The Pros and Cons of Annuities

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Life Insurance


Variable annuity "guarantees" against loss of principal:

Since annuities are long-term investments this guarantee has little value. You have plenty of time to recover from market drops even if you made the huge mistake of investing 100% in stocks.

A big broker "selling point" for annuities is that the insurance company guarantees that you will never lose your original investment (also known as your "principal"). This guarantee is a big "so what" because 1) Bonds protect against stock market volatility and 2) annuities are long-term investments and 3) over long-term periods the market has generally always been positive or at least even. If you are a short-term investor then you should not invest in annuities because annuities are not short-term financial products.


As previously mentioned even T Rowe price has admitted that annuities are meant to be held for 10 - 20 years. History has shown us that you're not likely to lose any of your original principal over a period of 10 to 12 years when diversified among asset classes such as stocks and bonds. Therefore it is not realistic to be worried about loss of principal over long periods of time. Yet this is the fallacy that unscrupulous brokers assume when they rave about this guarantee against loss of principal. Over even longer periods of 15 or more years it becomes completely unrealistic to be concerned about losing principal, especially if you plan on investing some of that annuity in lower risk sub-funds such as bond funds. So when a broker tries to sell a variable annuity to someone in their 20's, 30's or even their mid 40's based on this guarantee I say they are selling snake oil. Furthermore how do you think the insurance company is so comfortable making this guarantee? It's because they know that it's a very easy guarantee to make.


Historically on average the stock market has dropped at least 10% about once a year. It has dropped at least 20% every 3 1/2 years. It has dropped at least 30% every 10 years. It has dropped at least 40% every 25 years. And it has dropped at least 50% every 50 years. This is what annuity salesmen want you to fear. But what happens after the stock market collapses? It simply bounces back a few months or years later. History has shown us that over periods of 10 - 20 years you have plenty of time to recover from drops along the way. Over long time periods the stock market goes up -- not down! Beware of any annuity salesman who cherry picks short-term historical stock market performance data (such as 2008 - 2009) in order to make you fear the market! Annuity salesmen LOVE to do this and it's completely deceptive!


EXAMPLE: A lot of investors have been disappointed by the stock market's performance over the last decade and as a result some have been duped into investing in variable annuities for fear of "loss of principal". But even if you were the biggest loser of losers and you to entered into the stock market at the absolute worst possible time on Sept. 1, 2000, after 10 years and 4 months you were right back to even! NO loss of principal by investing in the stock market like everyone else! Again, annuities are long term investments, so an insurance company "guarantee" against loss of principal during this so-called "lost decade" was pointless and has only wound up costing you lots of money in high management fees, loss of stepped up cost basis, higher taxes, loss of liquidity, etc, etc. Even during this time period annuities were poor investments!



ANOTHER EXAMPLE: Now let's look at another bear market that spanned from the mid 60's to early 1980. Unlike the above "total return" chart, this "price return" chart below does not factor in dividend gains. Accordingly after 10 years one would expect the total return probably to be perhaps about 30% higher. This makes annuities look even less attractive. There probably wouldn't have been any "loss of principal" after 10 years had you invested when the S & P 500 was at $92.43 or $103.86 or $118.05....





So annuity guarantees are unnecessary for even the biggest loser of losers who made the fatal mistake of putting 100% of their money in stocks, and got in at historical peaks and right before long bear markets. With a time horizon of just 10 years (the minimum annuity holding period cited by T Rowe Price), eventually the market bounces back.


Again these charts are based on someone buying 100% into a volatile asset class (the S & P 500) at some of the absolute worst possible times in recent and relevant history -- at historical market peaks. Odds are that your timing won't be this bad and odds are that you would diversity! With diversification (into bonds) there would undoubtedly be much less risk of loss of principal and less time required to recover from market dips, thus making annuity guarantees even more unnecessary.


NOTE: I have not gone back as far as the 1929 crash because many changes have been made since then to prevent such crashes. Before 1929 the Securities and Exchange Commission and the Federal Deposit Insurance Corporation didn't even exist which left the door wide open for corruption and stock overvaluation. After the 1929 crash the Glass-Steagall Act was also passed to prevent future improper banking activity, which has been identified as a leading cause of the market crash. Accordingly, beware of any annuity salesman who tries to use the 1929 stock market crash to create fear in order to sell you an annuity.


