All My Thoughts On Reverse Mortgages

House_bills

I’m not the right age for reverse mortgages[1]but a reader asked me for my help. Some deep-down part of me will always be a mortgage guy, so I decided to learn more about these things.[2]

The reader, named Jesse, aged 73, called to relay his experience trying to get a reverse mortgage on his house, and to ask for my advice.

He’d seen advertisements by Tom Selleckfor a company called American Advisors Groupand it seemed to fit his financial circumstances.[3]

For Jesse, his idea was to use the money he could pull out of his house to help pay for taxes and insurance in the coming years.

Although I had never paid much attention to reverse mortgages, I previously had a vaguely negative feeling about them. I’ll describe those and sure, there are reasons to be cautious.

In the course of following up on Jesse’s inquiry, I also earned a bunch of unique and kind of awesome features of reverse mortgages which I had never seen in any other loan product. My overall thought is that under the right circumstances, these could be very useful mortgages.

No Payments, Ever

The first weird thing is that a borrower can decide to never make any principal and interest payments on the loan. For life! The debt accrues interest of course but the borrower can choose to never pay on that interest or principal. The lender gets paid back eventually, when the house is either sold or the owner dies, but in the meantime the loan doesn’t require any payments. Ever. I’ve never seen that on a loan structure before.

Second, as long as the homeowner complies with the mortgage agreement – which means staying current on taxes and insurance – neither the homeowner nor the homeowner’s spouse can be evicted from the house. Ever. It’s a bank loan backed by collateral, but the bank can’t take the collateral for the life of the borrowers. This is also something I’ve never seen before.

As it turned out, Jesse couldn’t move forward with the reverse mortgage, however, because his husband Ralph is only 51, and Texas requires both spouses to be over age 62.[4]Other states have more lenient spousal rules, but Texas has its own way of doing things, as you may have heard.

I’ll describe my three previous issues with reverse mortgages, as well as my evolving views.

Complexity is the Enemy of the Good

An important worry is that as a relatively unusual loan product, consumers could be more likely to make bad choices about a thing they don’t understand very well. Even a traditional home mortgage can seem complex but it resembles other products we’re familiar with, like an automobile loan or a personal loan.

A reverse mortgage, by contrast, acts a bit like a retirement account or annuity, in that you can take money out over time as you get older. It’s also a bit like a credit card or home equity line of credit, in that it “revolves,” meaning you can take money out but also pay it back as often as you like. But it’s also different than a credit card or home equity loan, because you don’t have to pay it back with regular or even any payments (until you die). One of my guiding principles of finance is simplicity. Reverse mortgages may be a complicated form of debt for some people, and complicated is the enemy of the good.

Somewhat reducing my fear, however, is that every prospective reverse mortgage borrower must take a financial counseling course by phone, mandated by the Federal Housing Authority (FHA), which regulates reverse mortgages. Guy Stidham, owner of Mortgage of Texas and Financial LLC, a San Antonio-based mortgage broker who offers both traditional and reverse mortgages, says these courses cost about $150 and take a few weeks to schedule, which serves as a kind of “cooling off” function for prospective borrowers.[5]

Borrowing capacity

One of the more complicated topics of a reverse mortgage is how much you can borrow. Big picture, you should know two things: First, you can generally borrow much less initially with a reverse mortgage than with a traditional mortgage. Second, the amount you can borrow against your house trends upward over time, at the same rate as your mortgage’s interest rate. Let me fill in a few details on this issue.

Your initial borrowing amount is calculated according to an FHA formula by taking into account three things: The value of your house, your interest rate, and your age.

House_billsThe FHA says that the younger you are, the less you can borrow against your house. This makes sense since time will eat away at your home equity, and you are not required to make payments on a reverse mortgage. The FHA also says that the higher the interest rate, the less you can borrow. This also makes sense because a higher interest rate, compounding over time with no payments, will also eat away at your home equity.

With an online calculator you can see how much of your home value you are allowed to borrow against. If you test out the calculator, you’ll see a 70 year-old charged 4.5 percent can borrow less than 50 percent against their house. The typical range of borrowing is between 40 and 65 percent of home value, substantially less than the 80 percent standard with a traditional mortgage.

Here’s a weird quirk of reverse mortgages, however, The amount you can borrow against your house increases over time, precisely in line with the interest rate you are charged. If you’re charged 5 percent interest, your available borrowing limit increases by 5 percent per year. For reverse mortgage borrowers using this as a home equity line of credit, the annually increased borrowing capacity will seem like a cool feature. For people concerned with reverse mortgages eating up your home equity, this increased borrowing capacity may seem pernicious.

