I grew up in a neighborhood where virtually every boy got into a fistfight at least once. Bullies tested every kid. If you backed down, you became a constant target.
In some ways, I miss those days. Back then, if another boy wanted to hurt you, he always made it clear. He didn’t smile, give you a hug, offer a chocolate bar and then kick you in the groin.
The adult world is different. Plenty of adults sell harmful or ineffective financial products, often pitching them with a smile, a handshake and caring questions about your kids. After doing so, they often earn big commissions at the investor’s expense.
Recently, a young schoolteacher contacted me. I’ll call her Mariah. “Our school recommends an investment company,” she said. “I met one of their advisors and he told me my [defined benefit] pension won’t be worth much when I retire, so he recommended an index-linked insurance product.”
After looking at the firm’s website, I couldn’t find any non-insurance-linked investment products. And their section on “indexing” refers solely to the index-linked scheme they were trying to sell Mariah. It reads, “Indexing is a powerful strategy to avoid market risk by participating in the gains of the market, but not suffering any of the losses during the bad years.”
The firm shows a nifty chart revealing how such a strategy (represented by the green line) is better than investing directly in a stock market index (the blue line). Not only does this chart show their strategy beating the index, it does so with less volatility. It sounds great, right?
The financial advisor who visited Mariah’s school suggested she select an index to invest in. He said, no matter what happens to the markets, Mariah would not lose money. That sounds even better. But this hook has several barbs.
Assume Mariah selected the insurance company’s version of the S&P 500. The firm offers her the return of the S&P 500 when the index gains ground, minus a 0.5 percent annual fee. Unfortunately, the company says it won’t match dividends for the index. What’s more, the insurance company sets a cap rate. In other words, it’s the maximum rate Mariah can earn in a given year. So, if the real S&P 500 gains 32 percent, as it did in 2013, Mariah would only earn the “cap rate” determined by the insurance company. If that cap rate were 9 percent, Mariah would miss out on 23 percent that year.
If that doesn’t smell bad, it should. Below, I pasted the table used by the advisor at Mariah’s school.
The image below shows two examples: a constant cap rate of 9.75 percent and another at 7.25 percent.
The above example shows if the investor had a cap-rate of 9.75 percent, she would have earned an average return of 5.70 percent over the ten years ending 2018; 6.71 percent over a 10-year period; 6.13 percent over the 15-year period and 5.54 percent over the 20-year period. Such results, based on the table, would have supposedly beaten the S&P 500 index over the 15 and 20-year periods (see the first two columns).
Now let’s blow the salesmanship away.
First, according to the insurance company, the index fund returns promised by the insurance company will be subject to a 0.5 percent annual fee. That isn’t included in the table above. Second, the insurance company says it calculates the performance of the index on a point-to-point level that ignores dividends (or reinvested dividends). That isn’t included in the comparison above, either. The average dividend yield of the S&P 500 between 1999 and 2018 was 1.9 percent.
In such a plan, Mariah would have given up that 1.9 percent annual dividend payment. She would also be charged a 0.5 percent annual fee for the insurance product’s index. Then there’s the difference in return between the real index (which includes dividends!) and the cap rate that limits what the insurance company offers each year.
The US stock market didn’t deliver a high average return over the 18-year period from 2000-2018 because it dealt with a huge crash from 2000-2002. But even so, an investment in the S&P 500 index would have beaten this insurance company’s smoke and mirror product by about 69 percent if the cap rate were 9.75 percent.
In other words, suggesting someone can earn index-like returns without down years is like trying to sell a flying hamster that can also make you lunch. Not happening.
The comparative example above supposedly tracks how a single deposit made in 1999 would have grown if it were invested in the S&P 500 index (without dividend payments and with a 0.5 percent annual fee) versus an index-linked annuity like the one peddled at Mariah’s school. But if we compared it to a real index fund, like Vanguard’s S&P 500 (VFINX), the index fund itself came out 69 percent ahead.
However, the true advantage of investing directly in index funds would be even higher because most people don’t invest single lump sums.
Instead, Mariah and her colleagues add regular monthly sums. Assume Mariah began investing $500 a month in Vanguard’s S&P 500 index beginning January 1999. She experiences some down years, but this allows her to buy an ever-increasing number of stock market units at a discount. When the markets recover, those units grow a lot because they don’t have a cap.
The following table compares the money-weighted returns Mariah would have earned by dollar-cost averaging equal monthly sums into the S&P 500 (see column one). Column two shows the compound annual average compared to the index-linked insurance scheme.
*Source for Vanguard’s money-weighted returns: portfoliovisualizer.com
The indexed returns include the annual fees for VFINX
**This difference is likely to be even greater because the insurance company lists average returns and not compound annual returns.
When insurance providers claim, “index-like returns without an annual loss,” they’re selling a crooked promise. And that isn’t right. Unfortunately, there’s even more to this broken dream: Assume Mariah and her colleagues caught on to the inefficiency of this scheme. They contact their advisor and try to sell after several years. They could cancel their contracts, but not without paying a stiff penalty. Larry Swedroe, the chief research officer at Buckingham Strategic Wealth, says such penalties run as high as 22 percent.
“The reason for the high penalties for early withdrawal,” he says, “is that the provider offers large commissions to the sellers of their products. In the case of early withdrawal, the provider would have already paid out the large commission, which it needs to recoup.”
What’s more, these annuities are less tax efficient. If the money is held in a tax-advantaged account, such as a Roth or IRA, there is no tax advantage to owning one. However, if it’s held in a taxable account, the advantage swings heavily in favor of direct investing outside these schemes.
Index-linked annuities offer taxed deferred growth, but once the money is withdrawn, investors pay tax at their ordinary income tax rate. For most people (especially teachers like Mariah who will earn a defined benefit pension) that tax rate would be far higher than their capital gains tax rate.
In other words, these schemes don’t offer tax advantages in tax-advantaged accounts, and they are taxed more highly than a portfolio of index funds held in a regular, taxable account.
Economists Dr. Craig McCann from the University of California, Los Angeles and Dr. Dengpan Luo, from Yale, wrote, “Insurance companies add trivial insurance benefits, disadvantageous tax treatment and exorbitant costs to mutual funds and sell them as equity-indexed annuities.” They also say 15 to 20 percent of the money paid by investors into equity-indexed annuities is a transfer of wealth from unsophisticated investors (like Mariah’s colleagues) into insurance companies and their sales forces.
If you want to give yourself the best odds of investment success, build a diversified portfolio of low-cost index funds. This would be less volatile than a single stock market index. Long term, it would also beat the pants off an index-linked insurance scheme.
Please spread the word. After all, we can use education to fight exploitation.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas