Summary/TLDR
Variable annuities and permanent life insurance are products which are often sold under the guise of various “guarantees”. When the fine print of these “guarantees” are closely inspected, however, it is often revealed that there is more to the story. Furthermore, there are tremendous conflicts of interest between the seller and buyer of these products. While neither are bad in-and-of-themselves, great care should be taken before purchasing either.
Introduction
The financial planning industry is full of conflicts of interest and “experts” who are actually just great salesman who know nothing about financial advising or planning. And there is perhaps no area where this is truer than in insurance. Particularly, variable annuities and permanent life insurance are two products that get marketed and sold to anyone who can hold a spoon, independent of any other factors that might not make these products the best fit for the client.
Neither variable annuities nor permanent life insurance are bad in-and-of themselves. Both can play a role in a client’s financial plan under the right circumstances. However, the way that these products are advertised is often very misleading and they are frequently sold under the wrong circumstances.
Products, Products, and More Products
Variable Annuities
Variable annuities are often advertised along these lines: “Your money is invested in the market and, if the market goes up, your funds go up as well. Furthermore, there is a guarantee built into this annuity that says you can’t earn less than 6%. So, if the market goes down, you’ll still earn money! The most you can earn is what the market earns, and the least you can earn is 6%! Finally, when you retire, this annuity will guarantee you an income for the rest of your life, even if you outlive your money!”
Does that all sound too good to be true? Then I’m sure you won’t be surprised to learn that the full story is not nearly as rosy. When you invest money into a variable annuity, the insurance company keeps track of two “buckets” based on your investment. The first is your actual investment, which is invested into the market and from which fees are deducted. The second is an imaginary investment known as the “benefit base”. The benefit base is entirely hypothetical – it is not real money! But every “guarantee” offered by this annuity is only granted to the benefit base. This means that the 6% “guaranteed return” in our example above is not given to your actual investment. Your actual investment will still go down when the investments go down. The benefit base is only used to determine the “lifetime income” you will get from your contract. If all of this is difficult for you to follow, don’t feel bad – variable annuities are complex products.
Furthermore, the fees charged for this myriad of “guarantees” are quite hefty and mostly hidden from the investor. The average total cost of a variable annuity that I’ve come across is about 3-3.50% and I’ve even seen one above 4%! This is about 3-4x more than the typical financial advisor charges for investment management and financial planning!
Finally, the commissions paid to those who sell variable annuities are quite generous. This doesn’t mean that every salesman is a scoundrel, but such a blatant conflict of interest has no place in the arena of financial advice.
In my experience, most owners of variable annuities would have been far better off had they never purchased one. But now, after 10-15 years of owning the contract, getting out of them might not be a feasible option since high fees and investment underperformance has whittled down the client’s original investment so dramatically.
Permanent Life Insurance
For the purposes of the discussion below, I am not talking about permanent life insurance as a product. In certain circumstances, permanent life insurance can play a very important role in one’s financial plan. All-too-often, however, permanent life insurance is sold to individuals under less scrupulous pretenses.
You’ll often find permanent life insurance pitched as some kind of tax-haven investment vehicle that only the rich and powerful know about. These products work by having two components – an insurance component, and an investment component. Essentially, you pay your premiums to the life insurance company, they deduct the cost of insurance from your premium, and the remainder gets invested (what it gets invested into varies widely depending on the type of policy). Commonly, and depending on the type of policy, the claims made in pitches for variable annuities get repeated with this “cash value” component in permanent life insurance – “guaranteed returns”, “your investment can’t go down”, etc.
The cash value is usually accessible to the owner of the policy to use as they please. Most often, the cash value is accessed through a policy loan which is not reportable as income on one’s tax return and is therefore tax-free. If, however, the cash value falls beneath a certain level, the policy will lapse, and the insured will lose both the insurance and their remaining cash value.
Again, if you’re confused at this point, don’t worry. These products are very complex.
Reality is not nearly as rosy as one is frequently led to believe in the too-good-to-be-true-sounding pitches made for permanent life insurance. First, the returns presented on the policy illustrations are not guaranteed. Even for policies that require the company to pay a dividend to the policyholder, the amount of the dividend that they are required to pay is not what the salesman illustrates. I have personally seen tons of permanent life insurance policies that have underperformed their illustrations by tens- and sometimes hundreds-of-thousands of dollars.
Furthermore, what’s almost never considered in any “strategy” that uses permanent life insurance as a part of one’s retirement portfolio is the counterfactual – that is, what is likely to be the case if the individual didn’t purchase the life insurance and instead invested their premiums into the stock market. Almost every time that I’ve looked at this for a client, we find that they would be much better off just investing their funds in the market, even after any potential tax consequences.
I happened to help a friend with this exact issue recently. They were paying just over $300/mo for a whole life insurance policy and hadn’t yet begun contributing to a Roth IRA or maxing out their Roth 401(k). As illustrated, the life insurance would have accumulated about $375,000 in cash value by his age 65 (and even this is not guaranteed). If he invested this money in a Roth, however, he could reasonably expect to have about $700,000 accumulated over this same period! Finally, even if he invested in a taxable brokerage account, he could still reasonably expect to accumulate almost $585,000 after-taxes assuming he was taxed at the highest rate on his growth!
Finally, as with variable annuities above, the commission paid to permanent life insurance salesman presents a tremendous conflict of interest. In fact, there are some life insurance companies that offer their agents over 100% commission! Perhaps you should get a second opinion from an advisor whose compensation is not contingent on selling products before purchasing one of these policies.
Conclusion
Both variable annuities and permanent life insurance are prime examples of how rampant conflicts of interest within the financial services industry harm consumers. The compensation arrangement under which these products are sold often leads to them being acquired by people who do not need them.
As with “investment only” advisors and high-load mutual funds discussed in the first part of these series, it is not uncommon to find that people who have been sold these products would have been better off had they never worked with their “advisor”.
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