Markets are getting long in the tooth. People are concerned a correction is due since a correction historically has typically happened by now. Thus, nervous people remembering 2008, seek some way to protect their savings.
One of those ways has been through an annuity of some kind issued by an insurance company. What people need to understand though, is that insurance by definition insures against a loss, but does not mean a gain. When one gets insurance, they should expect NOT to make money!
Okay, annuities can obtain returns – however, those returns are lower because of the insurance costs baked into the annuity product. The only annuity that guarantees income for life is a Single Premium Immediate Annuity (SPIA). Other annuities that claim income you can’t outlive are essentially assuming you’ll buy a SPIA with the money in the present annuity. Portfolios may also provide income with the ability to buy a SPIA at any time in the future … the older you are, the greater the income given the same dollar amount (see my published peer-review research paper).
There are many different kinds of annuities. Today, the Equity Indexed Annuity (EIA) has become popular because of the “never lose money” concept used in marketing and selling them. The Financial Industry Regulatory Authority (FINRA) has issued an Investor Alert on these. Of note – FINRA plainly answers the below:
“Is it possible to lose money in an EIA?” Quote: Yes. Many insurance companies only guarantee that you’ll receive 87.5 percent of the premiums you paid, plus 1 to 3 percent interest. Therefore, if you don’t receive any index-linked interest, you could lose money on your investment. One way that you could not receive any index-linked interest is if the index linked to your annuity declines. The other way you may not receive any index-linked interest is if you surrender your EIA before maturity. Some insurance companies will not credit you with index-linked interest when you surrender your annuity early. Unquote.
How is an EIA’s index-linked interest rate computed? Quote: The index-linked gain depends on the particular combination of indexing features that an EIA uses. The most common indexing features are listed below [in the alert linked to above]. To fully understand an EIA, make sure you not only understand each feature, but also how the features work together since these features can dramatically impact the return on your investment. Unquote.
Quote: Caution! Some EIAs allow the insurance company to change participation rates, cap rates, or spread/asset/margin fees either annually or at the start of the next contract term. If an insurance company subsequently lowers the participation rate or cap rate or increases the spread/asset/margin fees, this could adversely affect your return. Read your contract carefully to see if it allows the insurance company to change these features. Unquote.
The Motley Fool discusses the pros and cons of annuities and explaining that investors can do better in general elsewhere … I highlight investors because this term separates out investors from those who want to buy insurance wrapped around their savings.
CNBC has a good article “Annuities: More cons than pros? that also briefly explains the pitfalls of annuities.
Finally, one needs to understand that insurers can’t really insure against a market catastrophe because, as Kitces eloquently states, “The problem, however, is that unlike most types of insurance – where the law of large numbers allows the insurance company to have relative certainty about the timing and magnitude of potential claims – in the case of annuities with income guarantees against a market decline, the insurance company faces virtually no risk exposure for any of its policy owners, until a major market decline actually occurs… and then, suddenly, the insurance company must set aside reserves for everyone, all at once.”
Basically, concentrating money into an insurance company means that those assets are at risk of that insurance company’s liabilities. Mutual funds don’t have liabilities to support guarantees so the assets follow the markets without payment obligations to other parties to support the guarantees that insurance companies have. Properly structuring the portfolio to address exposure to the magnitude of market ups and downs is the key to managing money invested in the markets.
Ocean Waves analogy … when properly diversified through an indexed approach, it is unlikely all the companies in all the indexes that make up your portfolio may go to zero in value at the same time. Yes, portfolio values can go up and down. Becoming comfortable with ups and downs with your portfolio value, in addition to dialing in how big those ups and downs are, is what risk represents. Many people invest without realizing they’ve taken on more risk than they intended. This is because a proper approach to structuring the portfolio overall has not been done. There is a difference between allocation and diversification! Everyone has an allocation of some kind – not everyone is properly diversified.
You need ups and downs in order to obtain those greater returns in the long run (defined as the rest of your life).