The Good, The Bad and The Ugly of Annuities

I don’t know if it’s just my imagination but it seems to me with each volatile streak in the stock market, annuity sales pitches become more prevalent on the radio.

You may have heard them pitched as a “personal pension” or “your money is guaranteed to go up and can never go down”.  While these sound like great concepts, the most skeptical among us might react with “If it’s too good to be true, it probably is….”.  And it is of course, it is too good to be true.  Given this backdrop, I believe it would be helpful to walk through some basics of annuities and provide some perspective.  I believe my view can easily be summed up by the title from the classic 1966 western starring Clint Eastwood called, “The Good, The Bad & The Ugly”.  But I want to change up the order of my opinions in order of priority as I think about annuities:  “The Bad, The Good & The Ugly”.  Given the length of each list (below) most readers can probably guess where I usually come out on annuities.eastwood_good_ugly

But before getting into that, I’ll first define an annuity in the most basic terms.  An annuity is a contract you sign with an insurance company, usually to exchange a good chunk of money for a promise of future payments.  Now there are many, many variables that get applied to this agreement- from the underlying investments, to the time period for payment, to the time for payments to start, to who might get paid if the annuitant dies, etc.  Despite all the variances, it’s a contract between you and an insurance company.

Example: a 60 year old male, who wants payments to start immediately, might plunk down $250,000 in exchange for lifetime monthly payments.  How much will that buy him (according to immediateannuities.com)? About $1,245 / month for the rest of his life or a payout of about 6% per year.  Not bad right?    Well, read on for The Bad, The Good and The Ugly:

The Bad

Your Money Is No Longer Liquid:  Once you sign up for most annuities, you’re turning over a large chunk of change for future payments.  However, once your money is with the insurance company in most cases, you no longer have easy access to it, and neither do your heirs. If an emergency comes up and you need your money back, the contract usually stipulates there are onerous “surrender charges” of 10% or higher for somewhere between 7 or 10 years!  Also, if you were to spend $250,000 for some types (not all) annuities and drop dead in a year, your heirs get $0 (or a very small death benefit).

Usually Expensive with Conflicts of Interest:  Most annuity salesman will say “you don’t pay me, the insurance company does” but do you really think the insurance company would have the same payouts for their annuities if they didn’t have to pay some guy 5%, 6% or more UPFRONT for your annuity (that would be $12,500 payout on a 5% commission for $250,000 annuity).  Not only that, do you really want to ask an annuity salesman (usually posing as a financial planner) for advice on whether or not it’s a good idea to buy an annuity if he has a $12,500 payout hanging in the balance?

Limits on investment returns in exchange for “not going down”:  You may hear “your money is safe and it goes up with the stock market but is guaranteed to never go down”.  This has two nefarious aspects to it:

  • Nothing is guaranteed: I don’t care what any insurance company says- nothing is guaranteed. If an insurance company goes out of business because they were selling high-payout annuities and could not make good on those payments, then you are out of luck.  There are no guarantees.
  • When your money “goes up” with the stock market, your “upside” is usually capped and you don’t capture all the gain. So yes, your money won’t go down but if the stock market goes up 16% (like it did in 2012) or 30% (like it did in 2013) or 14% (like it did in 2014) your money can “participate” and go up but could be capped at something like 8%.  Who pockets the gain on your money above 8%? The insurance company.  Given the market has gone up 71% of the years between 1825 and 2013 AND only 26 of 189 years did stocks finish down more than 10%, who wins that bet most of the time?  I’ll give you one guess.

Ever hear this on the radio?

Annuities are Complicated:  Ever see an annuity contract?  It looks like a small print version of Tolstoy’s War & Peace.  Why do you think that is?  To clearly communicate the costs and benefits to you?  As usual, the devil is in the details on these contracts and the more complicated the details, the less able we are to adequately judge the value.

The Good

Despite all the bad attributes, annuities CAN, in limited circumstances, serve a purpose for some people.

“Peace of Mind”: One could argue there is value with the peace of mind in knowing fixed expenses in retirement would be covered by a combination of social security and annuities.   While I would argue this is expensive peace-of-mind, for some folks it’s worth it.  So I don’t dogmatically eliminate annuities from consideration but it’s not my main focus.