I won’t rule either way, except to say that debt in all forms is always a drug, which may be used for good or evil. The increasing borrowing limit just ups your dosage of the drug over time.

Are these high cost mortgages?

My second big worry was that reverse mortgage would be high cost products for borrowers. This fear turns out to be somewhat true, although there’s some nuance to the cost issue.

reverse_mortgageThe biggest cost of a reverse mortgage is mandatory mortgage insurance. Reverse mortgage borrowers are charged by the Federal Housing Authority (FHA) 2 percent of the appraised home value. For a $500,000 appraised home, the FHA would charge $10,000, which would be rolled into your loan balance at the time of origination. The FHA also charges 0.5 percent annually on the balance, as further insurance against losses. I think this is the biggest contributor to reverse mortgage costing more than traditional mortgages.

Next, what kind of interest rate should we expect on a reverse mortgage?

Most reverse mortgages charge a variable interest rate. According to Greg Groh, a reverse mortgage originator with All Reverse Mortgage, last week the starting variable interest rate was 4.32 percent which, added to the insurance cost, would mean a borrower’s cost of 4.82 percent.

What do I think of those rates? They’re slightly higher than a traditional mortgage, but also less than the rate I’m currently charged for my home equity line of credit, on which I pay 5.49 percent, and happily so. So, the floating interest rate isn’t a big knock on reverse mortgages.

Joe DeMarkey, Strategic Business Development Leader of Reverse Mortgage Fundingestimated fixed rates now between 4.375 and 5.125 percent, in the same ballpark as a traditional 30-year mortgage. So, again, the cost of a reverse mortgage isn’t particularly from an above-market interest rate.

DeMarkey points out that 80 percent of reverse mortgages have floating interest rates rather than fixed rates. With floating rate loans, the initial interest rate often starts out reasonably low but there’s always a risk that future higher interest rates make that same debt more expensive later.

Broker commissions and origination fees

Stidham allows that a broker like him can be compensated more by the lender to sell a reverse mortgage in part because they are a less competitive product. His fee for brokering a reverse mortgage could be up to 3 times higher than with a traditional mortgage.

Finally, there’s the issue of origination fees. The maximum origination fee is capped at $6,000, and would actually be smaller for smaller loans.

Closing costs like attorney fees, title insurance, and bank appraisals are all basically the same as a traditional mortgage. Groh reports that a reverse mortgage bank appraisal cost might run slightly higher, but on the order of $550 for a reverse mortgage appraisal rather than $450 for a traditional mortgage. Not a big deal there. The main big cost difference, as I said earlier, is the FHA-charged insurance, which is pretty hefty.

Servicing Details

The servicing component of reverse mortgages is slightly different than for a traditional mortgage. Since borrowers must live in their house, does that force a sale if an elderly person moves out to a nursing facility? Yes, and no.

Borrowers may live outside of the home up to 12 continuous months, meaning even an extended hospital stay or stint in a nursing home does not trigger any change with the mortgage.

Each year a lender sends an “occupancy certificate” letter to the home which must be signed and returned, according to Cliff Auerswald of All Reverse Mortgage. If the borrower does not return that certificate, then the servicer may send someone over to do a drive-by inspection of the property.

If the borrower decided to leave the home for more than 12 months, then in fact the loan would become due. For that reason, any borrower who doesn’t plan to stay in their home “for life,” should probably look for another product rather than a reverse mortgage.

Hollowing out Equity

My third big problem with reverse mortgages was that they clashed with my traditional view of the incredible wealth building potential of home ownership– a way to automatically build up a store of wealth by making affordable monthly principal and interest payments on your house over a few decades. Because reverse mortgages drain that value over time, they made me want shout “Wait…But that’s…that’s not how it’s supposed to work!

Look, my strongest advice would be to fully pay down your home mortgage over 15 to 30 years, don’t borrow against your house, and depend solely on accumulated retirement savings plus social security to support you in your old age. There’s nothing wrong with that advice except for the fact that it sounds a bit like: “My strongest advice to you is to be rich in your old age.”

And, you know, that’s not very actionable advice by the time you actually retire.

If you can’t be rich, my second strongest recommendation would be to take out a home equity line of credit, since these are revolving lines, they allow you to flexibly borrow as needed, and act like a low-interest emergency credit card. They are awesome and we used one to renovate our kitchen and paint our house. I love my HELOC. A reverse mortgage therefore is really a third-best option, but it seems to me a pretty fine choice under many scenarios.

