May

7

There are many positive aspects of insurance and annuities to consider, most of them revolving around peace of mind, at a price (usually a high price).

I have several senior citizen clients that are in annuities that are loaded with living (income) and death benefit guarantees. These benefits are quite pricey when you break them down. Really not worth the price, and people like Jane Bryant Quinn always vilify them, and rightly so. Most of them are mis-sold by salesman (who happened to have passed a Series 6 or 7 exam) to clients who don't understand them.

However, there are some benefits that need to be considered. I have clients that love the annuities I have them in (I use strictly no-load annuities (truly no-load, no-load in and no-load out, complete liquidity). These annuities allow them to stay in the markets when they otherwise couldn't stomach any volatility whatsoever. It's really just a peace of mind thing for them. I could get them a higher return if I managed their assets directly, but in reality, they wouldn't invest in the stock market if it weren't for the guarantees.

So the bottom line for me with annuities are this: Don't use them unless you really need the guarantees associated with them or if you plan to hold them for at least 8-12 years (the break even point between tax deferral and eventually ordinary income vs. paying capital gains tax as you go).

Life insurance is a complicated subject. If clients need "income protection in the event of premature death," then they need low-cost term insurance. They can get it over the Internet or through a good insurance broker.

A lot of salesmen try to sell insurance as saving vehicles. This kind of life insurance is 95%+ garbage (just as 95% of annuities are garbage). Don't fall for this pitch unless the person recommending it is a real planner who knows what he's doing and is using a stripped out no-load or low-load policy. And If they take this route, then they need to do a maximum funding/minimum face amount policy that doesn't violate the MEC laws. You want to make sure that the contract is not a MEC (Modified Endowment Contract). Furthermore, they need to make sure the contract offers zero interest loans (sometimes called a "wash loan"). And they need to be sure that they can afford to make the deposits that they commit (under a max funding/min face scenario).

Henry Gifford adds:

Once upon a time an annuity was an arrangement where a person paid money to an insurance company, typically a lump sum, and in exchange received periodic payments for life, sometimes starting immediately, sometimes starting at a future date.

The insurance company could use actuarial tables to determine that they were promising an income stream that on average, with interest figured in, was worth less than what they were selling it for. The same tables could be used to show the customer that if he lived longer than the average for a person in his category, he would receive a payout worth more than he had paid in. Thus for the customer it was similar to joining a pension arrangement, where people dying early subsidize those who lived longer, and all participants could be guaranteed income for life.

Things are not that simple any more. "Annuity" is now used to describe a dizzying array of products, few of which guarantee anything for life. Finding a simple description now is I think not a realistic goal.

Ray Humbert contributes:

The moving parts from an insurance company's perspective: mortality, interest, lapses, expenses and profits and taxes. It's all based on the probability of surviving (both actual and as a policyholder), and the time value of money. The buyer buys because his time of death is a tail risk tragedy and he is willing to pay more for less risk — a risk premium. But the real kicker is that any death benefit is generally tax-free and any cash surrender value also accumulates tax-free.

In general it is best to have the most complete underwriting that your health can support without getting "dinged." You want to be in the "pool" with the healthiest, least likely to die people to save mortality cost. Generally people like to pay a level premium, but this also means that if you lapse you probably are leaving something on the table (you paid your commission expenses early). However, maybe really you are giving up something that would go to your beneficiary.

Term insurance is pure insurance, no cash value. Whole life has cash value, which has a margin of safety for the insurance company, so they often share some of the "good experience" in a dividend. Universal life is like a saving account where they deduct your term cost monthly expenses and mortality. These often have a "back end load,", i.e. an surrender charge.

One of the frustrating things is that investments by insurance companies are highly regulated, and crazily taxed. Hence, it is hard for a insurance company to get you "efficient frontier" returns. If they are taking the investment risk, the regulators see it as there duty to make sure they do things conservatively, to protect very long term policyholders. But like most regulations, the definition of "conservative" must be so general as to make it highly inefficient.

This is somewhat mitigated by using "variable" products where the buyer takes the investment risk by putting the cash value into choice of mutual funds. However, these too suffer from tough regulations. Further, any time taxes are involved, everyone wants more than his share of the pie. More of that tax benefits should go to the buyer.

Annuities likewise have "tax-free accumulation." A deferred annuity is a tax-free build-up of a savings which you can latter "annuitize" (make it an income stream) which can be a set period, or for life, or a combination of guaranteed payments for X years to life or lives. The payout can either be fixed dollars or fixed units per payout period (usually monthly).


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