Mortality Credits help with “returns”:  When you and thousands of other people contract with an insurance company, the insurance is betting some of you are going to die early – and they are statically correct.  This calculated bet, allows for the insurance company to afford higher payouts than just passing through the earnings on their investments of your dollars.

Some low-cost options available:  Not all annuities are high-fee and high-commission.  There are low-cost options from Vanguard and other providers.  If a client is dead-set on an annuity, this low-cost providers are first on my shopping list.

The Ugly

Unfortunately, I still hear ugly stories of these products being pushed heavily on people, especially older people who may not know better.  For example, I recently heard of an 80 year old signing a contract and handing over a large sum of money in exchange for “guaranteed payments for life”.  In addition, this particular contract had a 7 year surrender period.    Who do you think is going to win that bet and how much did the salesman pocket?

Bottom Line: Overall, I’m usually not a fan of annuities in many cases but then again, I’m not compensated by having people buy them.  For select & limited situations it can make sense but like most financial products, annuities are usually “sold not bought”.  Hammer and nailOf course those that are compensated to sell annuities will have a different opinion but I’ll go back to an old phrase that I think applies to those who think annuities are always the best tools for retirement planning- “When all you own is a hammer in your toolbox, every problem looks like a nail.”

The Moving Parts Involved with Long Term Care

Our financial lives can get pretty complicated, pretty quickly.  If we were to sit down and draw on a piece of paper a box for each financial topic, then draw lines to connect how the topics touch each other, we would see a jumbled mess very quickly.  For example:  investments interrelate with taxes; taxes interrelate with retirement savings; retirement savings interrelate with college savings; college savings interrelates with income & cash flow; cash flow interrelates with insurance; insurance interrelates to estate planning; estate planning interrelates to investments…..

And those are just the one-to-one relationships.  We could certainly take each one of these topics and make the case that it “touches” every other in some form or fashion.

But there’s been another development over the last few decades that most people consider to be good news:  medical advances and better lifestyle choices mean we are living longer.  The not-so-silver lining to this however, is that this longevity has thrown a monkey wrench into this interrelationship of our finances, adding another topic that I believe sits right up there on the priority list.  From the title of the article, you already know I’m talking about long term care.

In short, I believe long term care is as complicated and interrelating a financial topic as any of those big ones I already mentioned. Financing long term care impacts retirement, cash flow, estate planning, insurance and investments.  Of course the primary reason for this is the magnitude of the potential expense it would take to pay for 2 to 6 years of nursing home or assisted living services.

How much are we talking?  A 2013 survey of 16,000 care providers by insurer John Hancock showed that one-year of a private room nursing home was running about $94,170 (yes, per year).  Of course the cost varies by location (Cleveland was around $80,000 while Naples, Florida was about $105,000 per year) but multiplying this number by say 4 years and that adds to a significant liability. In fact, I read one estimate stating ~70% of today’s 65 year olds will require at least some level of long term care before death.

But what are really the chances of a 4 year stay in a nursing home?  According to a recent survey by Genworth, one the few remaining insurers, 50% of claims that last more than one year extend to 3.9 years.   So 4 years x $90,000 or so = $360,000 – an unsustainable liability for most.  So bring on the insurance guys.

But is it really for everyone?  Well first I reiterate this is a complex decision and with my clients, I bring in a qualified and specialized long term care agent to help qualify, advise and fulfill the policy. (Obligatory disclaimer: I am NOT a licensed insurance agent and don’t give specific advice on insurance.  I don’t sell insurance or any other financial products).

To start thinking about how this all gets integrated, a good reference is a recent article in Barron’s which highlighted some key considerations.

First- who should buy it?  In short: both ends of the financial spectrum.  This means people who expect to have a low level of assets and people who are extremely wealthy can probably do without long term care.  The conventional wisdom is people with relatively low assets could qualify for Medicaid while those with $10 million+ in assets means self-financing is probably the best option.

Second- when to buy it?  Based on what I’ve read it seems like somewhere in the mid-to-late 50’s is a good time to really investigate long term care.  As the Barron’s article notes, a policy bought at 65 can be 50% more expensive than one bought at age 55 and an estimated 25% of applicants between the ages of 60-69 are actually denied coverage.

Third- what qualifies a person to make a claim? Unable to perform 2 of 6 basic activities:  eating, bathing, dressing, transferring from a bed, toileting and continence.  In addition, a person with severe cognitive problems might also qualify.

