Commentary on the WSJ article, "Downside Protection Has its Downsides"Article added by Steven Delaney on December 9, 2010
Steven Delaney

Steven Delaney

Chalfont, PA

Joined: November 15, 2007

Editor's note: This article is a commentary on the Wall Street Journal article, "Downside Protection Has its Downside," by Jason Zweig. The italicized text is that of the orginal article.

Money has hemorrhaged out of U.S. stock funds for 18 weeks in a row, with an estimated $15 billion flowing out in August alone. Much of that is being soaked up by a form of insurance sold as a safer alternative to stocks.

Fixed-indexed insurance products, commonly called "equity-indexed annuities," offer the promise of protection on the downside combined with a guaranteed minimum upside. They racked up a record $8.2 billion in new sales in the second quarter and hit an all-time high of $168 billion in total assets as of June 30, according to Limra and Beacon Research.

But while you can avoid the downside of the stock market with these annuities, you expose yourself to another set of downsides.

These products, issued by life insurers like Allianz, ING and Lincoln Financial, are typically structured as "deferred annuities," which, after you lay out money up front, can be used to generate regular income payments down the road. Any earnings in the meantime aren't taxable until you begin drawing on the income.

The insurer guarantees that your principal won't go down in value and will pass to your heirs as a death benefit if you kick the bucket before you tap the account for income.

Plus … there is a plus. You forgot to tell your readers that the FIA will lock-in all annual gains along the way. Furthermore, if the indices go down, the consumer gets a new plateau for growth because the contract resets at the new, lower numerical value of the index, giving the consumer better opportunity to make money.

The insurer also promises to pay a minimum annual income of 1 percent to 3 percent.

Actually, the insurer promises to pay a minimum guaranteed interest on your principal, so that in X number of years, even if the stock market stands still or decreases every year, you will receive your original principal plus a minimum interest rate.

In addition, through a formula linked to the price changes of indexes like the Standard & Poor's 500, the Russell 2000 or the Nasdaq 100, you also get a slice of any gains generated by the stock market. (Bond and other indexes also are available.)

Nowadays, these products have a typical "cap" of around 6 percent, according to the National Association for Fixed Annuities. The cap sets the maximum return you can pick up over the coming 12 months, no matter how high the market index goes. If you have a 6 percent cap and the S&P 500 goes up 8 percent — or 20 percent — then only 6 percent will be added to your account. On the other hand, if the market drops, you won't lose anything.

Since many investors remain ravaged by fear of another crash, that makes a good sales pitch. "With principal protection, guaranteed income and a piece of the upside potential of the stock market," says Jasmine Jirele, a vice president at Allianz Life, equity-indexed annuities are "a one-package solution for consumers."

But look closely if you unwrap that package. With commissions around 5 percent to 8 percent, some agents might be so eager to make the sale that they underemphasize an important point: Many insurers can reset the cap, usually once a year. Not long ago, caps of 8 percent or more were common, says Jack Marrion, an annuity specialist at Advantage Compendium Ltd. in St. Louis.”

OK, stop right there and consider that all persons get paid for providing a role in the manufacturing or the distribution of goods and services. Also recall that those who sell market sensitive investments, ie. mutual funds, REITs, managed money, variable annuities, bonds, etc. also get paid. They, too, get paid — either all up front, as with variable annuities or sometimes as a trail as well. Or they get paid every year, 1 percent to 2 percent, on the account values of their clients regardless as to whether or not the account values go up or down. These fees cannibalize the client’s investment account values, turning a 10 percent loss into a greater loss, such as 13 percent ,which requires a 17.94 percent return the next year just to get even.

RIAs get paid by putting a wrapper on everything they manage for the client, but understand that the money managers they hand their client’s money to — to actually invest — also get paid. So go ahead, add it all up, ask Jack Bogle how efficient buying different mutual funds is for the client, going in and out of the market. Ask Warren Buffet about the frictional cost involved in investing today.

