Variable Annuities: Beware These Promises of “Risk-Free Income”
by Floyd G. Brown, Advisory Panelist, Investment U
Wednesday, July 02, 2008: Issue # 815
The stock market’s recent woes are driving investors to safety right now. With this in mind, financial advisors and insurance companies are teaming together to offer an investment that’s flying off the shelves.
It’s sold to the unsuspecting like this: “How would you like investment gains with zero risk of losing money? Plus, you can have a steady check for as long as you would like. And to top it all off, when you die, your heirs can inherit your money.”
Wow! Who wouldn’t want a risk-free income for life? Too good to be true?
Baby boomers are snapping up these so-called risk-free variable annuities as quickly as they can be sold. According to Smart Money magazine, in the last decade, sales of these products have doubled. Currently, $750 million is being moved from savings to variable annuities every working day of the year. In 2008, projections show more than $200 billion worth will be sold.
The most common reason cited by purchasers is the desire to avoid stock market risk. But with 1,100 different variable annuities available right now, how can you be sure that there isn’t any risk?
Variable Annuity Investments - More Risk Than Investors Realize
Actuaries are the smartest people I know. One of their main functions is to assess the probability of certain events occurring and formulate policies that minimize the cost of that risk. Actuaries are essential to the insurance industry. With these risk experts on hand you’d think variable annuities would be bulletproof.
Trouble is, while variable annuities have a life insurance component, they are not insurance.
The concept of insurance is that:
- We bind together in groups to share risk.
- We all pay premiums for fire insurance for example, but not all of our houses burn down.
- Only the unfortunate few collect.
The problem with variable annuities is that they are all invested in the stock market. When the market goes down, everybody’s underlying annuity value is impacted. The “fire” burns everybody.
If the assumptions held by the insurance companies about the market are incorrect, they may not be able to perform on these millions of annuity contracts. Even the smartest of actuaries can make mistakes.
Promising Too Much On Variable Annuity Payouts
In the 1990s, Equitable Life Assurance Society in the United Kingdom - the oldest mutual life insurance company in the world - routinely promised too much in payouts on variable annuities. When interest rates turned and defied the actuarial models, it caused a crisis that cut the value of the annuities. This reduction in payments burned 50,000 policyholders.
American insurance companies say it will never happen here. There has never been a similar default on payments in the United States. Nevertheless, any annuity is only as strong as the company that issues the policy.
Today, the insurance companies selling these policies are raking in lucrative fees. They can run as high as 3.5% a year. On a $1 million annuity, that would be a fee of $35,000 every year. Insurance executives are hoping that these fat fees will cushion the trouble ahead should the stock markets not perform adequately enough to keep payments steady.
Yet there are thousands of Bear Stearns investors who found out the hard way that even the largest giants can fall - and that there are no guarantees.
There’s No Such Thing As Investing Without Risk
There is no such thing as investing without risk. Without risk, there is no reward. Even in these “risk-free” situations, there is the chance that the other party in your contract cannot perform. So as for no risk promises, I guarantee that if you read deep enough into the paperwork, you will find some risk.
My advice is to read the fine print. These are very expensive investment products and you might be better served in a diversified group of no load mutual funds. If it is the regular payments you desire, then look for funds that pay adequate stock dividends, and set up regular withdrawal payments.And be on your guard for the next “risk free” investment.
Good investing,
Floyd
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Today’s Investment U Crib Sheet
There are three main types of insurance contracts…
Annuities
An easy way to think about an annuity is that you are giving a company an amount of money, and they are giving it back to you (with interest) over a specified time period. This time period can be fixed at 20 or 30 years, or it can be fixed on the lifetime of an individual or couple.
A fixed annuity guarantees a minimum return with a possibility of more, depending upon interest rates. These policies give a low return because they assume very little risk.
A variable annuity gives the owner an option of where to invest, and has a flexible payout based upon the performance of the account. They give you a lower guaranteed minimum, but also have the potential for high returns based off their investment. Generally, these investments are in market-tracking funds or indexes.
The life insurance element of an annuity applies when payouts are based on an individual’s lifetime, and the company assumes the risk of paying more money than they collected in premiums.
- Term Life
A term life policy is a policy that protects you for a specified term for the contract amount. These generally run from 10 to 30 years. If the policy isn’t used by the end of the period, the policyholder gets nothing but the appreciation of life. These policies make more economical sense for protecting an item, like a mortgage or a college education. Or protecting an income, like one used to support a family or person. - Whole / Universal Life
A whole life policy - also called universal life - insures the individual for their entire life for the contract amount. The difference in a whole life policy is that they have a cash value. In the beginning of the policy period, when the cost of insurance is cheaper, a majority of the monthly premium goes into a cash account where it can grow. This cash value is used to support the growing cost of insurance, and can grow larger than the original contract death benefit. It can also be cashed out if need be, and many policies enable the policyholder to take loans from it. Insurance contracts can have tax advantages as well. As you can see, these contracts are structured with many benefits and features. Because of the cost, a whole life policy isn’t going to be appropriate for everyone. For most individuals considering these policies, you should already be maxing out your retirement contributions and savings plans before purchasing. Specific questions on how appropriate they are for your situation should be addressed to your insurance or estate professional. Be sure to look out for the 10 most common mistakes in estate planning. - Keep in mind that the more a product does for you - or the more risk that an insurance company takes on - the higher its policy costs.
- Finally, past performance is not an indicator of future results is a truism for stocks, but not necessarily for insurance companies. In the case of insurance companies, history and size is important. It means they’ve been listening to their actuaries.
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- How to Buy a Variable Annuity: Pocket an Extra $1,250 a Month
- Municipal Bonds: The First “Obama Investment”
- The 4 Pillars of Investing: Don’t End Up as Stock Market Road Kill
