I was reading an article from Morningstar the other day, and while I was agreeing with much of what the author said, a lot of it was troubling to me. Allow me to explain.
The title of the article was, “These Products Offer Protection, but at What Price?” Just that title is troublesome to me. Bear with me as I expand on this. In the article she was addressing some of the products we utilize a lot. For example, we use hybrid products that provide long-term care benefits, but also provide benefits if you don’t use the care. An example would be a life insurance product that provides tax-advantaged cash build up and a death benefit that can be accelerated for long-term care. Say you take out a policy for $600,000. That might cost you around $6,000 a year if you are about 50, which is twice what you would pay for a long-term care policy. However, a long-term care policy can raise rates on you later, and if you don’t use it, the money’s gone. In this case, you would have much more than that. By age 70, for example, you would have north of $100,000 in cash value. Yes, that’s less than what you put in, but what else do you have? You have $600,000 in death benefit if you die, and if you require care? $150,000 a year for four years, tax free, that can be utilized any way you want. For example, you could use the money to modify your home, reimburse a family member for home care, or even taking a trip, if that’s what you want to do. There are no limitations.
So, what is the price? It costs more, and it’s a long-term commitment. But what’s the payoff? Tax-free money for you to use should you need care, tax-free access to the money you put in to use in retirement, a death benefit for your heirs, or a combination of all three. The author’s hang up with this solution? “By plunking down a lump sum, the purchaser of the hybrid policy effectively cedes the right to earn a higher return on that money in a more favorable yield environment, turning it over to the insurer instead.”
But isn’t this the cost of any insurance policy? If I put money into fire insurance, don’t I cede the right to instead gamble that money in the market? Or health insurance? Or life insurance? In fact, isn’t that the choice with everything you buy? If you choose this, you cede that. However, whenever we are talking about financial matters, everything comes down to a choice between something and “higher returns market.”
In my mind that’s a false choice. In this example, your choice is preparing for long-term care in a way that ensures your money isn’t forfeited if you don’t need it, or you can risk losing it in the market. That’s the real choice. Being prudent and responsible about preparing for a very possible and likely event later in your life, or gambling your money on the outside chance you might make more in the market.
But let’s assume for a minute that’s not the choice and you do make healthy gains in the market instead of purchasing the insurance. Assume you are 65 and you need that care at 80. What would it take to provide $150,000, tax-free for 4 years beginning at age 80? You would have to put in $12,000 per year for 15 years and get a steady 15% rate of return to amass the same amount available to receive care. So the choice isn’t to either prepare and purchase the I insurance or get extra gains in the market. The choice is actually be prepared for a potentially devastating financial crisis in which case you could lose everything, or take a chance of losing everything even without that event. What kind of a choice is that?
Let’s take another example. The author talks about annuities, specifically, Fixed Index Annuities (FIA). These are products that are designed to provide superior returns to other fixed products by tying your gain to a stock market index. Be clear, your money is NOT in the market, it’s in the very safe general fund of the insurance company. This is the same pool of money used to pay death benefits on life insurance policies. Therefore, it is kept in very conservative and safe monetary vehicles that are closely monitored by all 50 state insurance commissioners, plus the District of Columbia and the American Territories. So, your money is never put at risk, only the interest, which is used to leverage options in the market. The results are usually superior gains to what you would get in other fixed products like CDs or money market funds, but with the same, or even better, levels of safety.
This is what she said about these. “With such products, the purchaser is guaranteed a minimum return amount while also participating in the equity market’s gains…. That all sounds appealing, but purchasers pay dearly for those protections. In addition to steep ongoing costs and high surrender charges, the purchaser typically forks over a portion of his or her equity portfolio’s return to ‘the house,’ in that gains from the equity market are capped in some fashion. Thus, the all-in costs associated with these products–both explicit costs and implicit opportunity costs–can be high indeed.”
There’s so much wrong with this it’s hard to know where to begin. First, you don’t give up anything “to the house.” In an FIA you are not buying growth, you are buying safety. With “growth,” you could lose everything and run out of money in retirement. In other words, you aren’t opting for “growth,” you’re opting for risk. And if you lose the money, which is highly likely, how do you get it back in retirement when it’s all you have and you need to spend it down to live?
With safety, you are assured of having guaranteed income for the rest of your life. In fact, this has always been our choice. My grandmother put her income generating money into CDs. My parents funded a pension. In neither of these cases were their choices “more money or this other thing.” In every case, the choice is between being prepared and responsible, or continuing to engage in the magical and tragic thinking that everything is a choice between the market and some inferior alternative.
It may not be too late to get smart after all!