaries and a 100-page prospectus.

Understanding these trade-offs is an important part of shopping for annuities. These are insurance contracts whose main benefit is to compensate for longevity risk. Focusing on ambiguous “market participation” or “guaranteed growth” should raise a yellow flag, if not a red one.

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