Every Investment is a form of speculation"~Ludwig Von Mises, "Human Action"
After reading CNN Money.com's article titled, Index annuities are a safety trap, several questions are brought up in reference to the "traps" of Index Annuities. Of course, this article grossly misrepresents annuities. However the purpose of this blog article is to explore some of the basic functions of annuities. This article will explore if the Index Annuity is an Evil Villain or Tragic Hero. At the end of the exploration, then you can determine if the Index Annuity is an Evil Villain or Tragic Hero. There are various forms of annuities; I will limit our discussion only to Indexed/Fixed Annuities.
What are Annuities?
Annuities are insurance contracts. They are not just any ordinary insurance contracts. They have some unique features unlike the average financial instrument or investment. From an economics perspective, this uniqueness comes with a cost, but in many cases is worth it for the right client.
Annuities allow the owner to place money inside the insurance "contract" during the accumulation period. During the accumulation period, the money can grow tax deferred. The unique feature with an annuity is this: At the payout phase, the insurance company provides a lifetime of income. You can NOT outlive an annuity. There are various pay out options to the annuitant. This is guaranteed in writing by the insurance company. How is the insurance company able pay out a life time of income to a client? Answer: Reverse Underwriting.
As established in the prior paragraph, the Insurance Company pays out for the entire life of the annuitant. It calculates the life span of the annuitant based on the Law of Averages and the Law of Large numbers of millions of similar annuitants. This is an estimate simply based also on the age and gender of the annuitant. Large amounts of statistical data are compiled in order to provide this benefit. Since the actuaries do not work for free, this "cost" is factored into the fees, surrender charges, etc of the annuity.
How does the accumulated capital grow?
The insurance company invests the capital from the aggregate pool of annuitants, and invests the money very prudently. Its not invested in the behalf OF the annuitants, but the annuitants benefit from the success of the Insurance company's investments. With an index annuity, the insurance company will invest those funds into the performance of an external index:i.e S&P 500. Based on the performance the annuitant the insurance company is able to place in writing that the annuitant will NEVER lose money on the account. The capital is safe from downside risk.
Ok no downside risk! What is the catch?
The annuitant is able to always maintain their principle, but has a cap on the ROI(return on investment) on the capital IF the index does extremely well. Those caps may top out at approximately 5%-7%. Keep in mind, if the index goes down, the insurance company will NOT reduce the principle relative to the negative direction of the index. The principle is safe and secure, future gains are locked in; AND this guarantee is placed in writing by the insurance company.
Surrender Charges: Are they a scam?
Most annuities have surrender charges. They are disclosed in the application and paperwork. Question: Why do annuities have surrender charges? Is it to "rip" the customer off? Let us never forget the obvious and salient point about Annuities: Annuities are insurance contracts. Insurance is based on pooled risk. Pooling a risk comes at tremendous cost--so does guaranteeing a lifetime of income. With Index Annuities, guaranteeing that the annuitant will NEVER lose money comes with an additional cost.
Let's suppose that the Insurance Company charges no surrender fees on these types of contracts. The client withdrawal turnover of capital will be high, simply because there are no fees discouraging the annuitant to seek long term growth in the contract. This high turnover of capital would inhibit the insurance company to maintain the satisfactory amount of leverage of capital to properly run annuities. They would not be allowed to provide all the wonderful benefits that an annuity offers: A Guaranteed Life time income and with indexed annuities a guarantee of NEVER losing the capital to the vicissitudes of the market.
Side note with regards to managing risk: Any time the risk is transferred, it is always done with a cost. In the case of Index Annuities, the Insurance Company is retaining the risk that is transferred from the owner/annuitant. With auto insurance, if your deductible is a $100 for physical damages done to the car, the cost will be higher as compared if the deductible was $500. With Index Annuities, the concept is very similar. The surrender charges are the explicit costs for the Insurance Company guaranteeing no loss of principle--and they are transferred to all the annuity policy holders.
Answering the Critics on Index Annuities
Here are some typical categorical complaints about Index Annuities
High Surrender Charges
As discussed in the prior section, Surrender Charges are the explicit cost of the insurance company managing the risk--this risk is the guarantee against the loss of principle, but allowing upside growth. Critics complain about the surrender charges, but do not take into consideration the life time benefits. Remember, one cannot outlive an annuity.
If a client is seeking to have an investment vehicle that matches all the benefits of an annuity, it would take a large amount of time to successfully create, manage, and run this copy. Why not transfer that expertise to someone who has an absolute advantage as compared to doing it all solo?
For people that want a higher ROI and lower or no surrender charges, maybe should consider Mutual Funds. However, Mutual funds do not provide all the benefits and guarantees that Index Annuities provide. Keep in mind, the majority of the risk is being retained by the insurance company, not the owner of the annuity. Mutual Funds, the owners have all the costs and risks associated with this product.
Agents make Larger Commissions when selling Annuities
This excuse is a puzzling and it leads to confusion. It is positioned that somehow that the rationalizing of the fees or surrender charges are to "pay the agent's" Commission. It is a fantastic story that is 100% utter non-sense and drivel. Earlier it has been established that surrender fees are part of explicit costs of running an annuity program. The costs are to protect the asset: The capital inside the annuity and the entire risk pool of the annuity program. Next, the commission is paid separately to the agent for the sale of annuity contracts. Commissions may range from 5%-10% on the annuity based on the company.
Low top end returns as compared to Mutual Funds or other investments
Index annuities allow the owner to participate indirectly into an index. The annuitant has that principle locked in for future gains! The guarantee by the insurance company gives out an additional trade off: a lower cap on top end gains. Typically that is around 7%-8%. I wonder how many individuals were concerned about the earnings as compared to being concerned about how to get their money back from substantial losses in the Stock Market! As Will Rogers stated, "Most people are more concerned of the return OF their money rather than ON their money"
More regulation of Index Annuities
The Financial Services industry is one of the most regulated industries in the Free Market. Contracts, disclosure forms, applications, etc are currently presented to the customer. The customer has a free look period with these contracts. And, the insurance company provides a written guarantee that they will pay a certain percentage on the annuity owner's accumulated balance REGARDLESS of the direction of the index!
The problem with most horror stories with annuities is about suitability-- People wanting to access their cash in less than 3 years. An index annuity is not the best fit for this situation. This problem is a communication problem with the client and the adviser.
In closing, is the Annuity a nefarious "villain" or a tragic hero misrepresented? It all depends on suitability. Most people are seeking the perfect investment. They listen to the radio pitchmen, read the national finance magazines advising them on the "best or perfect investment". The perfect investment does not exist. The most efficient investment does. That investment is based on what is best for your situation, goals and objectives.
Friday, June 3, 2011
Evil Villain or Tragic Hero: Analysis of Index Annuity
Every Investment is a form of speculation"~Ludwig Von Mises, "Human Action"