About "Investing" in Fixed Annuities
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|There are Fundamental Flaws in the Logic of Investing in the "Safe and Guaranteed" World of Fixed Annuities
Here's brutal life lessons from the School of Hard Knocks to keep in mind when your life insurance company agent is trying to get you to invest in the wondrous world of safe guaranteed high yield for life fixed annuities.
When your agent says, "With this wonderful new fixed rate annuity, you'll lock in a 5% safe and totally guaranteed yield for life! Better sign up today before they lower the rate again!" You'll think, "Wow, what an awesome deal, I'd better jump on that today so I can lock in that super-high ultra-safe yield!"
If so, then you're just asleep at the wheel and didn't do your math homework yet.
The first fundamental flaw in fixed annuity logic is this: When investors hear the words, "You'll get a 5% guaranteed fixed interest rate," what goes through their minds is bank logic. In other words, you invest $100,000 and this time next year you'll have $105,000 (or $100,000 with $5,000 of income to spend). This is NOT how anything works in the life insurance world!
This 5% is only applied to the net amount of money that gets invested AFTER the life insurance company deducts their fees and commissions. Then it usually doesn't even apply to the total return before annuitization.
Once the net proceeds get invested into the general account, then it gets the 5% guaranteed fixed interest rate. But then the life insurance company usually deducts expenses from it, so a little is shaved off annually. So if they do, then this is just part of the fleecing. The fleecing occurs during commission-paying, pre-annuitization interest crediting, then the major fleecing occurs during the annuitization process. Then the slaughter happens when the bells and whistles (riders) all add up.
Your agent will usually be making an immediate 2% - 12% up-front commission. So this in most cases is even higher than the highest front-end loaded A-share mutual fund. This money is just gets shaved right off the top of the check you wrote out.
Then the life insurance company has to make enough profit to sustain its business model, which is 100% based on maximizing value and profits and dividends for their stock shareholders; not policyholders (you). How do you think they can afford billions annually in TV ads, have huge ivory-tower offices fully-staffed with uber-expensive employees with full benefits, and grew up to be "too big to fail" (and had to be bailed out with taxpayer money - AIG, American International Group, which needed $182 BILLION to survive in '09)?
This mega money doesn't just magically appear from nowhere, "Wall Street financial innovations," or brilliant management. It just comes right off the top of the check you wrote to them. The life insurance company business model is not a pretty one, unless you're an agent or a stockholder. Check out this Word docx:
So the bottom-line is that when you look at this "wonderful 5% safe guaranteed yield for life," relative to the amount of gross check you wrote out, it can be as little as 4% - 4.5% (or 10% to 20% less than advertised). This is about the same yield as bank CDs, that also have just about as much in "safe guarantees," and (compared to annuities) have little-to-no restrictions on cashing out early (or you can just wait until it matures, then you'll have all of your money back).
Then because they're "tax deferred" you can't sell them, even if they're not yet annuitized, and/or the back-end redemption fee surrender period has expired, without paying a 10% penalty tax (if you're under age 60). All you can do is "exchange" it for essentially the same thing.
Then most of the annuity income is taxable at your highest ordinary income rates (whereas mutual fund dividends and capital gains are usually taxed at much lower rates - sometimes less than half as much).
Also keep in mind that once you annuitize the annuity (trade the market value, AKA accumulation units, in for an income stream, AKA annuity units), then you are totally 100% stuck with this for life with zero hope of ever getting anything out of the insurance company but your little paltry yield, which most of the time DOES NOT EVEN INCREASE WITH COST OF LIVING INFLATION!
So when you fall for this trap, after a few years of just 2% inflation (average long-term CPI inflation is around 3%), your actual real after-tax yield is negative. After that, then you're losing 2% every year, compounded, for the rest of your life. That's right, you're safely guaranteed to be losing money, more and more every year, for the rest of your life, with all fixed annuities when the income payout doesn't increase with inflation (see the Investment Comparison product demo for an example of these numbers).
