Insurance companies are supposed to be in the boring business of pricing the risks that, for example, a certain percentage of people will get into an auto accident, and calculating the average cost of fixing the car and paying the hospital bills. They also calculate that a certain percentage of people of a certain age will die each year, or have their houses flooded or burglarized. Then they have everybody pay in an amount which, in aggregate, will pay for the expected losses, plus their administrative costs. Some people won’t get into an accident, and their money will pay the repair costs for those who do, and theoretically it all evens out in the end.
How boring is that?
But some insurance companies offer products that are far more exciting and creative—and complicated, and profitable. Consider, for example, equity index annuities, where you give the insurance company your money to invest, and the company guarantees that you will get at least all your money back at the end of a certain period of time even if stock prices fall into a black hole and never re-emerge back into the space-time continuum. If stock prices go up—according to the promotional literature—you get to participate in that growth.
Heads you win, tails you don’t lose. What could be more exciting than that?
Despite the raging popularity of these products since the market downturn in 2008, here are a few problems with this wonderful offer. The first is that you pay dearly for the privilege of not losing your money, in a variety of ways. The first cost is the sales commission, which can be as high as 25% of the money you invest, more typically 12% to 15%, and which shows up as a surrender charge if you want to get your money back in the next decade or two.
Your investment money may also be paying for sales reward trips given to the people who are most successful at selling these exciting products and pocketing 12-25% of your money off the top. (Curiously, investors are never invited along on these trips where the successful salespeople are high-fiving each other.)
There may also be high fees and expenses larded onto the investments, but these will pale in comparison to the really big profit driver of equity index annuities: the clever way that the company calculates how you participate in market returns. Typically, you will be told that, in return for the guarantee that you’ll get your money back, you have to give up some of the upside. The contract may specify that you’ll get 80% of the upward movements of the stock market.
What’s wrong with that? First of all, since the market has historically gone up roughly 70% of the time, you are leaving real money on the table—or in the insurance company’s pocket. But the clever (or sly, or downright misleading) thing you may not realize is that you also don’t receive the dividends that the stocks are paying, since you don’t actually own the stocks that you are participating in. Those dividends—approximately 2% a year for the S&P 500 index currently—fall right to the insurance company’s bottom line. This is why some people think equity-indexed annuities may be the most profitable investment products ever devised—for the issuer, not for the investor.
A research report by two Ph.Ds in 2006 compared a sample equity-indexed annuity with a simple stock and cash investment, and found that the annuity would turn out less beneficial to its policyholder more than 96% of the time. They noted that they may have erred generously on the side of the annuity, and they may be right. A recent (and very creative) article by Alan Roth on the CBS News website (http://www.cbsnews.com/news/risk-free-stock-investing/) suggested that investors could become their own insurance companies. That is, they could build their own guarantee by dividing a $10,000 investment into roughly equal parts. $5,659 would be invested in a 10-year CD paying 3.3% a year. The remainder would be invested in the S&P 500 index. Total cost: 0.02% a year.
The results are interesting. If the U.S. stock market were to lose half its value over the next ten years—which has never come close to happening in the real world—then you would get all your money back. If the market rose just 4% a year—about half of historical average returns—you would get back 3.61% a year, the equivalent of a 90% participation rate on the upside.
Comparing the do-it-yourself annuity with the insurance industry’s exciting alternative makes it clear just how profitable these equity-indexed annuities are for some of the world’s most boring companies. Exciting for them; not so much for the poor investor.