More Proof That Insurance and Investing Don’t Play Well Together

oil and water

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.

Conclusions

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.

Other articles I think you’ll like

Oblivious Investor: Both the stock and bond markets are down recently, which makes this a good time to re-visit your asset allocation. If these (relatively tame) drops are making you jittery, that might be a sign that you’re invested too aggressively.

My Money Design: I’m just going to quote him directly: “Why do you want to make more money?  So you can no longer work someday?  And when you no longer work, will you spend more time with the ones you love?  Guess what – you could do that RIGHT NOW!”

Planting Our Pennies: Protecting ourselves from fraud and identity theft is one of those things that most of us don’t give much thought to until it’s too late. But there are some great tips here on how to do it as easily as possible. We should all give this some real thought.

Cash Rebel: Is money inherently bad? Does thinking about money make you immoral or unethical? Some interesting takes on both sides of the issue.

Debt Roundup: Grayson has been a big advocate of starting to save money even while you’re paying off debt, which is a viewpoint I very much agree with. This article is a great breakdown of exactly how he thought about it when he was paying down his $50,000 of debt.

Budget and the Beach: Sometimes we all need to be reminded of the days when life was simple and we did things simply because they were fun. There’s nothing stopping you from reliving them right now.

Escaping Dodge: The internet is here to stay and has more information about you than you probably know. Managing your online brand is a powerful way to control what potential employers know about you, which can make or break your future opportunities.

Cents and Sensibility: Depression is something that can get to all of us, affecting both our happiness and our finances. Lindsey’s piece here is a really honest assessment of her own feelings, with some great practical tips on how to deal with them.

Stacking Benjamins: Good money management, like good running, involves finding a rhythm that you can repeat successfully over and over again. Great analogy here.

Thanks to these carnivals for including me along with some other great posts!

Carnival of Financial Planning
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Financial Carnival for Young Adults

Photo courtesy of peterjroberts

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  • cashRebel June 28, 2013

    Wow, I’ve never trusted companies that sell annuities and this is just one more example. You are probably right that there’s a time and a place for most financial products, but I’d have a tough time accepting this type of product ever.
    Thanks for the mention!

    • Matt @ momanddadmoney June 28, 2013

      They’re really tricky products. There are some fairly simple annuities that can be a good deal if you’re purchasing them at retirement. But variable annuities have a reputation for getting very sketchy very fast.

  • John S @ Frugal Rules June 28, 2013

    Good post Matt! Having worked in life insurance myself I always grimace when I read stories like this and wouldn’t buy a VA if I was paid to buy it. There are, generally speaking, too many fees and not worth the hassle. Insurance is insurance and should not generally be a part of investing.

    • Matt @ momanddadmoney June 28, 2013

      Agreed. Good to hear from someone with some inside information too. Did you used to be in sales?

  • DC @ Young Adult Money June 28, 2013

    Yeah there’s pretty much a never-ending number of financial products out there, and there will always be new ones too! Insurance should be protection, not a way to gain money.

  • Khaleef Crumbley June 28, 2013

    It’s horrible that they can just change the terms like that, or simply choose not to honor them at all. I with that there was a way to make the terms of these types of agreements simple enough so that the average investor can understand all the risks. I bet the pricing would change dramatically.

    • Matt @ momanddadmoney July 1, 2013

      I couldn’t agree more on the call for simplicity. Just being honest about all of the terms and conditions would be a step in the right direction. I think you’re right that you would see a change in pricing as consumers learned more about the potential drawbacks of these products.

  • Lindsey @ Cents & Sensibility June 29, 2013

    Thanks for Link Loving me! That’s scary that they can just change things around and do whatever they want – it’s going to leave a lot of people in a potentially bad position. Not cool. Not cool at all.

    • Matt @ momanddadmoney July 1, 2013

      It definitely puts the consumer in a tough spot. It’s hard to plan on something when the terms can change on you.

  • MyMoneyDesign June 30, 2013

    Thanks for the mention Matt!

    This is a great topic. I got duped in my early 20’s into thinking permanent insurance was the way to go. Only after a few years did I realize what a big mistake this was.

    http://www.mymoneydesign.com/personal-finance-2/insurance-planning/which-is-better-term-or-permanent-life-insurance-part-1/

    The kicker for me was finding out that when you die, your death benefit is deducted from our “investment account”. Translation: You pay for your own death!! That is so ridiculous to me. After crunching the numbers, I found that the odds were much better in my favor if I just went with a term policy. That’s what I’ve got now for the next 30 years, and I’m good with that.

    Insurance is just insurance.

    • Matt @ momanddadmoney July 1, 2013

      Nice personal overview there! I think it’s pretty easy to get duped. The salesmen are really good at their jobs and make it sound incredibly appealing. But as soon as you stop taking their word and actually run the numbers, it gets pretty unappealing pretty quick. And yes, your point about only getting the death benefit OR the investment account is a good one. You don’t get to have your cake and eat it too.

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