Fourth – how much does it cost?  Of course it varies widely but premiums can range from $3,000 / year to $6,000+ / year and are subject to increases in future years.

Other “soft questions” to consider:  Do you expect to have help from nearby family members?  Is one of your goals to leave money for your heirs?  Do you want to rely on family members to act as caregivers in your home or theirs?

The bottom line is this:  If you expect to have anywhere between $500,000 and $5,000,000 in assets in retirement, long term care should be a serious consideration.  But there are many complexities with the policies themselves which include elimination periods, inflation adjustments, death benefits, etc.

This is why I believe long term care is very much a pressing topic.  Not only are the policies themselves complicated but add in the interaction with the other aspects of your financial lives and it’s easy to see how this topic can make our financial lives a whole lot messier.

Home & Auto Insurance Buyer’s Guide

We all get those renewal statements from our home & auto insurer every year.  As we walk back from the mailbox, we may open and peruse the summary sheet, our eyes likely focusing on the price of the premium to see if we’ll be paying more for our insurance coverage.  Most of us then probably toss it in a pile of paperwork to be filed or reviewed or maybe even toss it in the “circular filing cabinet” after we make sure our premiums are paid and the ID cards are placed in our vehicles.

For most of us, home & auto coverage is an afterthought and more of a necessary evil than something we really consider.  I wouldn’t be surprised if we researched our next TV or laptop purchase more than we do our insurance coverage.  But I believe a little homework and a solid understanding of our coverage can be time well spent as knowing our coverage can go a long way toward protecting us from potentially having a really bad day   sometime in the future.  The reason?  Understanding, and properly “fitting” or home & auto policies to our lives can potentially save us thousands if not hundreds of thousands of account-draining, retirement-killing expenses if some unfortunate circumstance were to befall us.

Realizing this and recognizing the need for specialized industry knowledge, I recently sat down with Dennis Neate, Vice President at the Hoffman Group a local provider of commercial & personal insurance services.  Dennis has been in the industry 21 years and has been a helpful resource in providing comprehensive answers on the nuances around personal insurance coverage for my clients.  His company represents 13 property & casualty insurance providers and works with their customers to tailor-fit their insurance needs with their coverage. We discussed the ins & outs of auto, home & umbrella policies and provided some useful insight as to what we should really consider when purchasing our insurance coverage. (Please note:  I receive no referral fees, commissions or compensation of any kind for including Dennis in this article or for any sale of insurance products.)

Dennis is the first in what will be a periodic spotlight of industry specialists in my blog articles, which are intended to provide a deeper dive into specialized topics.  As a financial advisor who provides integrated advice families (to my full retainer clients), I believe it’s best to engage specialists for some aspects of my clients’ financial lives.  I then coordinate the specialists’ knowledge with my clients’ broader financial strategy with an objective and conflict-free perspective along the way.

So let’s get to it:

Know Your Coverage: Before getting into the weeds on home, auto and umbrella policies, Dennis first emphasized the need for consumers to “understand what they are buying” and to “know your coverage”.  This is because no two families are alike and we all could probably use some tweaking to our coverage in order to ensure we have the right fit in the most cost-effective manner possible.  This means we must make sure those liabilities that could be “one-offs” (e.g. trampoline in the backyard? boat?  RV?) are properly accounted for.

Auto Insurance

  • The Big Picture: First and foremost, folks should understand those numbers on the statement.  For example, $100,000 / $300,000 / $100,000” is translated as:  In an auto accident that is your fault, after you pay your deductible (the first dollar expenses as noted in your policy), the insurance company will cover $100,000 of expenses per person you could have injured, up to $300,000 per accident (total) and up to $100,000 in property damage.
  • Biggest Mistakes: Related to the “know your coverage” point noted above, the biggest mistake people make is aligning their coverage with their personal balance sheets. For example, the “$100,000 / $300,000 / $100,000” limits are probably too low for most families and while it’s well above the State of Ohio minimum required coverage (according to Dennis), it’s the lowest level the Hoffman Group will quote.  It seems the $100,000 of liability would quickly be reached in most cases.  After that, we are on the hook for all expenses related to the accident and if substantial injuries were involved, this could mean liquidation of retirement accounts, future wage garnishment and other reimbursement mandates that would make for a really bad day.
  • Best bets: According to Dennis, people probably have too low of coverage (as noted prior) and too low of deductibles.  This means most families should increase their coverage (which would increase premiums) but also increase their deductible (which would lower premiums).  This is often the conclusion I come to in working with families and insurance providers in the periodic Insurance Review meeting, which I hold with every full retainer client.   In addition, Dennis noted people should keep an eye out for redundant coverage such as having a new car (may already be covered for towing, labor under manufacturers’ warranty), or if they have AAA coverage, which may already cover some expenses also covered in the policy.

