| There are a lot of really dumb things you can do | | | | Dow Jones Industrial Index (DJI) that provided |
| with your money and at the top of the list is | | | | 100% participation but its annual earnings were |
| buying an equity indexed annuity. Notice how I | | | | capped at 9%, your average annual return from |
| didn't say "invest" in an equity indexed annuity. | | | | 1920 through 2005 would have been 5.1% versus |
| That's because in order for a product to be an | | | | an average return for the index of 7.6%. With |
| investment it must have some sort of | | | | dividends, an investment in the DJI would have |
| redeemable qualities that merit the allocation of | | | | yielded 11.8% annually. (I used the DJI because it |
| funds to it. In this article, I'll clearly (and painfully) | | | | has a much longer history than the S&P 500 |
| outline why one should never, under any sort of | | | | and I already had the data. Most annuity contracts |
| circumstances, buy an equity indexed annuity. My | | | | are tied to the S&P 500 which is even more |
| case against these insidious products is divided into | | | | volatile than the DJI so the impact would be even |
| four sections which are as follows: | | | | more severe.) |
| - Part I: The Philosophical - How Insurance | | | | This is how the insurance company makes their |
| Companies Make Money | | | | money from an annuity contract. They have the |
| - Part II: The Practical - The Nuts and Bolts of the | | | | capital and discipline to withstand market |
| Policies | | | | corrections because they know in the long-run |
| - Part III: The Historical - Track Record for | | | | they will make a killing on the policy. The truth is |
| Insurance Products | | | | that average market swings are greater than |
| - Part IV: The Actual - Worthless Guarantees | | | | 17%, in either direction. So while you'd miss out |
| Part I: The Philosophical - How Insurance | | | | on some down years, you also miss out on most |
| Companies Make Money | | | | of the gains during up years. |
| On traditional insurance products, insurance | | | | Surrender Charge: Never buy anything where |
| companies make money in three ways: actuarial | | | | there is a penalty for liquidating it - PERIOD! If a |
| gains, the float and fees (administrative expenses | | | | product has merit, why is there a need to apply a |
| and such). In this section, I'll explain how insurance | | | | penalty for getting out of it? |
| companies can only make money off the fees | | | | Part III: The Historical - Track Record for |
| and expenses of equity indexed annuities (EIA) | | | | Insurance Products |
| contracts and how these expenses rob you of | | | | History has not been kind to the investments |
| any hope of appreciable gains. | | | | recommended by Insurance Companies. In this |
| Actuarial Gains: Actuarial gains are simply the | | | | section, I'll examine the track record of products |
| difference between what an insurance company | | | | sold by insurance companies over the past four |
| takes in as premium and what it has to pay out in | | | | decades. (I'm going to address the investment |
| the form of claims. The simplest example is that | | | | performance of life insurance contracts versus |
| of a term-life policy. If you buy a term-life policy | | | | annuities because the variable/EIA is a relatively |
| with a death benefit of $1,000,000 and you pay | | | | new phenomenon only dating back about a |
| $2,000 per year over 20 years, then the | | | | decade) |
| insurance company will recognize a $40,000 | | | | Life Insurance in the 70's |
| actuarial gain if you don't die during the term. If | | | | The majority of life insurance contracts sold in |
| you do die, they'll recognize an actuarial loss of | | | | the 70's where called whole life policies. A whole |
| $1M minus premiums paid. | | | | life policy is one that is guaranteed to pay a |
| There are no actuarial gains for an insurance | | | | specific death benefit. The nature of the contract |
| company when you buy an EIA for two reasons. | | | | is full guarantees. The premium is guaranteed not |
| First, every policy holder gets paid. With most | | | | to increase, the death benefit is guaranteed for |
| insurance contracts (i.e. Home, Auto, Life), the | | | | the life of the insured and so on. These policies |
| insurance company takes a small amount of | | | | were very popular in the 60's and early 70's when |
| money from a lot of people and pays out a lot of | | | | interest rates were at historic lows. But |
| money to a small number of people. With an EIA, | | | | guarantees have one big enemy - INFLATION. |
| or any annuity product for that matter, the | | | | Inflation erodes the buying power of any future |
| insurance company takes a lot of money from | | | | income so while the gross amount of money that |
| people and returns some percentage of that | | | | the beneficiary receives never goes down, the |
| amount in equal proportions to all the policy | | | | real amount adjusted for inflation can depreciate |
| holders. | | | | substantially. In the 70's, possibly the worst |