As my wife reminded me recently, one of my other long-standing theories of personal finance is that kids shouldn’t inherit stuff. Since we don’t intend to bequeath our house to our girls, I shouldn’t be opposed to draining the house of our home equity once we hit our 70s or 80s. At that age, the goal shouldn’t be to continuously build up assets (For what? For whom?) but rather to spend money to make our lives better.

If we planned to stay in our house, my wife and I recently agreed we’d be open to a reverse mortgage in our 70s.

[1]You have to be age 62, minimum.

[2]This post is a combination of a couple of columns I wrote for the newspaper, combined into one long post.

[3]A reverse mortgage, sometimes called a home equity conversion mortgage (aka HECM), is targeted to 62 year olds and up. Home equity, I should clarify, is the difference between the value of a house and the amount of debt on the house. That means a $300,000 house with a $100,000 mortgage has $200,000 in home equity. A reverse mortgage is a kind of home equity loan, specifically to borrow in old age without having to make payments, if you don’t want to.

[4]As an aside, Jesse wondered if discrimination from the bank was at play because he’s gay. I told him he should hope for that, as a class-action attorney could solve all his financial needs and he wouldn’t need the mortgage any more. Alas, Texas law says your spouse can’t be younger than 62 to take a reverse mortgage, whereas in other states your spouse can be younger than 62. It’s age discrimination, not LGBT discrimination. No big discrimination win for Jesse.

[5]Disclosure: I have done consulting projects for Stidham in the past.

 

 

Please see related posts:

Homeownership – Part I

Ask an Ex-Banker: HELOCs

 

 

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Flood Insurance – A Post-Harvey Revisit

Like everyone with a home mortgage, I have homeowner’s insurance that covers most catastrophes, although the list of covered catastrophes specifically does not include flooding.

flood_insuranceOccasionally I worry because my house backs right up to the San Antonio River. Fortunately, my yard and house are outside the boundaries considered to have a 1 percent chance of flooding per year, the so-called “100-year flood plain.” So up until now I’ve never had flood insurance, nor have I been required to have it by my bank.

There was a bit of weather recently in Texas you may have heard about, which got me thinking again about flood insurance, and also about how reliable our current risk-assessment methods are.

As a financial rule, I’m usually in the “don’t buy too much insurance” camp, urging people to self-insure whenever possible. Or as the French might say, I adopt an “après moi, le deluge” approach to many insurable risks.

Flood insurance, however, might be in the special category of things for which self-insuring doesn’t work as well. Meaning, even though my house sits outside of the 100-year flood plain, I really cannot afford the unexpected but catastrophic loss of my house due to flooding.

I called up my insurance provider this past week to get a quote on flood insurance for my house. I learned a few things.

I received an annual premium quote of $499 for up to $250,000 in damage to my house, plus an additional $100,000 for personal belongings, subject to a $1,250 deductible in each loss category.

Interestingly, I learned my insurance provider is acting not as the underwriter of flood insurance, but rather as a broker for the federal government’s National Flood Insurance Program or NFIP administered by FEMA, the Federal Emergency Management Agency. [LINK:]

In fact, everyone has to go through a private insurance company to get this federal flood insurance. Almost nobody gets private flood insurance.

I mean, there’s also a private market solution, but barely. I went to one provider online and entered all my data to match the quote I got from my regular insurance provider. The annual premium would be $3,219. So, more than 6 times as expensive as the FEMA quote. With that difference, you can sort of see why the federal government dominates the market.

Matthew Hartwig, a spokesperson for insurance provider USAA, told me that their flood insurance call volumes rose up to 9 times their regular rates before, during, and after the landfall of Hurricane Harvey. Customer inquiries even now continue at a higher than normal rate.

Unfortunately, none of those flood insurance sales in late August and early September can help Hurricane Harvey victims, because of a 30-day wait rule, before recently-purchased flood insurance becomes effective. Buying now only helps for the next flood.

Interestingly, engineering and flood risk specialists are in the process of re-evaluating how we deal with flood risk these days.

The old way of risk assessment is to simply map out whether a property is, or is not, in a 100-year flood plain.

Patrice Melançon, Watershed Engineering Manager for the San Antonio River Authority, described to me at least a few engineering discussions underway in the wake of Harvey.

She cited her counterparts in Houston who are actively discussing whether the right level of “risky” should be to look closely at properties previously considered to be in a so-called “500-year flood plain,” or areas that have only a 0.2 percent chance of flooding per year.

harvey_floodingOf course, a common-sense reaction to that news is to wonder whether things have changed, possibly due to climate change, such that previous rainfall data informing the 100-year flood plain is no longer accurate in 2017.