For those of you that still don't get it, the cost of buying everything in your life goes up all the time, but your fixed annuity income will not (this is why it's called "fixed"). So the amount you're "getting poorer by" escalates more and more every year. The pasted chart below from demo on the free annuity income calculator shows the effects of 3% annual inflation. The fixed annual annuity payout of $5,000 loses half of its purchasing power in 24 years (18 years at 4% inflation, 15 years at 5%, and 12 years at 6%).
Inflation is a force of nature that will never stop, so if your fixed annuity is funding a large portion of your living expenses, then eventually it's back to, "Do you want fries with that?" ya go, until you croak.
You'd be mad as hell if your Social Security paycheck did not go up every year with cost of living inflation, so you should be just as mad when this happens with fixed annuities.
Then if you buy any kind of an "inflation COLA cost of living benefits rider," which makes the annuity paycheck increase with annual CPI inflation to cover this guaranteed risk of losing your money, your net yield will drop around 10% to 30%. This reduction in income is the amount of premium paid to buy the income inflation rider - plus all of the built-in commissions, fees, and profits too.
Then if you die, they keep it all (whereas if it were invested in ANYTHING else, your heirs would just inherit it). Then if you want to counter this risk by buying some kind of payout option where the income goes to someone else when you die (AKA survivor options and/or term certain), then this will also cut 10% to 30% off of this wonderful safe guaranteed yield for life.
So if you buy insurance coverage for both of these bad things THAT ARE GUARANTEED TO HAPPEN (inflation and losing everything when you die) on a 5% fixed annuity, the actual yield on the amount you wrote the check out for could be lower than 2% (around two thirds less than advertised).
So no matter how you look at it, the only ones that are not guaranteed to lose out big time with any form of annuities are the life insurance companies, their stockholders, and their agents.
Everybody just needs to wake up and smell the reality of the life insurance company business model. There is NO FREE LUNCH, nor are there any "good deals" with any life insurance company product. There never was, there aren't any now, and there never will be. They employ whole armies of the world's smartest money rocket scientists (AKA actuaries) to ensure this is always so. You cannot "win," ever.
So if these are so "bad" then why are they always touted as being so "good"? Fixed annuities are just the one and only way life insurance agents can survive and feed their families when the markets are down, and when old retired sheeple are stuck frozen like a deer in headlights and are afraid to invest in America. When this is going on, then there's literally no other product agents can move enough to meet their sales quotas, so they won't get fired.
This is why fixed annuities are ALWAYS the current fad when markets are down or flat and/or bonds aren't yielding anything. So when you see fixed annuities advertised everywhere and talked about by everyone, it's not because "they're on sale" or are a good deal now. It's ONLY because salespeople know it's the one and ONLY decent-commission-paying-based product that sheeple will allow themselves to be talked into being fleeced into buying TODAY.
If advisers could make a decent buck from selling you a long-term 5% CD, then they would be doing that instead of peddling fixed annuities. But they can't. Some can sell CDs, but they only get paid a few bucks, so they don't do that. And the last thing they want you to be doing is going to the bank (about the only place you can buy CDs), because then they won't be getting paid at all. White Hat advisers don't like selling their sheeple fixed annuities, and some actually feel bad about it, but when that's all the sheeple will buy, then there's no choice.
There's a logical reason for most everything, so now you know to start thinking like a people and not a sheeple - especially when it comes to ALL forms of any product coming from any life insurance company.
Just do the math and see for yourself. This is not rocket science. Anyone can run the numbers with a simple calculator. Just have your agent run a "ledger" that shows the estimated income the fixed annuity will pay out once annuitized and divide that annual income by the amount of the check you'll write. The ledger is where the truth of reality shines bright.
For example, if you say you want to invest $100,000 and cover both of the major risk bases (inflation and losing everything when you die), and the ledger shows pre-tax income of $250 per month, then you're not getting a 5% safe and totally guaranteed yield for life - you're only getting 3% (and it's usually much less than 3% too, it could be less than 1%). This is 40% to 80% less than the original claim of "getting a 5% safe and totally guaranteed yield for life."
There's a free annuity calculator (#26) here where you can input the gross amount you invested, input the annuitized payment, and it displays the true yield.
Results will vary, and these numbers change daily, but the bottom-line is that once you start thinking, calculating, and acting like a people instead of a sheeple, then you'll see that ALL forms of annuities should be avoided like the plagues on society that they really are.
So as you can see, what's really "fixed" in the life insurance world is the overall money game, so no matter what you do as a policyholder of any kind, you will always lose and the life insurance company, their stockholders, and their agents, will most always win. There's only two ways to win in the fixed toward the house life insurance company game, and that's to either own their stock (because that's where all of these ill-gotten profits from fleecing the masses of sheeple end up), or buy term life insurance and then die (from an accident).
If you're now thinking, "If this is do bad, then why doesn't the government do something about this scam?" Well they did, that's what the annuity ledger is for (and life insurance ledgers). The catch is that you just acted like a sheeple and totally ignored all of the important bottom-line numbers in it. Just don't do that anymore.
If you're in the "free look period," then just send it back saying you don't want it. After that's over, then you're mostly stuck until you're age 60 or more (unless you want to pay the stiff surrender fees and/or the 10% penalty tax).
This free look period is also the government's way of protecting you by saying, "Okay sheeple, this is your last chance to wake up and cancel this bleep before it ruins your life. So you have (usually) 10 days to do your math homework to figure the reality of this out and cancel, then that's it, the permanent fleecing of your nest egg will commence on day 11."
If you're contributing money to any form of annuity periodically, then just stop doing that. Yes you are "allowed" to do that. The only "bad thing" that's going to result from that is having to endure an endless parade of whining from your agent and the life company.
Always remember that once you sign the form to annuitize it, and start getting your guaranteed for life paycheck, you won't be able to make any changes to anything ever, and you'll be 100% totally stuck with it for life, period full stop.
The best way to solve most all of these retirement income problems is to use our Conservative High-income Model Portfolio.
Why all of the usual "tax wrappers" (IRAs, 401(k)s, Roth IRAs, 529 plans, and all forms of annuities and all forms of whole life insurance) have around half of the value they did back in the "good 'ol days," is all explained in detail here.
Here's the Numbers from an Actual May '11 NY Life Fixed Annuity Ledger
These numbers match the contributions on the Investment Comparison demo, so you can easily compare fixed annuities to other methods of investing.
First, this was during a time when agents were claiming, "fixed annuities were paying 5%."
Then note that the total return you'd earn when in the accumulation phase (making contributions annually to the account) on this fixed annuity, is only 1.1% for the first ten years (then 1.0% after that).
So much for thinking all of the money you save will be growing at 5%, huh? This is rarely the case with fixed annuities - the current yield touted rarely has anything to do with the actual yield you're actually getting, both in the accumulation and the distribution phases.
The numbers in italics below show what you would have had if the total return during the accumulation phase was as input on the Investment Comparison program demo (instead of 1.1%, like it is). Instead of having ~$113,457, you'd have between $350,000 and $513,000. So $400,000 was used as the beginning value used to buy the annuitized annuity (Lifetime Income Annuity) in the following examples.
Next, agents will pile on all kinds of other bells and whistles (riders) that will also dramatically lower your yield. The numbers below ignore all of them, so it's all just a "straight vanilla fixed annuity" with the three riders explained below. Looking over all of the fancy sales brochures that came with the ledger, there's over a dozen little riders available (and so you'll probably have several of them if you let your agent run amok).
Just keep in mind that all riders are just add-on insurance contracts, that cost you big money in premiums, and that's how life insurance companies earn their profits. So if you got them all, your actual 4.1% (really 1.2%) yield would probably go down to under 2% (way under 1%).
Here's how much these riders lower your yield:
Straight Vanilla Single Life Payout (no riders). The fixed annual payment for life would be: $7772.29. You'd get this amount until you die, and it would be exactly the same and cannot be changed.
Single Life: Getting a 25-year term certain rider lowers your yield by: 12.6% ($6,792.43).
Single Life: Getting a 3% annual inflation rider lowers your yield by: 26.3% ($5,727.79).
Single Life: Getting both of the above riders lowers your yield by 37.4% ($4,867.97).
Joint Life: Getting a 25-year term certain rider lowers your yield by: 12.5% ($6,801.28).
Joint Life: Getting a 3% annual inflation rider lowers your yield by: 38.3% ($4,799.75).
Joint Life: Getting both of the above riders lowers your yield by 40.7% ($4,612.89).
So you started out with a plain vanilla fixed annuity that yielded 6.9% (if you had $400k instead of $113,457, then this yield is really only 1.9%). Then if you want to "insure" for all of the three risks that are certain to happen to you in the future, then your yield drops to 4.1% (again, if you had $400k instead of $113,457 to start with, then this yield is really 1.2%). This is a 40.6% decrease in yield.
Now compare this actual yield of ~1.5% to the yield and (total return) on our Conservative High-Income Model (CHIM). More than likely, just the yield is significantly more (usually more than twice as much, it changes monthly).
Then realize that if the CHIM has an annual total return of 8%, and 5% is yield, then your account balance grew by 3% in that year. So next year's 5% income yield would be based on 3% more principal money than you had last year. This is how you get your free automatic "inflation rider" by doing it yourself with mutual funds. If you noticed, 5% is two thirds more of an inflation rider than the 3% quoted in the fixed annuity ledger. If you ran the ledger with 5% annual inflation, the payouts would drastically decline much more than what's shown in the above math.
This "income growth" is guaranteed to NEVER EVER happen with a straight vanilla fixed annuity. Granted, the CHIM can and will lose money in bad markets. But most of the time, over the long-term your income naturally goes up more than inflation with the CHIM, but the risk is that it can also go down. And you'll get about the same amount of income yield with the CHIM even if the market values of the mutual funds go down. Yields sometimes even go up when the markets go down.
But even if it did go down, and stay down for years, when it goes back up then it won't take very long to outgrow the annuity, when that is only accumulating interest at 1.05%.
Then think about the fact that you are not locked into anything with any of our investment models. If you have an emergency and need money, you can just sell shares and deal with it. Then you can control which ones are sold, and how they're taxed, (or not). Also, you may even be able to sell what's currently down at a loss, creating a tax credit (the opposite of paying a tax).
With a fixed annuity, you can't do anything (once it's annuitized). Sometimes you can sell before annuitization, but only about 10% of the account balance per year. If you sell before it's annuitized, then you'll probably also have high surrender charges - which are as follows. This is the amount of money the insurance company just keeps if you sell out "early." Then there's taxes, and maybe even a 10% penalty tax to pay too.
Here's this annuity's surrender charge schedule:
Year #1: 7%
At time of this writing, the CHIM yields 5.0% and the best NY Life fixed annuity yields 4.1% (assuming you dealt with all of the risks that are certain to happen with riders, which the CHIM covers all by default for free anyway). This difference in yield is 18% (4.1% vs. 5%).
Then when you look at it from the point of view that you should have had $400,000 when you annuitized (and not just $113,457), you're comparing whatever the CHIM is getting to a yield of ~1.1% (not even the 4.1% used in the previous example).
The chances of the CHIM's annual total return averaging less than 2% for an extended period of time (more than ten years) is slim to none, and Slim left town. If it did, then things would be so bad that even cash under the mattress would be virtually worthless. This is because most everyone would be dead (oh yeah, and if things really did get that bad, then most all life insurance companies would be belly up, they won't be paying at all; and so your annuity would be even more worthless than the CHIM, because you could still sell shares for pennies on the dollar).
So the bottom line choice to make is this: Do you want to give up control, and 18% (really 78% - the difference between 5% and 1.1%) of your retirement paycheck, just to get the "safe life-long guarantee" from a life insurance company? When you think safety, also think, I'm totally 100% stuck with this contract for life too.