| Second, actuarial gains can only be achieved when | | | | investment you could have made would be one |
| insuring against non-systematic risk. An EIA is | | | | that paid a low, fixed, guaranteed rate of interest |
| providing insurance against a systematic risk since | | | | - which is what whole life policies did. |
| every policy holder will be exposed to the same | | | | Life Insurance in the 80's |
| set of circumstances - the price performance of | | | | Inflation was destroying Whole Life sales in the |
| the index. If the market crashes, every insured | | | | 70's as interest rates soared for the entire |
| account crashes. Insurance companies cannot | | | | decade. Insurance companies were slow to react |
| realize actuarial gains when every insured realizes | | | | but came up with a solution which was the |
| the same investment returns. | | | | Universal Life (UL) policy. UL policies pay a variable |
| The Float: Interest and capital gains on the float | | | | rate of interest which is linked to some sort of |
| are the primary means that insurance companies | | | | "official interest rate" (The "official interest rate" |
| have of making money. The float is the use of | | | | can be any number of options such as Treasuries, |
| insurance premiums up until a claim is paid out. | | | | LIBOR, ect.) |
| Take a car insurance policy for example. Assume | | | | Interest rates peaked in the mid-80's and have |
| you pay $1K in premiums for 5 years. In the 5th | | | | decreased ever since. The 10-year treasury |
| year, you get in an accident and the claim is $5K. | | | | peaked at 13.56% in June of '84 and bottomed in |
| Even though the insurance company will not | | | | June of '03 at 3.33%. The track record for UL |
| realize an "actuarial gain" on your policy, they will | | | | policies is pitiful (I know personally b/c when I first |
| have realized income on the premiums dollars | | | | started in the Financial Services business, I was |
| prior to paying your claim. | | | | given a handful of UL policies that were about to |
| (Editorial Note: The float is why Warren Buffet's | | | | lapse despite the original illustration showing them |
| initial purchases were insurance companies. | | | | having millions of dollars.) |
| Berkshire Hathaway is technically an Insurance | | | | While bond investors in the mid-80's saw their |
| Company. Buffett knew that he could allocate | | | | investments appreciate as bond yields decreased, |
| investments better than just about anyone else | | | | UL policy holders saw their policies lapse as the |
| so he bought a company that had a lot of money | | | | "illustrated" interest rates were significantly more |
| to invest.) | | | | than realized interest rates. One of the most |
| There is no float for the insurance company in an | | | | foolish investments in the 80's would have been |
| EIA. The vast majority of the purchase needs to | | | | buying a non-guaranteed policy where the |
| be invested in the index. With all other types of | | | | investment returns were tied to interest rates |
| insurance premiums, the company can do | | | | that would decline over the next two decades. |
| whatever they please with the money until they | | | | Life Insurance in the 90's |
| have to payout the claim but with an EIA, they | | | | Declining interest rates and low inflation made UL |
| have to fully invest the premiums so that they | | | | policies obsolete so the insurance companies |
| can keep up with the redemption value of the | | | | reacted with a new product called Variable |
| policy. | | | | Universal Life (VUL). This product allowed a policy |
| Fees and Expenses: This is the nickel and dime | | | | holder to invest in pseudo-mutual funds, called |
| stuff. Those nasty little line items that appear on | | | | Variable Portfolios that invested in equities and |
| your statement or bill. This is the smallest piece of | | | | bonds. |
| the profitability pie for insurance companies on | | | | While some early adopters started offering |
| normal insurance products (home, car, ect.) | | | | policies in the early 90's, the idea didn't really take |
| But with an EIA, the only way for an insurance | | | | off until the mid to late 90's - just in time to |
| company to make money is from fees and | | | | suffer the steep losses in the tech bubble. In |
| expenses. These fees and expenses are carefully | | | | order for these policies to "work" they had to be |
| hidden underneath mountains of actuarial and legal | | | | wholly invested in equity funds which got |
| documentation but they are most certainly there. | | | | obliterated in the Tech crash. |
| It is well documented that the key to successful | | | | Life Insurance and Annuity sales in the 2000's |
| index investing is keeping expenses to an absolute | | | | As a result of the worst bear market since 1929, |
| minimum. The market only returns between | | | | Insurance companies developed products that |
| 7-11% over any fixed period of time and if you | | | | combined some of the benefits of market |
| load up expenses, your account will never | | | | participation along with guarantees. There is a |