While FEMA still relies on maps that show the 100-year flood plain, they are developing – in conjunction with local partners like SARA – a more sophisticated set of maps that show the likelihood of flooding within 30 years, as well as the probabilistic severity of flooding inside and outside the 100-year flood plain, The new maps are “informational” and “consultative” rather than being used for regulatory purposes like the 100-year flood plain maps, but nevertheless represent the next level of risk-analysis.

I’ll be checking out those new maps. Even now, about 25 percent of flood claims occur on houses located outside of a flood zone. That’s on houses that are deemed safely outside the flood plain, like mine.

Finally, Melançon mentioned to me that SARA expects to receive, in another 3 or 4 weeks, updated computer modeling and analysis of what would occur if Harvey-level rainfall dumped on the city of San Antonio. I’m pretty interested in those results too.

Personally, I don’t want to pay $500 to protect against a thing that’s never going to happen.

On the other hand, a “thing that’s never going to happen” just happened all over the city of Houston and in towns up and down the Texas coast. And four different Category 4 and 5 hurricanes were never going to make landfall within four weeks of each other until Hurricanes Harvey, Irma, Jose and Maria actually smashed all normal expectations of weather patterns.

nuclear_bomb_explosion
Not covered in your homeowners insurance policy

So, yeah, we’re buying flood insurance.

As a scary epilogue to this story, you know what else is not covered by regular homeowner’s insurance? Property damage due to nuclear war. And I know that’s never going to happen either, right? Anyway, enjoy your morning coffee with breakfast, everybody.

 

A version of this post ran in the San Antonio Express News and Houston Chronicle.

 

 

Please see related posts:
Insurance Part 1 – Risk Transfer Only

Insurance Part 2 – The Good, The Optional, and the Bad

Insurance Part 3 – Life Insurance Calculations

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How Not To Invest: Viaticals

death_eatersI’m a big fan of niche financial markets as well as learning about how NOT to invest. This leads me this week to the “life settlements” industry, and a subset of that business known as “viaticals.”

Living owners of life insurance policies sometimes seek to sell their policies on the secondary market to receive a lump sum of money as well as to relieve themselves of the obligation to keep up expensive life insurance premiums. Life settlement investors pay that lump sum, maintain the policy premiums, and then collect the death benefit when the original policy owner dies.

The purchasers of secondary life insurance policies, investment funds seeking an above-market return, usually take over policies of elderly or terminally-ill patients who no longer can afford, or who no longer wish to afford, the life insurance premiums on the policy. For the investor, ideally, the insured person dies quickly, before the premium costs eat up returns.

While regulated and considered legal transactions in 42 states, there’s an obvious ick-factor to life settlements, as investors essentially bet on, and benefit from, the early death of policy sellers. The faster the death, the greater the profits. Which when you think about it, you know, ugh. A life insurance policy for someone who beats the odds and lives a long time will end up costing investor the money, who pays too much in premiums, for too long, to ever make a profit.

Viaticals, a subset of life settlements, refers specifically to investing in policies of terminally ill patients, with less than two years to live, or the chronically ill, unable to perform two “activities of daily living” like eating or dressing oneself. For the policy purchaser, you can see how a life insurance policy of a terminally ill person on death’s door is worth a lot more than the life insurance policy of a healthy person.

The legitimate financial cases for buying a secondary life insurance policy are twofold. First, terminally-ill or elderly folks may need access to their cash today for end-of-life care. The industry first grew up as a response to the crisis of terminally-ill and relatively young men with AIDS in the late 1980s. They needed money right away and worried less about heirs or estate-planning.

Those earliest pools of viaticals, dedicated to purchasing AIDS policies, blew up catastrophically for investors in the mid 90s, when a miracle cocktail combining protease inhibitors and two other drugs transformed HIV from a death sentence to a chronic illness. The insured survived, and investors lost everything.

The second major category of sellers today are often older high net-worth folks who purchased life insurance as an estate-planning tool, but who later find their estate-planning needs have changed, and they no longer want to maintain their policy.

The “ick factor” associated with viaticals is not the main reason why I’d urge you to avoid this business opportunity, should it ever come your way. Rather, I’d avoid life settlements because the industry seems to attract both fraud and financial blowups like a jelly donut on my counter attracts ants.

The fraud probably happens because life settlements and viaticals are just niche-y and opaque enough to attract a certain type of scheme-promoter, who knows how to appeal to a risk-taking investor. That risk-taking investor in turn usually thinks they’ve found a relatively hidden, low-risk, high-return way to invest.

Fraud in the industry has been perpetuated in a variety of clever ways.

