29 May 2015 Beware of the “Guarantee”
Since the Financial Crisis of 2008 and 2009, insurance agents, stock brokers, and bank representatives have been in high gear selling life insurance products to investors clamoring for anything that ensures them against the drubbing they received in the markets. They hear of enticing promises like “Guaranteed Income,” “Guaranteed Principal,” and “All the market’s upside with none of its downside” and they find them hard if not impossible to resist. Are annuities and indexed life products as good as their promoters claim they are?
The range of products available and the complexity of their designs could baffle an MIT graduate student, but we need only use our common sense to address the question of whether these products are too good to be true. Insurance companies invest the premiums paid to them pretty much like you and I would. They use the capital markets to grow their reserves which are needed to pay policyholders’ benefits. Some will invest better than others some of the time, but on balance, all will achieve similar results over longer periods of time – again similar to what you or I might achieve.
Most owners of annuities or indexed life insurance policies have no idea of how much the guarantees they seek truly cost them. There are mortality charges, fund charges, caps on the amount of market upside that can be earned, and percentages of participation they can earn on those gains. The expenses can easily run from .75% for fixed annuities to as much as 3.5 or 4% on the more complex life products.
Think about it this way: You buy an annuity or index life policy with half of your money and invest the other half with the same mix of stocks and bonds, but without the insurance wrapper. In the second portfolio you would have none of the expensive bells and whistles offered through the insurance products.
Now think of two identical cars, A & B travelling side by side at equal speeds. Now we drop the armor of guarantees onto car A significantly increasing its weight and drag. Knowing what you do about momentum and friction, which car will travel the greater distance? In practical terms, which portfolio will endure longer to provide greater wealth and lifestyle enhancement?
Simply put, guarantees carry a cost and that cost is measurable in dollars and in lifestyle. The very sad fact is that most people who buy these life insurance products to secure lifetime income will not realize the extent of lifestyle they have given up until it is too late. It is not an overstatement to say that when investments in these products represent substantial amounts of retirement savings, the lifestyle cost is measured in the hundreds of thousands, even millions of dollars, depending upon the size of the nest egg and the number of years that lie ahead.
When we are given the opportunity to evaluate life products our clients or prospects share with us, as fiduciaries we gladly do so as objectively and as bias-free as is humanly possible. We model as best we can the promises of the insurance product, including all its costs and compare it to the efficient market portfolios we use every day for our clients, also including the fee and expense burdens.
We consistently find that these products basically ensure against a very small probability of running out of money (1 to 10%) while ceding to the insurance company the huge remaining 90% to 99% of upside potential of creating substantially more wealth. In essence, buyers of these products are paying the insurance company to give them their own money back over their lifetime only to forego the significant probabilities of significantly higher wealth, and commensurate lifestyle.
We understand why people are drawn to the promise of security and guarantees of annuities and other life products. But we deeply regret that our industry addresses their fears by preying on their most basic human instincts to sell them products that ultimately lock them into sub-optimal lifestyles. The practice highlights the differences in how the industry is regulated; from the suitability standard that regulates brokers and insurance agents to the fiduciary standard that regulates Registered Investment Advisors.
Simply put, a fiduciary always acts in his client’s best interest over his own, disclosing all conflicts of interest. A salesman, broker, or agent bound to the lower standard is required only to ensure that the products he or she sells are suitable for the customer. He is not required to act in his client’s best interest and in fact is compensated with commissions and trips that are overly-weighted toward his own interests compared to those of his customers.
There are certainly occasions when life products make good financial sense and we often recommend them when indicated. But because we do not sell these products, we can offer bias-free advice which is based on our holistic understanding of their needs relative to every goal they value, not simply to what specific needs the product in question addresses.
When you or a friend hears of some great new product from a life insurance company, please seek professional, fiduciary advice from an advisor who will not answer your questions until he or she understands, has modeled, and has stress-tested in that model every important goal and priority you value. Otherwise, you will surely make a poorly-informed, sub-optimal decision. Without a target, how can you possibly hit a bulls-eye?