| outperform a more secure bond portfolio. | | | | whole host of them of which EIAs is one of |
| Part II: The Practical - The Nuts and Bolts of the | | | | them. |
| Policies | | | | An EIA provides limited upside market |
| In this section, I'll address four distinct attributes | | | | participation with a protection against losses. This |
| of index annuities which make them possibly the | | | | is all well and good except for the fact that |
| dumbest thing you can do with your money short | | | | inflation is again taking hold of our economy. As I |
| of burning it. They are: | | | | stated previously, the last thing you want to buy |
| | | | in an inflationary environment is a low-interest |
| 1. No credit for dividends | | | | guarantee. EIAs provide nothing more than a |
| 2. The number of people getting paid on the policy | | | | dress-up low-interest investment product. They |
| 3. Tax treatment of index funds vs index | | | | guarantee against loss in capital but not against |
| annuities | | | | loss in purchasing power. |
| 4. Market volatility | | | | Historically, insurance companies always get it |
| 5. Surrender charges | | | | wrong. They create "fad" products that their sales |
| No credit for dividends: When you own an EIA, | | | | force can sell using manipulative sales pitches |
| you do not receive any compensation for | | | | designed to create an emotional response in the |
| dividends paid by the companies in the index. The | | | | prospective client. These products have never |
| contract value goes up in line with the price | | | | done well and I think its foolish to believe that it |
| change of the value of the index. Currently, the | | | | will be any different with the products they are |
| dividend yield for the S&P 500 is 1.8%, | | | | currently pitching. |
| therefore, before expenses and fees, an EIA will | | | | Part IV: The Actual - Worthless Guarantees |
| automatically under perform the S&P 500 | | | | In my opinion, the guarantees provided by the |
| index by 1.8%. | | | | insurance companies are absolutely worthless. |
| 1.8% may not sound like a lot, but over 20 years | | | | Over the next decade, the stock market will |
| the difference is substantial. A $100,000 lump sum | | | | either be higher or lower. If the stock market is |
| earning 10% invested for 20 years would be | | | | higher, your guarantee is worthless and you would |
| worth $672,750 where as this same investment | | | | have done much better in an equity index fund. If |
| receiving 8.2% would only be worth $483,667 - a | | | | the market is lower, it will be the result of a |
| difference of $189,084. Now you know why the | | | | multi-year depression resulting form excessive US |
| insurance company is willing to such steep | | | | debt, a steep decline in the US dollar and a severe |
| commissions to sell these things. | | | | contraction in consumer spending by Baby |
| The number of people getting paid on your policy: | | | | Boomers. |
| When considering any investment, you should | | | | There has already been a 50% decline in stocks |
| always ask yourself, "How many people are | | | | this decade. While a severe pullback in equity |
| getting paid before me?" With any "sold" | | | | prices over the next couple of years is possible, |
| investment product the investor is the last person | | | | the likelihood that the markets will be in down |
| to get paid. Everyone makes money before you, | | | | over the next decade is minimal unless our |
| but the question is how many and how much. | | | | nation's economy suffers some sort of |
| Here is quick rundown of who is going to get | | | | catastrophic event (Banking crisis, US$ crash, ect.). |
| "theirs" before you get "yours". | | | | If the US economy suffers a catastrophic event, |
| | | | it would call into question the liquidity of our |
| 1. The agent/salesperson/broker: Commission on | | | | nation's banks and insurance companies. Every |
| these products range from 5% to 14%. The | | | | EIA will "be under water" a. This will lead to a run |
| majority pay commissions in the high single digits. | | | | on these assets that the insurance companies |
| 2. The sales organization: Whether your agent is a | | | | won't be able to meet. Furthermore, whatever |
| broker or a captive salesperson, there are layers | | | | the insurance company has to invest of their own |
| of sales managers on top of him who all receive a | | | | money is invested in the same asset classes as |
| nice override on your purchase. | | | | the EIA. If index annuities are under water, the |
| 3. The underwriter: Insurance companies have | | | | insurance company's portfolio is going to be down |
| never been or never will be the altruistic type. | | | | as well. Combine both of these factors and I |
| They have one objective and that is to make | | | | would assume that any insurance company |
| money. | | | | offering index annuities will be insolvent. |
| 4. The Investment Manager: Fidelity charges 1/10 | | | | Conclusion |
| of 1% for their index funds. Anything more and | | | | As I stated earlier, index annuities are possibly |
| you're paying too much. While it is impossible to | | | | one of the worst investment options for your |
