The Downside of Downside Protection

Posted on September 14th, 2010 in Investments, Newsletter Articles, Risk Management by wayne

Since the 2008 stock market crash, an insurance product called an “equity-indexed annuity” has been actively marketed.  This deferred annuity offers participation when stock markets are up, yet suffer no losses in years in which the market is down.  With no downside losses and the large (5% to 10%) commissions paid to sells agents, over $8 billion of these deferred annuities were sold in the second quarter of 2010 alone.

With so much of this product being sold, it is likely that someone will soon offer you this product with “no downside risk.”  Let’s explore whether this annuity product has any downsides.

All annuity products are sold by insurance companies through licensed insurance agents.  With equity indexed annuities, you are often provided a 10% “signing bonus” and the guarantee that your purchase price (including the bonus amount) will never go down, provided you hold the annuity throughout the surrender period.

Each contract year, you are allowed to pick a specific stock (or sometimes bond) index in which you can participate.  If the chosen index appreciates, your annuity will go up, subject to a predefined “cap” (maximum amount) that is set annually by the insurance company.   If the index goes down, your annuity amount remains the same as in the previous year.

Currently, index caps are between 5% and 8%.  If the market goes up dramatically, as it did in 2009, your upside is limited by the cap.  Most equity indexed annuity products also allow you to choose a guaranteed income option for the year.  With this option, your deferred annuity increases by a set amount for the year.  Currently, income rates are typically between 2% – 4%.

Are their any downsides to guaranteed downside protection?  Consider the following:

1)    Since caps and interest rates are set annually, insurance companies may lower the cap or the guaranteed interest rates each year.  This will likely occur if interest rates remain low.

2)    Surrender charges, as high as 12% of the annuity purchase price, are applied if you need your money before the end of the surrender period.  Until recently, most deferred annuities had surrender periods of 6 to 8 years.  Most equity indexed annuities have surrender periods of 10 to 14 years.  While each year you may withdraw up to 10% of the account value with no penalty, can anyone be certain that they will not need the invested funds for 14 years?

3)    In inflation skyrockets, will the annuities guaranteed interest rates and/or caps exceed the CPI.  If not, equity indexed annuity owners will receive a negative real rate of return, even as the markets may be prospering.

4)    All annuity gains are taxed at ordinary income tax rates when withdrawn.  With investments in stocks and other capital assets, gains are taxed at capital gains tax rates, which usually are significantly lower than ordinary income tax rates.

A conservatively managed portfolio of stock funds/ETFs, bond funds and alternative investments, can usually outperform “safe” deferred annuity products over a period of 10 to 14 years.  Recently we analyzed the performance of two equity indexed annuities, using the S&P 500 as the linked index.  With the current cap rates of 6.25% (for a 10 year surrender period annuity) and 7.65% (for a 14 year surrender period annuity) the equity indexed annuities provided  annualized returns of 3.89% and 4.49% respectively from 2000 until 2010,.

Next, we analyzed the performance of a conservative balance portfolio, consisting of 25% stocks (represented by an S&P 500 ETF), 10% alternatives investments (represented by a gold ETF) and 65% bonds (represented by a Barclays Aggregate Bond Index ETF).  The portfolio, rebalanced yearly, provided an annualized return of 6.49% (2% more annually than the 14 year surrender period deferred annuity) from 2000 until 2010.

For a $100,000 investment, the balanced portfolio provided $35,000 more than the 10 year surrender period annuity and over $27,000 more than the 14 year surrender period annuity.

To quote columnist Jason Zweig in a recent Wall Street Journal article concerning equity indexed annuities,  “If you want only some of the gains from a bull market in stocks and none of the losses from a bear market, I would advise rolling your own.”

Inflation or Deflation Try Meflation

Posted on September 14th, 2010 in Investments, Newsletter Articles, Risk Management by wayne

Lately, there has been considerable press about how the US is on the precipice of deflation, where prices, wages and asset values decline.  However, with food and energy prices rising and health care costs continuing to increase, it is hard to see any deflation.

Recently, an economist explained this apparent paradox in a manner that I could actually understand.  From his perspective, while most of our everyday costs continue to increase, a significant amount of deflation has already occurred through our most valuable asset, our homes.

As most homeowners know, the price for which we can sell our home is less than it was in 2006.   To make matters worse, our financial institutions, including the Fed, still have trillions of dollars of “toxic mortgages” on their balance sheets.  These mortgages are carried on their balance sheets at their original values.  As mortgages are ultimately forced into foreclosure, more downward pressure will be placed on the value of our homes.

For many of us, our most valuable single asset is the equity in our home.  As the value of our home declines, we experience financial deflation, even though our consumption costs (food, energy, health care, etc) continue to rise.

If financial institutions are allowed to continue to carry toxic mortgages on their books, at values above their market value, we will likely suffer the same economic malaise as Japan has experienced over the past twenty years.  Over time, this economic malaise will depress the value of other financial assets, including the stock market, and could lead to economy wide deflation.  If this occurs, the only mechanism available to the Fed and US Treasury to “salvage” our economy from deflation would be to drastically devalue the dollar.  If those measures are taken, they could produce runaway inflation.

Since there seems to be no political will to address the core cause of our nation’s financial and economic malaise, let’s look at some ways that you can protect yourself regardless of whether we experience inflation or deflation.

In a recent Wall Street Journal article, Jason Zweig used the term “Meflation.”   He defines meflation  as the direct, personal impact of the changing cost of living on your investments, your budget and your labor income.

Meflation requires that you first determine whether inflation or deflation is a greater personal financial threat.  A younger person, with good future employment prospects, a stock portfolio and a home with a fixed rate mortgage, faces much greater financial damage from deflation than inflation.  However, a retired person, living on a fixed income, could actually benefit from deflation, as prices would fall while their pension and or social security benefits would remain constant.

Meflation suggests investing to protect against whichever future cost of living direction (inflation or deflation) creates your greater financial risk.  While it may appear counterintuitive, the best investment strategy for a younger person, who will prosper more with inflation than deflation, is to invest in assets that do better in deflationary times.

Japan has experienced deflation since having a similar financial crisis in 1990.   Over this 20 year period, stocks have had an average annual real rate of return of -6%, while long term bonds have increased by an average of 5.3% annually.  The accepted investment “wisdom” is for a younger person to put a large percentage of their investment portfolio into stocks.  However, since a younger person will often prosper in inflationary times, they can better protect their assets by holding more bond funds, which may perform better than stocks in deflationary times.

Conversely, a retired (or soon to be retired) individual or couple, for whom inflation poses the larger financial risk, should invest in Treasury  Inflation Protected Bond funds (TIPS) as well as a well diversified portfolio of financially sound, dividend paying stocks.  A small amount of the portfolio should also be in gold and/or Real Estate Investment Trusts (REITS) which often perform well in an inflationary environment.

No one knows whether the future will hold inflation, deflation or both.   A “meflation” approach, in which your investment strategy provides protection against the more financially harmful scenario, can help you weather the financial storm, regardless of its direction.