So, over the lifetime of the money, who gets paid more? It depends. If the annuity is held for seven to 10 years or longer, the fixed indexed annuity agent is never paid again unless they elected a trail commission. If they did, that is identical to the way many financial advisers are paid anyway, right? You should know that agents service the client who placed their money in these fixed indexed annuities for their lifetime. Have you read Charlie Gasperino’s “The Sell Out” and it's descriptions of what happens on Wall Street — the risk, how much money is made, and how often the client comes first? Insurance companies keep your money safe — they reserve for the client’s premiums and the money is there, if needed. You know that doesn’t happen with non-insurance products.

Today, one version of Allianz's top-selling MasterDex X annuity is capped at 5.25 percent. But the cap resets periodically and can go as low as 1 percent at the company's discretion. (It also could go higher.)

Yes, this, Allianz will tell you, is how the product is filed with the state insurance departments in order to protect the policy holders against market conditions that could, in extreme situations, cause the hedging/option part of these insurance contracts that provide the upside potential or “excess” interest earnings to become so expensive that the cost of the hedging/options would not provide the same upside provided the day the contract was originally issued. However, everything is relative — interest rates and market volatility will affect all products on the spectrum of risk and return.

In addition, it does not serve the insurance company well to make their customers unhappy. They buy the options according to market conditions, and it is worth stating that the insurance company does not keep any extra upside potential beyond the cap. How so? Well, the insurance company will invest in high-grade corporate bonds/debt, U.S. Treasuries, small amounts of mortgages, or other investments to secure the amount of money needed to secure the future guarantees. Some money goes to administration/commissions, some for profit in terms of an initial spread for the insurance company to remain a profitable ongoing concern, and the remaining sum creates an option budget. The option budget, depending on the volatility index and the risk free rate of return, will in some years provide less upside in terms of a lower cap than initially offered. However, in other years it will provide a higher cap than initially offered, and this upside is on top of minimum guarantees.

If interest rates fall further, caps could drop again, constricting your gain if stocks do well — as they often do when rates decline. Your return from stocks could go down even as their performance goes up.

If interest rates fall and you have an existing contract, the bonds purchased to support your annuity were purchased the year or years before. Thus, your upside potential, your cap, would be affected by the cost of the options in any given year, and the amount of money allocated to the purchase of options from the insurance company that year.

Indexed annuities aren't for anyone who might need the money any time soon. While you can withdraw up to 10 percent of the account at no charge, you generally won't have access to your full balance for 10 years.

You always have access at a known cost. The cost is the surrender charge applied in that year, so if the surrender charge is 7 percent, you get 10 percent free, and any amount over 10 percent would have a surrender charge applied. If your money is invested in the stock market in one form or another, you don’t know what the cost for getting access to your money will be, because you do not know if the market will be up or down, plus fees.

On larger withdrawals, a "surrender charge" of up to 12 percent will apply in the first year, typically declining by one percentage point per year.

Allan Roth, a financial planner at Wealth Logic in Colorado Springs, maps out a functional equivalent you can build yourself at low cost and high certainty of return. Say you have $10,000. You could put $7,260 into a 3.25 percent 10-year certificate of deposit from Discover Bank and $2,740 into Vanguard Total Stock Market, an exchange-traded index fund that invests in more than 3,000 U.S. companies.

No, you would not receive the same benefits of the annuity. In terms of a 10 percent free withdrawal, you would not be able to lock in gains; you would not be able to annuitize and receive lifetime income forever; you would not be able to grow your income base by 5 percent to 8 percent guaranteed; you would not receive a premium bonus; and you would not have access to your money, which has been protected and all gains locked-in with no surrender charges applied to long term care waivers and terminal illness waivers. Only insurance companies and their products can offer all of these guarantees and benefits.