Homeowner’s Insurance

  • The Big Picture: Overall, you are covered for some dollar amount for:

o    “Dwelling” – Should cover the replacement value of your home.  This includes the cost to demolish and rebuild your home in the case of near-total destruction from fire, tornado

o     “Liability” – covers your liability for injuries to people while on your property including slips/falls, dog bites, swimming pool accidents

o    “External Structures” – covers anything NOT attached to your home like a shed, fence

o    “Personal Property” – covers the “stuff” in your home like jewelry, artwork, electronics

  • Biggest Mistakes:  Much like auto coverage, having coverage levels and deductibles that are too low are the most common mistakes.  Another one is NOT having additional coverage for backup of sewer & drain coverage, especially if you have lots of money invested in a finished basement.  In addition, damage from a flood is NOT covered by homeowners insurance and needs to be a separately purchased policy, usually with very limited coverage.
  • Best Bets:  People should be aware of the difference between “replacement cost” and “actual cash value” when evaluating coverage.  Replacement cost is the dollars it would take to replace your property while “actual cash value” is effectively the “depreciated value” (much lower).  For that destroyed 10-year old couch in your home, you probably won’t be going to buy another 10-year old couch, you would buy a new one so you’ll want to be properly covered for “replacement value”.  Another recommended attribute is the aforementioned backup of sewer & drain coverage, especially up north with our “man caves” and “media rooms”.

Other Nuggets of Insurance Wisdom

  • Consider an Umbrella Policy:  Much like I noted in my video blog (http://knwm-llc.com/umbrella), most people should consider adding an “umbrella” policy for liabilities that go above auto and home liability coverage.  It’s usually cost effective and can really be a God-send in serious situations.
  • Buy From a Broker:  While this may seem self-serving, this is my recommendation too.  I have purchased from an insurance broker myself because I like the fact I can make a call to a “consultant” first as to what to do (should I file a claim?) before I have to make a call to my insurance company, which could negatively impact my coverage in some cases.  In addition, I like having a consultant to help customize coverage for my unique situation and having them “shop” across many insurance providers for the most cost effective solution.
  • Package Discount:  Typically, it makes sense to bundle your purchase of home, auto and umbrella policies as insurance carriers usually provide a package discount for buying all three.  While you may get a cheaper policy by buying auto insurance on-line, your overall insurance expense may still be lower by buying all three policies from one carrier.

Dennis Neate contributed to this article and can be contacted at dneate@thehoffmangroup.com or 330-723-3637.  

Straight Talk on Life Insurance Selection

As many people already know, life insurance is a critical building block in a rock-solid financial plan.  But when it comes to discussing with clients the various ins-and-outs of the best type of life insurance (i.e. term vs. permanent), I’ve found this topic yields the quickest yawns, eyes-glazing-over or bored-looks-out-the-window.   However, brushing this issue aside is a mistake because I believe choosing the right type of life insurance is not only important, but also one of the most common mistakes I see in clients’ financial lives.

DISCLAIMER: I don’t sell insurance or any other financial products.  But I do take and over-arching and integrated approach on families’ financial lives with life insurance being an important piece.

So why is this so important?  Because I believe for most people, buying term life and diligently saving throughout a lifetime is a much more efficient strategy than using life insurance as way to “invest”.  Now I realize I will probably get assailed by the insurance guys out there who are very sensitive to this topic and for some, I am essentially questioning the legitimacy of what is probably a large percentage of their income.  However, I believe my thesis is correct with one small caveat:  there are a few limited situations where it does make sense for a family to own permanent insurance (mostly due to a tax strategy, which I detail below) but the short story is the vast majority of folks are pitched permanent insurance when in my view, they would be much better off with buying term life and diligently saving their hard earned dollars in their own accounts.

