When I wrote a post last week comparing the purchase of an annuity with one of sustainable portfolio of dividend stocks, I did of course expect some disagreements but I was surprised at many of the reasons behind it. In this article I would like to tackle one key factor that was brought up over and over on the blog, on SeekingAlpha, by email and Twitter. It was mostly about the fact that the big difference between the two products was that one was a guarantee of payments for a determined period of time while a dividend portfolio was subject to lots of variation. I think that argument could be a valid one but it is used in very flawed ways. To be clear, that is exactly how the annuity salesmen will try to get you to sign on that dotted line. Why?
Annuity Is Indeed Like Any Other Insurance
As you can imagine, I’m in favor of insurance in general and do have house insurance, car insurance, life insurance and even a few other types. So yes, I can certainly understand and agree with the need to “buy certainty”. Buying insurance is paying a premium to be compensated if something goes wrong i.e. diminishing risk, feeling more secure, etc. The fact that I can park my car anywhere, leave my house for a few weeks on vacations or not feel afraid that if something happened to me, my wife would be in financial trouble clearly has tremendous value. I can also agree that being sure that I will have a steady income flow for the rest of my life without having to worry about “over living” has a lot of value as well. I would be more than happy to pay for such a benefit. If I get back to the graph I used last week, having a steady cash flow also has its value compared to the more volatile payment from dividends (which is smoothed out here but would likely have more volatility involved).
The Difference Between Most Annuities And Other Types Of Insurance
When I am shopping for car or house insurance, it is fairly easy for me to perform two critical actions:
Compare Competing Offers: Most of these types of insurance are fairly standard and it becomes fairly easy to compare between them. Just watch a Geico ad and you will see that within a few minutes, you can know how much you could be saving if you switched to a new insurance company. There are very few differences apart from the amount of coverage, deductible and annual fees to buy the insurance. Auto insurance is also similar while life insurance is a bit more tricky but still fairly easy to compare.
Evaluate The Cost: If I have a $20,000 car and am a 30 year old male driver, I can know find out that the odds I will need to make a claim might be around 5% per year and that claim might be for an average of $10000 for example. The “average year” would have me save $500 but it could range between $0 and $50,000 (or higher) for example depending on other cars involved. Am I willing to pay $900 annually to avoid the “uncertainty”? Yes, absolutely.
Back To Annuities
First off, even in the comments of my last post, at least a dozen different options (bonuses, inflation, etc) were discussed and each of them can have a significant impact on how much your annuity is worth. Not only that, since there are almost no identical annuities, comparing between them becomes a major challenge. Pricing these instruments or comparing between them becomes very difficult, even for the sales guys. If you have shopped for an annuity in the past, could you give me any kind of idea what type of margin the seller was making? Could you tell if the price was too expensive? If the annuity was indexed to inflation, how much is a fair price to pay?
How Much Is It Worth?
I very much understand the point that security and certainty can be very valuable, especially for many retirees that do not want to worry or take care of these things. My main question however would be:
“How can you buy a product that you have no idea how much you are paying for?”
That security and certainty is valuable, but it does have a price. If I told you that for $1000, I will give $10 per year for life, back by the US government, would that be a good deal? Of course not. What if it was $20? Or $30? Or what if I gave you a $500 premium at death? Or if it were indexed to inflation? These are not simple considerations.
Not All Annuities Are Bad
The problem is not the actual concept of annuity but rather the fact that it is sold with high margins and based more on quantitative reasons than for a fair price. You should know that “illiquid’, “complex” or “unlisted” products have always and continue to be the most profitable products for financial institutions. Credit default swaps have been discussed over and over as a major cause of the recent credit crisis. One solution was to put these products on listed exchanges, increase transparency, etc. The main reason it has not yet happened is that financial institutions have too much to lose. In a similar way, I would say that annuities could be a lot simpler and easier to compare but that is unlikely to happen because those selling them have too much to lose.