American retirees will come into contact with reverse dollar-cost-averaging in the decumulation phase of retirement, and it is not pretty. With down markets, plus fees, plus withdrawals, one will cannibalize account values and run out of money and liquidity. Thereby, there is nothing remaining for their heirs. I find, as you probably do as well, that market-oriented advisers are not putting enough thought into this concern. Most people don’t.

In order to understand the spectrum of risk and return, combined with life insurance principles that provide the guaranteed income for life, you need to be cognizant of the fact that insurance companies reserve for their future obligations. With mutual funds, variable annuities and stock portfolios, no reserving is done to protect the consumer's principal because these consumers are involved in speculation/gambling — fine if you have the discretionary dollars, the ability to actually accept the risk of the stock market, plus all of the fees.

The leverage consumers benefit from when they are able to take advantage of life insurance and actuarial pooling concepts, life expectancy tables, which provide the risk free part of the equation here, are intrinsic to these products and these products alone. They enable the consumer to get unique, financially sound leverage — again risk-free.

Some people die young, some live to age 100 or more, and some people die right at the average life expectancy. You must figure in lapse ratios — when people will walk away with their account values and not exercise their guaranteed withdrawal benefit. Or, if the consumer does opt for life-long income, they have an option (liquidity). They may change their mind in ensuing years and, again, walk away with their account values. I trust that the average consumer may not have a handle on these issues, and this obviously eludes many financial advisers, as well. If you had a handle on this material, you probably would not have written the article.

Even if the U.S. stock market goes to zero over the next 10 years, the yield on the CD guarantees that you won't lose any money overall. If stocks gain an annual average of 4 percent, your combined return will work out to 3.5 percent yearly. If stocks return 6 percent annually, your total gain will be 4.1 percent a year. And if interest rates rise, Mr. Roth says, you can invest in a new CD at a higher rate and still come out with an increased net return even after paying the penalty for early withdrawal.

Please take into account 1 percent to 2 percent or more in fees for the adviser managing the assets and/or selecting index or mutual funds or selling variable annuities. What did the consumer make? Now consider timing issues. Will the market be up or down when you need to access or live off your assets? You do know what the mutual fund/Dalbar studies look like right? They examine fund returns vs. consumer returns, taking into account tax drag and timing issues — and then consider the consumer’s advisery fees. The disparity was, and is, alarming.

Finally, if stocks take off, your profits on the fund will be taxable as long-term capital gains; in an indexed annuity, withdrawn gains get taxed at the higher ordinary-income rate. If you want to bequeath money to your heirs, Mr. Roth's approach is probably more tax-efficient on that front, too.

Well, let me point to a study, "Investing Your Lump Sum at Retirement," that could be deemed the holy grail of retirement planning. David F. Babbel, fellow, Wharton Financial Institutions Center professor of insurance and finance, and Craig B. Merrill, fellow, Wharton Financial Institutions Center and professor of finance at the Marriott School of Management, Brigham Young University, conducted the study. The Wharton study talks about the advantage of having a guaranteed income in retirement provided by an annuity:

“Trying to replicate this advantage of a secure lifetime income, but without the risk-pooling of a life annuity, will cost you from 25 percent to 40 percent more money, because you would need to set aside enough money to last throughout your entire possible lifetime, instead of simply enough to last throughout your expected lifetime.”

If you want only some of the gains from a bull market in stocks and none of the losses from a bear market, I would advise rolling your own.

It is important for you to understand that some financial advisers with a strict stock market orientation may contend that stocks and bonds are still the best way to prepare for income needs in retirement. They are correct in the sense that a mix of stocks and bonds in a client’s portfolio, depending on one’s tolerance for risk, may in fact be a fine method for the accumulation phase of one’s nest egg.

However, The Wharton study “Investing Your Lump Sum at Retirement,” is about the decumulation phase of one’s nest egg, and it provides the research — the evidence if you will — that advisers who maintain that a mix of stocks and bonds, for the purpose of providing income in retirement, are simply incorrect.
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