My friend Michael Stern, a successful industry veteran of the life settlements industry over a dozen years, described to me a few of the classic scams.life_partners

In Texas, one of the industry’s most notorious operators, Life Partners Inc, filed for bankruptcy in 2015 following $46.9 million in court-imposed fines against the company and its main executives for fraud and insider trading. The Wall Street Journal reports that Life Partners depended upon a physician – working on commission – who assigned shortened life-expectancies to policies where independent estimates would have been much longer. Those short-life estimates juiced the price at which the operators could sell life insurance policies to relatively unsophisticated investors.

Following that, maintaining the policies sometimes got too expensive for those investors, so the Life Partners executives repurchased policies from their customers to the financial benefit of insiders, leading to insider trading fines. The executives seem to have avoided jail time, and the business exited bankruptcy in December 2016, to be liquidated for the benefit of investors.

Stern explained to me that because policies are expensive for existing investors to maintain, some operators have fallen into the illegal practice of paying off old investors with new incoming investors, the classic definition of a Ponzi scheme.

us_virgin_islands
USVI suffered some problematic pension investments

Stern also mentioned that his industry now has learned to blacklist or avoid purchasing policies from certain zip codes with a preponderance of fraudulent medical reports, where a medical examiner is likely boosting the value of policies by diagnoses which exaggerate the risk of imminent death.

In the US Virgin Islands last year, a viatical investment gone awry blew a $50 million hole in the territory’s government pension plan, a plan that was already in distress. The 2016 auditor’s report reads like a “what the heck just happened?” story.

Although the life settlements industry remains a relatively small few billion dollars in policies per year, compared to the maybe $20 trillion in face value outstanding of the traditional life insurance business, large and sophisticated sponsors do participate, such as Apollo Global Management (APO) and American International Group Inc (AIG).

As a side note, I decided long ago that when I write my first novel – a financial thriller obviously – the main plotline will involve a hedge fund dedicated to viaticals. Could a certain unscrupulous hedge fund manager, maybe, put a thumb on the scale to speed along the process of death? Nothing too obvious, you know, just some prudent risk management and juicing of returns on the margins. The patients were already pretty sick, you understand, so it’s a mercy, really. Think Robin Cook’s Coma meets Michael Lewis’ The Big Short.

While viaticals make a brilliant premise for a creepy novel, my financial advice is to leave this investment opportunity entirely to the professionals, partly for the ick factor, and partly because they are best equipped to navigate the fraud and blowups that seem to follow this industry niche.

 

A version of this post ran in the San Antonio Express-News and The Houston Chronicle.

Please see related posts:

 

Book Review: The Big Short by Michael Lewis

Annuities: Loved By Insurance Companies and Death Eaters

 

 

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Financial Readiness – My 5 Stages of Grief

financial_readinessMy personal bank – which also offers insurance and investments – recently invited me to discover my ‘Financial Readiness’ score, available in five minutes by taking a quick online survey.

Now, I am a competitive person who likes to win. For example, I know my SAT scores from high school, as well as my fastest one-mile and marathon racing times, by heart.

As a finance guy, I knew I would rock the Financial Readiness score. Bring. It. On.

The online survey asked me about my type of work, personal annual income, plus household income. Not bad, I thought, not bad.

Next, I answered questions on whether I rented or owned a home, the size of my monthly housing payment, and whether or not I budgeted. Home ownership, yes, budgeting, not so much. I hate budgeting.

Further questions prompted me to discuss my insurance against disability or loss of life, my dependents, and my retirement savings and investments. Well, I like to think I don’t over-insure, but I do have some retirement accounts.

Finally, the survey asked about whether I have documented my will, and whether I have named a health-care proxy. Yes. Totally. Nailed it.

My score

At the end of the survey my pulse quickened in anticipation of a huge pat-on-the-back for my incredible financial readiness.

I got a 66. Out of 100.

What?! Me? There must be some mistake.

A 66?

I’ve never gotten a 66 on anything in my life. Even worse, a 66 on my finances?!

I have three thoughts about my Financial Readiness Score.

financial_readiness_score
A 66?!

My first thought I already told you, which is: “What?!”

That thought represents “Denial” and “Anger” steps in my five stages of grief.

Second Thought

My second thought – (possibly part of “Bargaining and “Depression”?) – came from a closer review of the Financial Readiness plan which my bank provided, following my score.

My Financial Readiness Report showed areas where I could improve my score, by reviewing and changing my approach to savings, planning, and financial protection.

The report suggested setting budgetary goals. That’s probably not happening. It also prompted me to consider upping my insurance coverage. Not surprisingly, my bank is also involved in savings accounts and insurance, so you can see a bit where they’re coming from.

I’m not saying their wrong. I’m just saying they have an agenda.

I have strong feelings about some of these things, and I think on at least a few topics, reasonable people could disagree.

Building an “Emergency Fund” – which my report strongly encourages – happens to be something which I philosophically disagree with, as I’ve written about in the past. LINK [http://www.bankers-anonymous.com/blog/some-terrible-financial-advice-the-emergency-fund/]

Boosting my auto-insurance total coverage, or my wife’s life insurance coverage – also recommended by my Financial Readiness report – also is something I’m not likely to do, as I’m philosophically an insurance minimalist [LINK: http://www.bankers-anonymous.com/blog/guest-post-dont-buy-too-much-insurance/]

In exploring these areas for boosting my score, I noticed robust prompts to action. In modelling out my retirement planning, for example, I got a chance to see how my intended retirement age, as well as my appetite for risk, would affect the probability of meeting my retirement goals. It was pretty cool, actually.

Third Thought

financial_readinessMy third thought about my Financial Readiness score, as I move toward “Acceptance,” is that these simple but potentially catalytic surveys – paired with calls to action – might be quite useful. Let me expand on that thought for a moment.

Most of us need financial guidance. A fundamental theme of my financial writing is that almost nobody feels confident that they have all their finances figured out, yet few know where to turn to a trustworthy source.

We don’t like banks. We don’t trust our financial advisor. Insurance confuses us. The last thing we want to do as adults is spend precious free time with a lawyer to talk about what happens to all our stuff when we die. In all that confusion and natural aversion, we tend to not even know where to begin. So, like everybody else, we punt decision-making until some medium-distant future, maybe months from now, maybe when a crisis happens, or maybe until never.

Possibly, a five-minute internet-style quiz from my bank becomes the on-ramp to better planning and decisions?

I mean, not in my case, since the quiz is obviously flawed and they got my score wrong. But, you know, maybe for others.

 

A version of this appeared in the San Antonio Express News

 

See related posts

Why I hate my bank

Emergency Fund – That Silly Sacred Cow

Insurance

 

 

 

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Shit Sandwich – Variable Annuities

In my favorite movie of all time, Rob Reiner recalls the two-word alliterative review of Spinal Tap’s unsuccessful second album “Shark Sandwich,” as simply “Shit Sandwich.’

The band members react to this shocking review with resentment, but also with a sense for what newspapers are allowed to actually say.

David St. Hubbins: “Where’d they print that?”

Nigel Tufnel: “That’s not real!”

Derek Smalls: “You can’t print that!”

Which bring me to my two-word review of an extremely popular ‘investment’ product known as the variable annuity. For variable annuities, I’ve got the same two-word review: “Shit Sandwich.”

variable_annuity_shit_sandwich
Variable annuities deserve the same two word review: “Shit Sandwich”

They Can’t Print That

As I wrote this, I knew the newspaper I write a column for wouldn’t carry my real review of variable annuities.1

Of course they won’t let me print a traditional four-letter word. But, for the record, I really don’t think scatology is why most media “can’t print that’ when it comes to my review.

No, they really ‘can’t print that’ because insurance companies are really important media advertisers and variable annuities are really profitable for insurance companies. Hence, you will rarely see an honest review of variable annuities in traditional media.

I’ve been a faithful reader of the Wall Street Journal for nearly twenty years. They are the best daily newspaper when it comes to finance. Just about every three months or so the ‘Retirement’ or ‘Investments’ section of the Journal has a special on annuities, including ‘variable annuities.’ Alongside these sections of course are a slew of brokerage and insurance company advertisements. (If you didn’t already know, that’s the point of these special sections. This is the nature of the Financial Infotainment Industrial Complex.)

That’s where the fun begins. The writers of the Wall Street Journal are smart, and they are also commercially sensible, by which I mean they know where their bread is buttered. So they do this funny tortured-writer’s dance when describing variable annuities. “New annuity guarantees raise questions,” mumbles one ambiguous headline, or “They’re changing our annuity!” writes another, in which, buried in the heart of the article, we learn of many things that can go wrong with these things, without the writer coming out and saying the one thing he or she clearly knows, which is “stay away from variable annuities if you plan on having enough money in retirement.”

Up until this point I haven’t really explained: What is a variable annuity? Also: why should you care?

I’ll start with the second question first. You should care because an overwhelmingly large number of people who don’t know any better have followed their investment advisor/insurance broker/retirement specialist’s advice and bought this shit sandwich, to the tune of approximately $660 Billion. And this overwhelmingly large number of people plan to use it as a main vehicle for their retirement. Don’t know if you have one? Check your retirement plan. Do you use an insurance company for your investments? If yes, chances are, sadly, you bought one of these.

But back to the first question:

What is a variable annuity?

The insurance companies claim that a variable annuity is an investment product that offers both things that every investor wants, namely ‘safety’ plus ‘good returns.’ The variable annuity appears to offer ‘safety’ via a guaranteed income in retirement. The variable annuity also appears to offer ‘good returns’ by adjusting the guaranteed income upward if stock markets do well during the investment period of the variable annuity.

Ok, so…safety and good returns sounds pretty nice…What’s the problem? The biggest problem is extraordinary fees. Like, probably, all-in fees of 3.5 percent per year on your portfolio, which is a serious drag on your money (but great for the insurance company!)

All appearances to the contrary, insurance companies are really not magical wand-wavers that offer the mythical unique combination of safety and good returns. They pretty much just invest your money in stock and bond markets (plus real estate and some derivatives I guess) just like you can directly, except instead of offering you the actual returns of the blended portfolio you bought, they offer you the returns of a blended portfolio minus decades of huge fees. A really dumb combination of stocks and bonds invested over decades will beat a similarly-invested variable annuity every single time. Because of the fees.

variable_annuity_fees

Other problems

There are some other problems with variable annuities which I’ll list here for completeness’-sake.

  1. Once in a while, but more often than we’d like, insurance companies totally miscalculate variable annuity payouts and throw themselves into receivership (a kind of bankruptcy for insurance companies.)
  2. State insurance regulators know this, so they really like to see heavy fees to accompany these products, to keep up the capital base of insurance companies, to avoid receivership. That’s not good for you.
  3. The other way insurance companies avoid receivership is to change the rules governing payouts after you’ve already bought in to the variable annuity. Yes, they do this, and that’s not good for you either.
  4. States typically charge a special tax on payouts from variable annuities, possibly to compensate states for that future receivership problem. Also not good.
  5. You owe ordinary income tax (meaning, top tax rates) on variable annuity income. Regular investments in taxable accounts, held for over a year, offer better tax treatment than this.
  6. Variable annuities are roach-motel investments. You can get in easily, but it’s hard to get out, typically unless you pay hefty “surrender charges” if you try to get out within a 5 or 10 year “surrender period.” This is, basically, unconscionable. My advice: Just make like the French army,2 take the pain, and move on to a better investment.
  7. Variable annuities come to you accompanied by unreadable documentation, incalculable payouts, and small-print ‘disclosures.’ Nobody buying into these things can actually explain to themselves how they work.3
  8. That lack of understanding includes your insurance broker. Ask him some time to explain, in plain language, why this is a better deal than a simple blended portfolio of stocks and bonds. Whatever his moving lips appear to say, the real answer is “my fat commission,” which runs about 5 percent of the amount you invested.

As I’ve written here before, I don’t sell any investment product for a living, and no investment company or insurance company is paying me, so I don’t benefit whether you follow my advice or not.

Variable annuities are good for the insurance company because they make excessive fees from them. They are good for your insurance broker/retirement specialist because of the commission.

variable_annuity_two_out_of_three
Good for the insurance company and great for your broker. Not good for you. But hey…

They are not good for you. But hey, as Meatloaf sang, “Two out of three ain’t bad.”

Newspapers of the world: I challenge you to print honest reviews of variable annuities.

But as Derek Smalls said, “They can’t print that.”

 

 

A version of this post, without the scatological reference, and with a toned-down version of my critique of how the Financial Infotainment Industrial Complex really operates, ran in the San Antonio Express News.

 

Please see related posts:

Very simple, final word, on how to invest

Stupid Smart People

Guest Post: The Simplest Investing Approach Ever

Insurance Part 2 – The Good The Optional The Bad

Insurance Part 1 – Risk Transfer Only

 

 

 

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  1.  I’m not so much concerned with the vulgarity. (Although my editor was!) After all, let’s talk truth for a moment: you can’t read the national or international news section of any ‘respectable’ daily paper without worrying that your curious ten year-old will glance over your shoulder and ask you for definitions of ‘beheadings,’ or ‘pedophile,’ or ‘systematic rape.’ I mean, we’ve got worse problems than a little scatology.
  2. Surrender immediately, obviously
  3.  Except apparently this guy at www.annuityreview.com who offers, for an initial $150 fee, (and who knows after that, maybe more?) to analyze your variable annuity and give you a ten page report on all of its features, pluses and minuses. I don’t have any ties to the service myself, I only saw it referred to in the WSJ, but it strikes me as a good idea for people already stuck with these roach motels. Also, note the fact that if you need a ten-page report to describe your investment product then that investment has violated the “Keep It Simple, Smarty” rule of investing.

On Warranties

warranties_suckI’m the least handy person I know.