| tell what sort of "cut" the investment team for | | | | money. If you have been approached by a |
| an EIA is receiving, you can be assured that it | | | | salesman seeking to put your money into an |
| exceeds what Fidelity or Vanguard charges for | | | | annuity, I encourage you to ask him the following |
| their index funds. | | | | questions: |
| Tax treatment of index funds vs. index annuities: | | | | - How much lower will my average returns be |
| The only valid reason to ever invest in a deferred | | | | since I won't receive any dividends? |
| annuity contract is for the purpose of tax | | | | - Why would I need the benefit of tax deferral |
| deferral. I cannot possibly conceive how an | | | | when an index mutual fund essentially grows |
| insurance company can even begin to promote | | | | tax-deferred? |
| the benefit of tax-deferral when selling annuities | | | | - How much are you getting paid to sell me this |
| FOR ALL PRACTICAL PURPOSES, INDEX FUNDS | | | | product? (My personal favorite) |
| GROW TAX-DEFERRED TO BEGIN WITH. THEY | | | | - What is the average percentage change in the |
| DO NOT NEED AN INSURANCE CONTRACT TO | | | | market index each year? (I would suppose that |
| GROW TAX DEFERRED! | | | | any salesperson doing any sort of due diligence on |
| Furthermore, an annuity is the only investment | | | | a product would know this. If the answer is |
| where long-term capital gains are converted to | | | | anything other than around 17% per year, you're |
| ordinary income and taxed at a higher rate. The | | | | being lied to.) |
| ugly truth about index annuities is that they | | | | - How would the performance of an EIA stack up |
| create a greater tax burden for the investor than | | | | against a simple portfolio of laddered, investment |
| an index-tracking mutual fund. The fact that an | | | | grade bonds? (A portfolio of diversified |
| insurance salesman even utters the term | | | | investment grade bonds would theoretically have |
| tax-deferred or tax-preferred when selling an EIA | | | | a lower default risk than an EIA, a more |
| is practically blasphemy. | | | | predictable income stream and in all likelihood |
| The largest mutual fund in the world is Vanguard's | | | | higher returns over both the short and long-term.) |
| S&P 500 Index fund (VFINX). Over the last | | | | - How much would I have to pay if I want to get |
| five years, only 3% of its average annual gains | | | | out of my investment in one, two, three or four |
| were recognized and taxed, where as 97% of its | | | | years? How long is the surrender charge? |
| gains was tax-deferred. Therefore, it has grown | | | | - How does this investment protect me against |
| 97% tax efficient (Source: Fidelity Investments). | | | | inflation? (the answer is that it doesn't because |
| Furthermore, given the nature of indexes, it is | | | | stocks and their indexes tend to perform poorly |
| safe to assume that all or most of the gains | | | | in an inflationary environment, furthermore, stock |
| were taxed as long-term capital gains which carry | | | | markets are extremely volatile in inflationary |
| a maximum tax burden of 15%. | | | | environments which means that you'd miss out |
| Market volatility: While index annuities supposedly | | | | on more upside.) |
| insure you against losses during down years, they | | | | - How long have you been in the business? What |
| also limit participation in up years. They limit the | | | | were you selling a decade ago and why aren't |
| upside participation in two ways. First, they will | | | | you selling that anymore? How do I know the |
| limit the amount of upside by capping gains at a | | | | same won't happen to my EIA? |
| certain percentage. Second, they may limit the | | | | Insurance companies prey on people's emotions. |
| percentage of gains that you can participate in. | | | | They sell greed when people are greedy and they |
| The contract may have one or both types of | | | | sell fear when people are fearful. These new |
| restrictions. Often times, it is a combination of | | | | instruments are trying to meet both objectives - |
| both such as 80% up to 10%. Index annuities are | | | | appeal to both greed and fear. The unfortunate |
| set up this way because the insurance companies | | | | trade off is huge fees and complicated formulas |
| are counting on you being naive about the nature | | | | that guarantee one thing and one thing only - the |
| of market volatility. The truth is that markets are | | | | insurance company will make money and you |
| very volatile year in and year out. | | | | won't. If you want a real guarantee, buy |
| The average up year for the Dow Jones Index | | | | short-term US Treasuries or a diversified, |
| since 1920 is 19.2%. Therefore, if you're only | | | | laddered portfolio of investment grade bonds. |
| participating in the first 9%, you'll realize less than | | | | They are far safer than index annuities and will |
| half of the market's potential in up years. | | | | likely outperform them in both the short and the |
| Assuming that you invested in an EIA tied to the | | | | long-term. |