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