Furthermore with each subsequent market crash, additional measures have been put in place to 1) prevent over valuation and 2) to prevent exaggerated panic selling.


In summary all of this fear of losing your principal is completely exaggerated by brokers who want to sell you annuities! Remember that it's diversification that should be used to protect your money from market volatility -- not annuities!


Avoid annuities especially after market collapses

BELOW: Remember there is NO good time to get into an annuity. Completely avoid annuities. But the absolute WORST time to lock your money up in an annuity prison is after the market has collapsed, such as the areas circled in red below. When the market is at historical lows, this is the LAST time you would ever need such an unnecessary "guarantee" against principal loss! At this time your strategy should be the complete opposite -- to invest in and feel much more comfortable about investing in more volatile investments like ordinary stock-based index funds (ETF's). Yet paradoxically this is when amateur investors get scared and flock to perceived conservative investments like annuities, and when brokers happily jump at the opportunity to sell annuities, earning huge commissions.



bullAvoid conservative investments (like annuities) right before bull markets

Furthermore if you are actually considering investing in an annuity you might want to take into consideration that we are already about 13 years into a bear market. If you believe that the overall stock market will continue to move in bull and bear cycles as it has done for over 100 years, then what are the odds that the current bear market will continue to go sideways for another 10 years or more? Since 1896 there have been 4 bear market cycles including the one we have been in since the year 2000. The prior bear markets lasted 18 years, 25 years and 17 years. In the past, bear markets have eventually turned into bull markets. Annuities are long term investments than are designed to be held for many years, and buying at market lows is the worst time to load up on conservative investments like annuities. When we enter the next bull market, those who are invested conservatively will be missing the train.


Bankrupt insurance companies keep no promises:

Certain annuity guarantees may crumble

Another thing to consider about annuity guarantees is that if there was some sort of worst case scenario whereby the market collapsed, the insurance company that issued your annuity might become insolvent. We all saw how the world's largest insurance company AIG nearly went bankrupt in 2008 were it not for the federal government bailing them out. Next time there might not be a government bail out or there might only be a bailout for pennies on the dollar. Sometimes another (solvent) company will swoop in and buy out the insolvent company, but there's no guarantee that will happen. Therefore it's reasonable to assume that the annuity "guarantee" might not be worth the paper it's written on, or only worth pennies on the dollar. Yes, for example the state guarantee fund is supposed to insure certain annuities for up to a certain dollar amount (varies by state), but should we really assume that they will pay 100% of that guaranteed amount? What if the fund gets tapped out due to a massive market collapse? Many economists such as Peter Schiff say that the US budget deficit cannot be paid back, and when the economy finally crashes, painful cuts will have to be made everywhere. Guarantee funds could be stretched. During our current economic times of over 16 trillion dollars of debt, I say the LAST thing you want to do is be invested in long-term, illiquid investments like fixed annuities. Insurance companies also tend to be highly exposed to long term government bonds, which are the very investment products that are at risk if the US government defaults on some of its astronomical debt.


March 2012: Hartford Financial Services Group is getting out of the annuity businesses. And since they had promised so-called "guaranteed" benefits, they are already asking annuitants if they want to take a "settlement". This underscores the idea that those annuity "guarantees" are merely promises that are only as strong as the insurance company itself. Imagine what happens when the market goes down and an insurance company has to pay off a lot of guarantees all at once, and they just plain don't have the money? Insurance companies can go out of business at any time.


pieInvestors usually break the 5% rule with annuities

As rule #2 states, never invest more than 5% of your savings into any one investment! In the event of insurance company insolvency, your annuity may or may not be protected by it's guarantees. Investors of Executive Life found that out the hard way. If you are heavily invested in an annuity (or annuities that were all issued by the same company) then under certain circumstance (described above) that entire investment may hang on the stability of that one insurance company that wrote the annuity contract(s)!!! Unfortunately all too often financial planning consultants break this most incredibly basic rule because they're only interested in pocketing that huge sales commission with minimal effort and in one fell swoop. As a result you are left at risk.


Variable Annuity Sub-Funds Fall Short

Most variable annuities don't offer enough diversity of funds. For example the annuity will offer a broad market bond fund and perhaps a short-term bond fund. 10 years ago you were OK, but In today's market environment, with long-term bonds (20 - 30 years) at risk of rising interest rates, investors want to avoid or have very little exposure these types of bonds. Unfortunately you can't do that with a broad market bond fund.


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