Insurance = Bad Investment

From time-to-time, I get asked about the biggest or most common investing mistakes. Somewhere at the top of my list is this - insurance is a bad investment.

Don't get me wrong, insurance is absolutely necessary for asset protection. But many people go well beyond that, drinking the insurance agent Kool-Aid that it should also be used as an investment. Of course, the insurance agent makes a much larger commission then, but pay no attention to the man behind the curtain!

A primary example of unnecessary insurance is a variable annuity. (I could also pick on universal / cash value life insurance, maybe another day.) Variable annuities are insurance contracts that claim to offer a ‘guarantee’ that investors will earn something like 5% or more annually, regardless of market performance. In theory, even if the market value of the account drops, you will still be ‘earning’ 5%. Sounds great, right? With a closer look, most people won’t think so.

First off, the ‘guaranteed’ return is actually based on a hypothetical (not actual) account balance. This hypothetical balance is the minimum basis for a small annual amount that may be accessed prior to death. But to take full advantage of this ‘guarantee’ you have to keep your money tied up for a very long time – in many cases for 10+ years – and you lose the ‘guarantee’ altogether if you make excess withdrawals prior to then.

During this entire period, you are paying dearly for that ‘guaranteed’ return. The additional charges can be 1%-2% or more every year on top of the annual fee, regardless of whether you ever use the benefit. That’s in addition to the 1%-1.5% per year charge for administrative fees. And that’s in addition to the management fees of 1%-2% paid to the people running the actual investment sub-accounts. All in all, you could be facing annual fees of 3%-5% per year or more! That’s a real reduction in invested funds, as compared to the hypothetical ‘guaranteed’ return.

Finally, there is a low probability of needing the ‘guarantee’ in a variable annuity. Insurance companies know history, and historically, these products benefit the insurer. If a person desires a guaranteed lifetime income stream, this can be done far more efficiently and inexpensively through a basic fixed annuity.

So why are variable annuities sold? Because insurance companies make huge profits on these products, and in turn pay high commissions to the brokers who sell them. And while they are very complicated products – many people who market them don’t even know how they work – they are easy to sell to unsuspecting investors. Insurers and their salesmen know that in the current economic environment, people are scared, making them easy prey to purchase anything that looks like a guarantee.

Don’t let pricey gimmicks distract you. The expense of a variable annuity will produce a significant drag on performance each and every year. Your funds will be much better off in a low-cost, properly managed investment account. It may not be flashy, but it works, while allowing you to maintain control and flexibility over your money.