April (and May…) Fool’s
The Games Financial Product Pushers Play
If, on April 1st, someone offered you an investment that promised the higher returns of the stock market with no risk of loss, you would suspect a prank. I’d hope that if you heard this on any other day of the year you would would immediately think “scam.” Yet, every day of the year some stockbroker or insurance agent is making this outrageous claim about a product referred to as some variation on the term “indexed annuity” or “indexed life.”
According to those selling these indexed annuity or life insurance products, only fools invest the ‘old-fashioned” way - in stock mutual funds. Who wouldn’t want the return of stocks which have averaged about 10% per year over the past 90 years with none of those scary bear markets in which stocks have plummeted 30 to 50%? Why would anyone take a chance on a equity fund that could be worth half of what you invested without warning?
The truth is that, despite this provocative and somewhat prevarigative pitch, such a product cannot exist. There is no way to make a lot with no risk, but the insurance companies behind these products know it’s what you want. So, they pretend to give it to you.
Here’s the truth about these foolish investment vehicles (using the word ‘investment’ very loosely): Indexed insurance products offer only a PORTION of the stock markets return – during good markets – and don’t lose value during down markets. They do this by investing a small portion of the money in stock market futures or options – typically S&P 500 contracts. These increase in value when stocks rise and expire worthless if stocks continuously fall. The rest of your capital is placed in a pool of reasonably safe bonds that help purchase future options and create revenue for the insurance company.
In good years, the insurance company provides a portion - 70 or 80% - of the appreciation of the index without any of the stocks dividends up to some carefully calculated cap. These caps tend to range between 3% and 5%.
Suppose the S&P 500 returns 10% in a given year (it’s 90-year approximate average) and 2% of that is in the form of dividends. That brings the gain for the year down to 8%. If your participation rate is 80%, your return should be 6.4%, but because of the cap you would only receive 5% or less on your investment. That means that even in the best years your maximum return is 5% annually. During those few down years – historically about 25% of the time – you make nothing. The bottom line is that an investors average annual return is likely to be in the 3% range – or less– no where near the expected return for stocks.
What about the guarantee that you can’t lose money? That, too, is a bit of a stretch. Because these products pay the salesperson as much as 10% - yes, 1/10th – of your investment, the insurance company needs to make sure they get that back from the fees and profits they expect from your assets. That’s why every one of these policies has some sort of surrender fee - in some instances as high as 12%. In this case, if someone investing $100,000 wants his or her money back in the first year after purchase, they will lose $12,000. That’s real money. These surrender fees gradually decline over many years, but the net result is that, rather than an investment guaranteed against loss, you have an investment with a multi-year guaranteed loss.
To avoid becoming an April (or May, June, July…) fool, you must realize that no matter how badly you want it, there in no such thing as wealth without risk.