Avoid Evaluating Risk Products With Investment Tools
“There is a lot of controversy in the press about variable products and their use,” said Terry Altman, a financial professional with MONY Life Insurance Company, Troy, Mich., in an educational session at this years Society of Financial Service Professionals annual meeting here.
A lot of that controversy is generated by members of the press and public who do not have a good understanding of variable products, specifically life insurance and annuities, said Altman.
“Most of the confusion around annuities is a result of someone asking the wrong question,” he said, explaining that addressing poor questions asked about annuities and life insurance can create confusion for both advisors and clients. To illustrate his point, Altman drew a parallel to someone asking the question of which type of car you would prefer: a Ferrari or a tractor?
Altman noted that this question is poorly statedit doesnt ask which is more expensive, or which has more appeal, or which goes the fastest. Obviously, the answer to this question purely depends on the vehicles intended use.
“The most important question here is what do you need it for? You cant pull stumps with a Ferrari,” he said.
This logic carries over into a discussion on annuities. Many people considering immediate annuities feel they can earn a better return by investing their money in the market, but Altman said this is not the right comparison for people to make. They do, however, and as a result many planners try to evaluate the internal rate of return (IRR) of an annuity vs. an investment.
Altman believes this approach is flawed in that these people are now using investment tools and terminology to evaluate risk management tools. “Its like trying to decide between the Ferrari and the tractor without knowing what you want to use it for.”
Furthermore, determining the IRR for either an annuity or a life policy is impossible because the time period is an unknowna critical component of the IRR calculation.
But this is the view many pundits in the financial press have when evaluating these products, he said.
Similarly, when it comes to life insurance, “the press will always favor term over permanent because you can buy more death benefit with the same premium,” Altman explained. Of course, this is only true if you die while the insurance is in force, he added.
Even many financial advisors discuss cash value life insurance with clients as having “a savings element, an investment element or cash accumulation.” Some planners even refer to cash value life insurance as a “forced savings plan,” he said. But all of these approaches completely miss the point of life insurance, he said. “All these terms are investment terms, this is a risk decision.”
Comparing annuities with mutual funds and other investments also misses the point of an annuityto distribute income. “Annuities are designed to protect you against living too long,” Altman said.
“In the financial press, everything revolves around IRR, but your highest objective should be to fulfill your clients goals,” he said. “IRR is not necessarily the number one goal when youre dealing with risk management tools.”
But many planners succumb to the pressure clients put on them to make this comparisonespecially during the accumulation phase of deferred annuities. As a result, many planners put emphasis on the tax-deferred nature of annuities. “If the only reason for selling an annuity is tax deferral then that is a misuse,” he said. “Annuities are designed for risk management.”
In addition, annuities have the ability to solve the biggest financial planning problem of the 21st century: outliving your assets. Since people are living longer and many are looking to retire early, the possibility of outliving ones assets is a real risk. The only solution to this problem the financial planning community is putting forward, however, is to invest in more equities, Altman said.
Granted, equities historically have shown superior returns than any other type of investment, but this approach is flawed because “you are attempting to solve a risk problem with an investment tool. Its like trying to pull a stump with a Ferrari,” he said.
“If you try to push a tool to do something its not designed to do, it wont work,” he said.
Altman drew another comparison of this logic by asking attendees if they would solve a life insurance problem with a sinking fund.
Another objection planners face with clients when discussing annuities and lifetime payouts is the belief that if you annuitize and die right away the insurance company keeps all the money. This objection will often come from the same person who turned down life insurance coverage because he thinks hes going to live forever, he noted.
People need to understand that annuity distributions are a result of an actuarial sharing of risk, similar to life insurance. The money from annuitants with a life income option who die early is used to fund the distribution expenses for those who live beyond their life expectancy, he said. Just as an individual with a life insurance policy that pays premiums beyond life expectancy is helping to fund death benefits that are paid to individuals who die early. “Fundamentally, the annuity is life insurance in reverse,” he said.
Another reason why people dont annuitize their investments is because they want to leave their money to their children. “When people raise this issue, I ask how much they want to leave. If youre concerned then lets buy some life insurance to achieve that goal,” he said.
Using annuities for retirement income purposes can help increase clients chances of achieving their goals. The use of an annuity shifts the risk of living too long on to the insurance company. Annuities can also lessen an individuals overexposure to equities caused by the fear of outliving assets. “We need to learn to address the risk with a risk tool,” he said.
Reproduced from National Underwriter Life & Health/Financial Services Edition, November 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.