If you chose the annuity, then you're just a sheeple, because you can do better most of the time with just bank CDs (when considering all of the risks).
Also keep in mind that life insurance companies do go under! If it wasn't for $182 BILLION (or 92% ownership) of your bailout tax dollars, the biggest life insurance company in the world (AIG) would have went belly-up and defaulted on everything, including their fixed annuities, in 2009. So don't fall for their guarantees - if "the world breaks enough" that you think these guarantees will save you, then most all of them will be going under as well. Then money in the bank (under the FDIC limit) and under the mattress will end up being the only place where you'll still have some left.
So as you can see, there are NO guarantees whatsoever in life - regardless of who tells you what. All life insurance companies are just as risky as everything else in the financial services industry, when you account for everything correctly (which BTW, this site is the one and only place anywhere you can read about all of that and get actual proof). Our Money eBook is the best Real World education you can get anywhere to get a better grip on reality.
So no matter how you look at it, if you use cold hard logic, there's little to no reason to buy fixed annuities (and variable annuities are much worse).
This chart shows how $5,000 worth of annual fixed annuity income declines over time with 3% inflation. If the price of everything in your life goes up by 3% annually, then your real annuity income will be less than half in 15 years.
Why You Shouldn't Fear Bond Mutual Funds when Interest Rates are Low
Another reason why investors buy fixed annuities is because they think they're going to lose a lot of principal forever if they buy bonds when interest rates are low (and are about to go up).
This is very true if you're an investor holding or trading individual bonds. But with bond mutual funds, not so much. Why:
• They hold hundreds of bonds of all different sectors and maturities. So a rate increase in one sector won't be as much of a hit in the others.
• When you invest in mutual funds "correctly," you'll own a few types of bond mutual funds of different sectors, maturities, and countries. So a rate increase in one sector, or country, won't be as much of a hit in the others.
• When bonds mature, or are called, these proceeds are used to buy new bonds with the current higher interest rates. This raises the average yield of the fund.
• If there's a net outflow of money because of redemptions (from scared sheeple buying high and then selling low), then the fund will sell bonds at a capital loss - effectively eradicating these lower-yielding bonds from the portfolio. So just don't be in the herd of scared people doing that, and it won't matter too much this time next year. If it's a good bond fund, then this is the best time to buy more shares on sale (which will greatly increase your paycheck later).
• There's usually net inflows of new money into bond funds (just from economic growth and new investors entering the markets), and this money is used to buy new bonds with the higher interest rates.
• The constant automatic reinvestment of bond coupon interest is used to buy new bonds with the higher interest rates.
• When the bond fund's yields start to go back up to par with market rates (because new high-yielding bonds are always being purchased), then this attracts a ton of money that was sitting on the sidelines waiting before, because they were afraid of interest rates going up. So when it's "safe to buy again," a flood of new money comes in (to get the higher yields), which enables the fund to buy even more new bonds at the currently higher interest rates. This creates a vicious cycle which creates a self-fulfilling prophesy.
So the combined effects of the five above points all lead to both dampening the initial NAV decline, NAV slowly increasing over time (usually back to its original level), and making it so your yield steadily increases back up to prevailing market interest rates over time. All of this increases your retirement paycheck over time. So all you need to do is nothing, just wait it out.
• Bond mutual funds sometimes use derivatives to hedge their portfolios to not be hurt when this happens (PIMCO does this too much, which is why it was banned).
• Low yields are a sign of a bad economy. If you're in a bad economy in the 21st century, and interest rates go up, it's because the economy is getting better (not because inflation is rearing its ugly head again, which was the main concern in most of the last century). What's going to happen then is credit quality will improve, creating a damper on price decreases (because existing bonds in the marketplace will have their prices bid up because they're now "safer," because the issuing firms are making more net profits, lowering the chances of defaulting).
