Pre-packaged Investment Products are NOT What They Seem

Pre-packaged Investment Products are NOT What They Seem

Pre-packaged Investment Products are NOT What They Seem

Index and variable annuities are popular right now and you’ve probably either attended or been invited to attend free luncheon and dinner seminars where you’re told how the guarantees provided will give you the peace of mind that you won’t lose money when the market goes down. Plus you’ll make money when it goes up. What could be better?

Invariably, these annuities have some form of an income guarantee. Some of them guarantee that your balance will increase by 7% a year before you start taking distributions, and then you’ll be guaranteed to get distributions of 5% for life.

After hearing this pitch, you conclude, “Wow, I’m NOT guaranteed to make 7% a year in the stock market, and with this I’d make at least 7% in those years the stock market goes down and still make at least that when the markets go up—there’s no way I can lose! This is the best investment ever. I just have to put whatever I want inside the oven, turn the little knob on the side and set it and forget it!”

The problem with this conclusion is confusing a paper return with an actual return. The return on a stock or mutual fund is real. It’s yours. You can access it. The 7% guarantee associated with annuities is a paper or make-believe value increase. It’s not yours. You can’t withdraw it. It only comes into play IF you take lifetime distributions.

And those 5% distributions? You probably think it means you earn a 5% return on your money. It doesn’t. Notice they use the term “income stream,” not “return.” That’s because only 1% of the payment might be “interest” you’ve earned while the other 4% is a return of your principal. Let’s say you give me $100,000 and I guarantee to pay you $5,000 for 20 years. Assuming the underlying investment doesn’t earn any money, the money left after 20 years is $0. The insurance companies would call that a 5% income stream even though your actual return was 0%. Worse, you gave them free use of your money for 20 years!

Please re-read the preceding paragraph so that you understand what a “5% income stream” actually means.

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The best way to analyze an annuity is to calculate the minimum guaranteed return you will earn using the worst case scenario. This alleviates any confusion over what you are being told you can expect and what you are guaranteed. The minimum guaranteed interest rate is set by each state. On some policies I’ve looked at, it is 1.5%. Even that is misleading, though. That doesn’t mean that you are guaranteed to earn 1.5% per year on every dollar you put in. It means you earn the minimum guaranteed interest rate on 87.5% of what you put in. Read it yourself:

What is the Guaranteed Minimum Return?

When EIAs were first sold in the mid-1990s, the guaranteed minimum return was typically 90 percent of the premium paid at a 3 percent annual interest rate. More recently, in part because of changes to state insurance laws, the guaranteed minimum return is typically at least 87.5 percent of the premium paid at 1 to 3 percent interest. However, if you surrender your EIA early, you may have to pay a significant surrender charge and a 10 percent tax penalty that will reduce or eliminate any return.[1]

So, let’s say you put in $100,000 and they generously “give” you a bonus of $10,000! You are NOT guaranteed to make 1.5% a year on the $110,000, and you are not guaranteed to make 1.5% on $100,000. You ARE guaranteed to make 1.5% on $87,500. Look how this works out over 10 years:

 

Invested GSV BOY Interest 1.5% GSV EOY
Year 1 $       100,000 $           87,500 $           1,313 $           88,813
Year 2 $       100,000 $           88,813 $           1,332 $           90,145
Year 3 $       100,000 $           90,145 $           1,352 $           91,497
Year 4 $       100,000 $           91,497 $           1,372 $           92,869
Year 5 $       100,000 $           92,869 $           1,393 $           94,262
Year 6 $       100,000 $           94,262 $           1,414 $           95,676
Year 7 $       100,000 $           95,676 $           1,435 $           97,111
Year 8 $       100,000 $           97,111 $           1,457 $           98,568
Year 9 $       100,000 $           98,568 $           1,479 $         100,047
Year 10 $       100,000 $         100,047 $           1,501 $         101,547

 

That’s right! After 10 years you are “guaranteed” to earn only $1,547 more than you put in.

The guarantees benefit and income riders provided by annuities are based on certain requirements being met, and very few investors are apt to ever meet all of the requirements. Even if they do, the returns probably aren’t going to be what they think they’ll be.

Before leaving the topic of annuities, I want to comment on the risk associated with investing in them. I believe that those considering annuities often incorrectly assess the true risk involved. They have experienced losses in equities and tend to focus on how annuities may prevent that in the future, while ignoring other risks that can be just as devastating, such as surrender penalties.

Most people dismiss the potential loss associated with the penalties because they think there is little chance they will ever pay them. They tell themselves, “I don’t expect to start drawing on this money for 10 years, so the penalties won’t apply to me.” Yet the likelihood of keeping the same annuity for 10 years is very small. Why? Because insurance companies are constantly coming out with newer and better products so the agents can talk you into switching from one annuity to another. That protects the insurance company because they don’t have to deliver on the promises on the surrendered annuity and it will be years before the investor accrues any benefits in the new one. It’s GREAT for the insurance company and great for the agent (they get another 7% of your money); it’s not so great for the investor. Is this one of the best investments for retirees? No.

Thus, two ways in which your approach has to change:

1) to realize that no one is going to be as concerned about your money as you are.

2) that most packaged products like annuities and mutual funds aren’t what they seem to be.

You must recognize that all things considered, traditional investments are going to be the best instrument to use.

 

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[1] http://www.finra.org/investors/protectyourself/investoralerts/annuitiesandinsurance/p010614, retrieved 6/9/13

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1 Comment

  • William E. Roberson November 13, 2014 at 10:07 pm

    Excellent reference to use when you are approached by different Insurance companies selling various Annuities or other prepackage products.

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