Just last week I wrote a long piece detailing all the reasons why whole life insurance is a bad investment. Now this week comes more evidence that mixing insurance and investing is a risky proposition.
Michael Kitces at Nerd’s Eye View has a pretty shocking description of some of the lengths certain insurers are going to in order to get out of their previous commitments. You can read the full article here: AXA And Hartford Prospectus Changes A Troubling New Trend For Existing Variable Annuities.
The article itself is a little technical, but the premise is fairly simple and is important to understand before you do investment business with an insurance company. Let’s walk through it.
Defining some terms
The article is talking about a product called a variable annuity. A variable annuity is an insurance product with an investment component, just like whole life insurance. Basically, the policy owner has a set of investments that they can choose from and the value of their policy will rise and fall with those investments. This is the investment component. At some point in the future, the policy owner can decide to “annuitize” the policy, which simply means that he or she will start to receive annual payments for some period of time, potentially the rest of his or her life. This annual payout is the insurance component.
The particular policies that Mr. Kitces talks about also had a component called a “guaranteed living benefit rider”. This is an additional feature that guarantees the policy holder some minimum amount of annual withdrawal, no matter how the investments do.
While these policies are clearly not the same as whole life insurance policies, they are similar in many ways. They are issued by insurance companies, mix insurance with investing, are sold on the promise of providing stable long-term investment returns, and have complex terms and conditions. Many of the same drawbacks that apply to whole life insurance apply to variable annuities as well.
What happened here?
According to the article, from 2003 to 2008 insurance companies issued about $500 billion worth of these variable annuities, many with guaranteed living benefits. After the stock market crash in 2008, many of these companies decided that they couldn’t or didn’t want to live up to the guarantees anymore. So they stopped issuing new policies, but now they’re also enforcing some of the more remote contract terms and are even attempting to change the terms of some of those contracts. In some cases, they are simply upping the cost of of the guaranteed benefits, which of course reduces the investor’s return. In a more extreme case, one company is attempting to force policyholders into more conservative investments, with the threat that if they don’t do so by October then they will lose their guaranteed benefit. That’s right, they’re trying to take away their policyholders’ “GUARANTEED” benefits!
What are the implications?
First of all, I feel sorry for anyone who bought one of these policies with the expectations that the guarantees were actually guaranteed and is now suffering. Hopefully they have other investments that can keep them stable.
But this is a perfect example of some of the points from my warning about whole life insurance. Again, while whole life insurance is a different product than a variable annuity, they have similarities that cause them to have many of the same downsides.
Undiversified – Anyone who had a significant chunk of money in one of these policies is now suffering from their lack of diversification. Because they were relying on the prospects of a single company, they exposed themselves to a lot of unnecessary risk. Diversification allows you to spread your risk around so that the fortunes of one company will not overly affect your investments. It’s just too beneficial to pass up without some really good compensation in return.
Not guaranteed – I wrote that whole life insurance returns are often presented as if they are guaranteed when they are not. And even the portion that is guaranteed is actually much worse than what is communicated. In this case, the “guarantee” didn’t even turn out to be that! It was a sham! Whenever you’re investing and someone wants to guarantee you a return, you need to be very wary.
Illiquid – The holders of these policies are left with a bunch of bad options. In many cases they likely can’t take their money out without significant penalties or significant underperformance. If a mutual fund changes its policies, you can simply switch to a different one. It’s not quite so easy with these insurance policies. That’s a heavy price to pay.
Complicated terms and conditions – Do you like how they can just raise the cost at their discretion? What about them simply changing your investment options? Or altogether getting rid of the guarantee you’ve been paying for? There are so many “gotchas” with these policies that are not discussed at the point of sale and are not clearly communicated in the documents they provide.
There is a time and a place for almost every kind of product imaginable. Nothing is inherently evil or inherently good. Knowing how to use it is what makes it useful or not for you specifically. But for most of us, mixing insurance and investing is a bad deal. And it isn’t just a theoretical argument. You can see the dangers for yourself from this unfortunate string of events.
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Thanks to these carnivals for including me along with some other great posts!
Photo courtesy of peterjroberts