The whole paradigm where everyone fears interest rates going up wildly, because inflation is going up wildly and will become out of control, was very much only a 20th century problem. It will be decades before that problem ever comes back. The problem of the 21st century is so little inflation that the risk is actual deflation. There won't be annual inflation over 5% for many many years. The Federal Reserve "jacking up interest rates" to very high levels to squash an inflationary spiral only happens when inflation is above 6%, and is expected to keep rising. This scenario is not going to happen with an economy that's "permanently broken" like ours is, for many many many years to come, if ever again.
• Bond funds also like to hold bonds to maturity, which makes this all moot. All of this only matters if the fund plans to sell bonds before maturity. They usually don't for five reasons, 1) they don't have to because they have a perpetual time horizon (there's no events coming up to create a need to sell anything), 2) they don't want to take the loss, 3) there's usually a steady stream of new money coming in, which means they usually need to buy much more than sell, 4) there's usually enough cash on hand to easily meet net redemptions, and 5) they really only sell early when there's a nice capital gain profit to be plucked, so when there's no easy profit, they just hold until maturity, thus eliminating all potential losses. So they just don't sell before maturity most of the time.
So most of the effects of bond mutual funds going down when interest rates go up are much less than an individual investor holding individual bonds. Then the NAV declines only last a year or so, then they tend to return to previous levels (whereas the price decline in an individual bond is locked in until maturity - so just don't buy individual bonds - that’s an “80’s way of investing” back before basic online discount brokerage technology).
So if you are not planning to sell shares within a year, then all that's going to happen is that you'll start to see your average yield slowly increase. This is what you want, more retirement paycheck over time.
When the NAV (share price) does go down, this is just a temporary opportunity to buy more shares on sale, so do that.
When interest rates are low, and you buy fixed annuities, then you're guaranteed to be getting a very bad deal. This is because you're permanently locking in a temporarily very low interest rate.
It may go up a little when interest rates go up, but not much, because usually your slice of the general account your traunch was invested in is permanently linked to the low-interest bearing bonds actually bought. In English, the life insurance company just goes out into the marketplace and buys a bunch of long-term bonds, say at an average of 7%. Your money is what funds this purchase. Then you get 5% and they keep 2% as their profit. This small slice (traunch) of the much larger pie (general account) is usually stuck married together for life (at least 20 years because they're usually buying 20-year+ bonds). So even if prevailing interest rates go up, it doesn't matter to you because the investments in your traunch didn't change. The only thing that changed is that the price of the underlying bonds went down, given the insurance company even more reason to not increase your yield. So even if the rest of the general account now goes up to 8%, your slice of it is stuck only getting 7%. So this is why you may not see an increase of more than 5.5% if you lock in a fixed rate of 5% (all of this is the actual meaning of the word "fixed" when it comes to fixed annuities). Your yield is guaranteed to not go below 5%, but one of the many very high prices you pay for that is that it will rarely yield much more than 5% too.
So your 5% may seem great when the economy is broken, you're stuck frozen like a deer in headlights and are afraid to invest in America, but guess what? This is America - we will eventually bounce back one way or another. So when things become less broken, you're not going to be a happy camper when the same annuity rate is 7%, bank CDs are paying 6%, and bond funds are paying 8%, and the stock markets are back to going up 10% per year. People know to buy investments low when everything is on sale; and sheeple... well they just follow whomever is leading them into the slaughterhouse at the moment.
So if all of this is a reason why you were considering fixed annuities instead of bond mutual funds, then just don't do that, and you'll be much better off.
The way to solve most all of these retirement income problems is to use our Conservative High-income Model Portfolio.
Here's the shortest bottom line on all forms of annuities (and all forms of whole life insurance, AKA VUL): If you work in the life insurance business, either as an agent or an employee of a life company, or hold life insurance company stock; then annuities and whole life insurance are the greatest invention since the wheel (because they pay by far the most in immediate commissions of any financial product available today, making them by far the most profitable part of the life insurance company business model). But if you're an investor, then not so much. Just "do the math" and you'll see in a New York minute.
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