How do life insurance companies make money? From the law of averages. On average, the life insurance company collects more in life insurance premiums than it will ever have to pay out in death benefits. That’s because with hundreds of thousands, sometimes millions of policyholders with life insurance policies, most pay more in premiums than their families will collect in death benefits. How do life insurance companies ensure they always win? By factoring in every little detail about your health to swing the odds in their favor. That’s why the smoking, DUI collecting, skydiver pays astronomical life insurance premiums. The insurance company wants to make sure they collect enough premiums from this high-risk policyholder to come out on top. Got cancer or another terminal illness? Forget it. You’re uninsurable.
There’s another way life insurance companies make money and it has to do with the law of averages as well – annuities. You’ve heard of them because your life insurance agents push them every chance they get. How do annuities work? Like with many financial products, there are various types of annuities, but in its simplest form, an annuity is a product sold by an insurance company where you make a lump-sum payment in exchange for a guaranteed income stream. Like with life insurance policies, the insurance company leverages the law of averages to always come out on top because they’re betting (and most of the time they’re right) that you’ll die before receiving a full return of your initial payment.
Typical annuities consist of two phases, the accumulation phase (i.e., deferral phase) and the distribution phase (i.e., annuitization phase). After funding your annuity, during the accumulation phase, the insurance company invests your funds to build up the value of your account (more like lining their pockets but more on that later). Your funds will more than likely end up in the stock market in an index fund. With average returns on a fixed annuity of around 3%, these insurance companies can simply throw your funds in an index fund to cover your payment and make a tidy profit, none of which you’ll be entitled to.
Then during the distribution phase (usually timed for the beginning of retirement), you get a fixed monthly return until you die. Like with life insurance policies, these insurance companies are relying on the law of averages. They’re betting that most people will die before receiving a full return of their principal. But you’re thinking, at least my heirs will get the principal back when I die. Wrong. And this is where insurance companies swing the pendulum in their favor. Because you are guaranteed not to receive your principal back, they come out on top on almost every contract. Annuities are stacked against you from the get-go and for the reasons outlined below, you should never put your money in an annuity.
Real Rate of Return
You’re looking at the average rate of return for an annuity and you’re thinking 3% isn’t that bad. Those rates beat even the best long-term CD rates, which hover just above 1%, you’re thinking. But, when compared to other investment alternatives, the stated rate of return pales in comparison. An Index Fund’s average annual return over the past 20 years is approximately 8.6%. Average annual returns from commercial real estate during the same period averaged 9.5%. A guaranteed return of 3% is OK, but what most people forget is 3% is not the real rate of return.
When taking into account the fact that you don’t receive a return of your principal, the real rate of return is much lower than the 3% and then it becomes apparent that a CD might actually turn out to be a better place to put your money. Shoot, in some cases, it’s better to put your money under a mattress. Case in point. Even if you had an annuity paying 5% annually, it would take 20 years just to be at a 0% real rate of return because at year 20 is where you receive a return of principal. So, if you die before the 20 years, the annuity was a financial loser. So, for 20 years, putting your money under the mattress would’ve been a better investment.
An annuity is a contract and the main provision of that contract is that you can not withdraw your principal at all and in the rare cases where a contract allows you to withdraw, it won’t be without severe penalties. Depending on the timing, the penalty usually starts at 10% of principal. So, if you’re thinking about annuities, you should be 100% certain you want to tie up that principal for the rest of your life because in most cases you won’t be able to get it back and even if you can, the cost of taking it back will be astronomical. You should think of that principal as being gone forever because, at your death, the principal will not be transferable to your heirs. It belongs to the insurance company. Don’t forget that your payments stop as well. So, in terms of wealth transfer, an annuity should never be a part of anybody’s estate plan because its value disappears at death. So, if you go to a lawyer’s office to discuss a relative’s estate and you find out he put all his money in annuities, you should walk out of the lawyer’s office immediately and consider suing the lawyer for malpractice for wasting your time because everyone should know an annuity is worthless once the beneficiary dies.
Payments from annuities are taxed as ordinary income. Compare that to the capital gains rate from mutual funds or real estate and the real rate of return from annuities makes them even less attractive. With real estate, the tax can be avoided altogether with a 1031 exchange. So, from a tax standpoint, annuities are a bad investment. Even worse, if you funded your annuity with pre-tax dollars, when you withdraw your principal (if you can withdraw your principal) not only will you be penalized at least 10% by the insurance company but you’ll get taxed by Uncle Sam at ordinary rates.
If annuities are so bad, are they right for anybody?
Maybe someone who is willing to trade a liquid asset in for a fixed stream of income because they’re highly confident they’ll outlive the break-even point of the payments and who doesn’t care about getting higher rates of return elsewhere. Truly, the only people who love annuities are the insurance agents who make commissions off selling them. They’re only successful at talking people into annuities because they don’t paint an accurate picture of having an annuity. For the rest of us, there are better options for our money. Some annuity holders tout the security of their investments. Even that is no guarantee. There is no guarantee that the company issuing the annuity is going to be around when you’re due to start receiving distributions.
Remember mortgage-backed securities? Those were a sure thing.
Many of the institutions issuing those securities have gone the way of the dodo and dotcoms. True, some companies selling public stock may not be around in 20 years, but you know what will still be here in 20 years? Real estate. So, for those considering annuities, please reconsider. There are better ways to plan for retirement.