I was reading an article from Morningstar the other day, and while I was agreeing with much of what the author said, a lot of it was troubling to me. Allow me to explain.
The title of the article was, “These Products Offer Protection, but at What Price?” Just that title is troublesome to me. Bear with me as I expand on this. In the article, she was addressing some of the products we utilize a lot. For example, we use hybrid products that provide long-term care benefits, but also provide benefits if you don’t use the care. An example would be a life insurance product that provides tax-advantaged cash build up and a death benefit that can be accelerated for long-term care. Say you take out a policy for $600,000. That might cost you around $6,000 a year if you are about 50, which is twice what you would pay for a long-term care policy. However, a long-term care policy can raise rates on you later on, and if you don’t use it, the money’s gone. In this case, you would have much more than that. By age 70, for example, you would have north of $100,000 in cash value. Yes, that’s less than what you put in, but what else do you have? You have $600,000 in death benefit if you die, and if you require care? $150,000 a year for four years.
So, what is the price? It’s more money each year, and it’s a long-term commitment. But what’s the payoff? Tax-free money for you to use should you need care, or tax-free access to the money you put in, or a death benefit for your heirs, or a combination of all three. The author’s hang up with this solution? “By plunking down a lump sum, the purchaser of the hybrid policy effectively cedes the right to earn a higher return on that money in a more favorable yield environment, turning it over to the insurer instead.”
This the fallacy behind most of the objections I encounter about the guaranteed products we have: that if you use your money for this, you give up your opportunity for more potential gains in the market. To me, that sounds like, “Yes, you could use your money to purchase, say a life insurance product, but then you give up the opportunity to take that money and leverage it in Las Vegas.”
Let’s take another example. The author talks about annuities, specifically, Fixed Index Annuities (FIA). These are products that are designed to provide superior returns to other fixed products by tying your gain to a stock market index. Be clear, your money is NOT in the market, it’s in the very safe general fund of the insurance company. This is the same pool of money used to pay death benefits on life insurance policies. Therefore, it is kept in very conservative and safe monetary vehicles that are closely monitored by all 50 state insurance commissioners, plus the District of Columbia and the American Territories. So, your money is never put at risk, only the interest, which is used to leverage options in the market. The results are usually superior gains to what you would get in other fixed products like CDs or money market funds, but with the same, or even better, levels of safety.
This is what she said about these. “With such products, the purchaser is guaranteed a minimum return amount while also participating in the equity market’s gains. The products also offer tax deferral on the investment gains. That all sounds appealing, but purchasers pay dearly for those protections. In addition to steep ongoing costs and high surrender charges, the purchaser typically forks over a portion of his or her equity portfolio’s return to “the house,” in that gains from the equity market are capped in some fashion. Thus, the all-in costs associated with these products–both explicit costs and implicit opportunity costs–can be high indeed.”
So, what’s the message here? To me, it sounds like, “Watch out, if you do this you are giving up all those great stock market gains.” But what’s the assumption here? That if you do this you don’t get that, as if you were really going to get that. The truth is, the average equity investor made only about 3.98% in the market over the past 30 years, according to the 2017 Dalbar Quantitative Analysis of Investor Behavior. During that same period, the market did north of 10%. Why is this? Because we are creatures of instinct and emotion, and instinct and emotion are the worst possible things you can employ in something like the stock market.
There’s more that’s wrong with the Morningstar article. For example, as you year retirement, the focus should shift from accumulation to preservation. So, with an FIA, you might do between 4%-6% on average. This isn’t the 10% you might get from the market, but if you are an average investor, you aren’t going to get that anyway. And in the market, your money will never, ever be safe. Either from market volatility, or our propensity to pull it out after a crash and put it back in after a serious run-up, which is how most people operate.
Further, understand that the corresponding asset class to an index annuity is NOT the market. The market is risky. It’s tough. It causes people to worry and make dumb choices (like buying high and selling low). The asset class you need to compare an FIA to is a CD. It’s safe. It won’t keep you up at night. And it could still outperform what the average investor can expect to get from the market.
On top of that, it may provide as much as two to three times the income you can expect from the market, plus there may be a long-term care benefit as well.
We may be getting old, but let’s be smart, too.