The Fourth Law of Thermodynamics in my household states: “Physical objects that appear to be broken, will remain broken through time and space.”

I carry my un-handyness with me through life, including matters having to do with cars. When I came up with a flat rear left tire a few weeks ago on the way to drop off the girls, I rolled into the national-chain tire store a block away from their school. We walked from there.

Tire guy called me a half-hour later. (I will now paraphrase our conversation.)

“Your tire is unfixable, we’d recommend replacing that. We also noticed your two fronts are about three years old, have seen some wear-and-tear, and we are coming up to the fourth-year factory-recommended replacement time. So you should probably have us put new ones on there as well.”

“Ok, how much will that be?”

Now, as I mentioned, I am not handy. This places me at a specific disadvantage when it comes to having people diagnose and fix physical things for me, like my car’s tires. Tire Guy could have used some Walter Mitty-speak (“Uh, sir, we’re noticing the bifurcated invertabrator is missing three hamnails, and we’d recommend slotting in a T-bolt in the five-square”) and I’d probably agree to get those things fixed as well. I mean, how could I argue with him? It sounds legit.

A crucial error

goodyear_tire

But then Tire Guy made a crucial error. He quoted me the price for new tires. It was roughly $90 for one tire, including – he wanted me to know – a very good deal on a warranty, or $270 for three tires, again including a great deal on the warranty, plus labor. That put me all-in around $330.

Ok, that’s a lot, and I don’t know anything, and I knew I’d probably have to agree to that price.

But I do know one big rule of personal finance, which I will now pass on to all of you, and which constitutes the entire purpose of this long-winded tire story:

Warranties, generally speaking, are bad.

“So ok, $330, that sounds like a lot,” I tentatively began, “how much would it be without the warranties?”

“Oh well, you see, that was a really good deal on the warranties,” he began to reply.

“Ok, I get it, but let’s say I want to skip the warranty?

“Let me recalculate here. Um, yeah, it looks like about $385 without the warranty. You see it’s all part of the package deal.” (Please note: $55 bucks more without the warranty)

“No. I don’t see. That’s not right. You can’t offer me something supposedly valuable, like a warranty, and then charge me more when I remove the warranty. Excuse my language, but that’s…”

…And…you’ll have to imagine the classy and stylish way in which I expressed displeasure to emphasize my point.

“Well, let me see here, ok, I suppose I could replace the three tires – without the warranty – for about $315.” (or about $5 less per tire without the warranty.)

More tire warranty details

Now, my finance-guy curiosity took over. I wanted to know more details about this supposedly good-deal warranty.

“If my new tire needs replacement while I’m still under warranty, would it be free?”

“Not free, but it will only cost you only $20 to replace.”

“If I have a warranty with you guys, can I get the tire replaced anywhere else?”

“No, we’d be the only ones to honor the warranty.”

“Ah, I get it, so you want me to pay part of the cost today of the next tire needing replacement, and I have to do the work at your shop, rather than anywhere else where I happen to get a flat or have a problem. So really the point of the warranty is to get me to come back only to your shop?”

“Well, not exactly, but see they do want us to sell these warranties…”

“Forget it. Don’t do three tires. Just replace the one tire, no warranty.” And then I told him the problem of misleading customers – especially gullible and unhandy ones like me – is that customers who lose trust in their service-provider generally don’t come back. That’s a separate issue from a warranty, of course, and a fundamental rule of business, but an important point nevertheless. I will do my darndest to avoid going back there.

Rewinding for a moment, however, to review the personal finance issue of warranties: For most electronic devices and most household durables, most people most of the time would do better to forgo paying for a warranty. It’s a kind of excess insurance-policy that you should avoid, unless special circumstances apply.

Another warranty story

Cd_changer
What even is this thing?

I remember purchasing in the early ‘00s a totally awesome stereo-component: A 100-CD changer (roughly the size of an overseas shipping/railcar container, if memory serves me correctly). The Best Buy salesman really, really, really wanted me to get that warranty. I found it odd that he focused on the high likelihood of my totally awesome 100-CD changer breaking within the next year, as I had not even left the store yet. I declined. I’m happy about that choice, even though of course it broke within three years, because by then Apple had begun to render moot all legacy music devices, with the iPod.

And I know what your next question is:

“What’s a CD?”

 

A version of this post ran in the San Antonio Express News.

Please see related posts:

Audio Interview – Wendy Kowalik on Insurance

Longevity Insurance – Do You Feel Lucky?

Guest Post by Lars Kroijer – Don’t buy too much insurance

On Insurance Part II – The Good, The Bad, The Optional

 

 

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