Quick Primer: What’s the difference between “term” and “permanent” life insurance?

  • Term Life: Term insurance is where someone pays an annual (or monthly) premium to a life insurance company for a fixed period of time (a term) in exchange for a promise from the insurance company to pay out the death benefit in case that person dies during the term.  The premium is fixed but so is the time period of coverage so once the contract term is up, the policy is usually ended or the rate is adjusted upward (significantly).  So an example would be a 40 year old man pays the insurance company $584 every year for 25 years and if he dies during that period, the beneficiary gets $500,000 tax free.  He wins the bet: sort of- his beneficiary wins the bet because he’s dead.  If he dies after the policy terminates, the insurance company wins the bet as he does not get any of his premiums back.
  • Permanent Life (packaged in various forms: whole life, universal life, variable universal life): Permanent is just that, the insured is covered until death of the policy holder and upon death the beneficiary gets a death benefit (tax free) AND whatever cash balance has accrued from all the years of payments.  Sound’s great BUT there’s a big difference is premiums paid.  For example, a 40-year old male may pay $3,100 every year for ½ the death benefit ($250,000). The extra premium paid amounts to a glorified “savings” account where one portion of the $3,100 premium pays for the death benefit while the rest is “saved” with the insurance company.  Usually the insurance company promises a “guaranteed” rate of growth (somewhere around 2-4% today) and a potential rate of growth (maybe 4-6% today) which depends on how well they invest your money.  The big problem is that your money is usually tied up (i.e. you can’t get it all back for a surrender period- which could be 5 to 10 years) AND it could be years before the “growth” of the insurance company’s investments on your behalf break-even and surpass what you could have done by “buying term” and investing the difference yourself. The reason it takes so long is you have to recover the expense (commissions & fees) of the contract.

What are the scenarios where I would recommend someone look into permanent insurance?  I think there are two very limited scenarios, one where it makes financial sense and one where it make psychological sense.  For the financial example a client would qualify (in my opinion) if they can say “yes” to ALL the following:

  • Do you need a death benefit?
  • Are you already maxing out your retirement plans with your employer (401(k), 403(b), etc) or at your business?
  • Do you make significantly above $191,000 (for a married couple) and are thus phased out of saving with a Roth IRA?
  • Do you have ample excess cash flow targeted for aggressive savings?

If all four are “yes” it might make sense for a portion of life insurance needs to be fulfilled with a permanent policy.  This is because the cash value grows tax free (like a Roth IRA) and using permanent insurance acts as hedge on higher tax rates in the years to come, which I think is valuable.  Even then, folks need to shop around as it could be an expensive way to go and very restrictive in the early years.

The psychological scenario is when someone does not have the discipline (or a good advisor or both) to diligently save for their retirement themselves.   In this case, they are mandated to “save” with their premium payment and the cash value build-up would function as an investment account.  Again, they would need several years to break even after paying the commissions to the sales guy but at least they would have something saved.  Again- a very, very expensive and restrictive “piggy bank”.

So why do I think so many people have permanent insurance when they should really have term?  I would answer a question with a question:  Ever watch a golf tournament on TV?  You’re probably wondering how that’s related but it is.  If you ever watch a golf tournament you’ll see an abundance of advertising from large insurance companies pitching “safety” and “security” and “lifetime income” (i.e. annuities) to their audience.  The reason these companies are paying so much for advertising and selling so hard is because it’s so profitable for them.  I’ve seen some estimates where the sales guy could get 85-100% of the first year premium for a commission.  So if you were in the insurance business what would you rather pitch to someone: a whole life policy with an annual premium of $3,500 or a term life policy with a $500 premium?  Term isn’t nearly as profitable and for the most part, it’s commoditized so there’s not much margin there.

So wrapping up:  This isn’t to call out all financial advisors who work for insurance companies as bogeymen.  I happen to know a few good ones who “get it” and wouldn’t recommend something that’s not in the best interest of their clients.  However, I think people should be aware of the potential for “grey area” and rationalized justification on the part of an advisor for a recommendation with a juicy financial incentive.   Think about it: Have you ever received a recommendation for life insurance from anyone other than someone who sells life insurance for a living?

Maybe it’s time you did.