Sunday, April 26, 2009

Are Some Annuity Products Ponzi Schemes?

A Ponzi scheme involves a scenario where there is never enough money to pay all investors, with one investor’s money being used to pay other investors their promised returns.
There are two key ingredients to most Ponzi schemes:
1.   A “huckster” who offers a too-good-to-be-true investment opportunity.
2.   A willing investor that wants to believe (so I guess they do) that you can get something for nothing.
The two emotions that can wreak havoc on investment success are greed and fear.  Human nature will always allow for the self and promulgated perception that there is such a thing as a “free lunch”.
Over the past decade, insurance companies have offered products to consumers with features such as:
1.   Stock market returns with no stock market risk.
2.   Guaranteed income, even though the annuity value has gone down.
I have been warning the public about the risk posed by “too-good-to-be-true” annuity products for over a decade.  While most “get it”, there is still a minority of the public that do not.  Since the unraveling of the “promises” typically will not unfold until one or both (if married) investors die, mom and dad may go to their graves never knowing that a decision made years earlier may have blown up after their death.
According to the recent Wall Street Journal article “Getting Smart About Annuities”; the total annual internal fees of these complex “multi-promise” annuity products may exceed 4% annually.  My own research of various 200-page prospectuses (that investors fail to read) has concluded the same.  The article goes on to say, “due to the complexity of the contracts, they generally need to be bought through financial advisors”. 

I failed to mention earlier that the commission a so-called “financial advisor” can earn at the point-of-sale on these products can range from 4-15%.
1.   Bernard Madoff offered his illusion of high returns via numerous placement agents across the country that were paid handsome commissions for directing the business to Madoff. 
2.   Insurance companies market their illusion of high returns via agents and brokers who are paid handsome commissions. 
3.   As with Madoff, the vast majority of annuity peddlers can tell you how much in commission they will earn, but are unable to describe how the investment works, both initially and over a long period.

Let’s summarize the key points of these complex annuity products:
1.   Your money can get the return of the stock market, with the safety of a CD.
2.   You can receive a guaranteed income of 4-7% annually, regardless of how the investments you choose perform.
3.   Many agents suggest to the investor that since the insurance company is bearing the risk if the stock market goes down, the investor need not worry about diversification and can go ahead and invest 100% in stocks!
4.   Annual internal fees can exceed 4% annually.
5.   The annuity peddler is paid 4-15% in commission up front at the time of sale.
Another Ponzi Scheme

The insurance companies that market these gimmicky products are in essence running this part of their business like Social Security, which by design, is a Ponzi scheme.  With Social Security, the retirees are paid retirement income not from the capital that has been contributed or grown via the retirees’ lifelong contributions, but instead are paid from the new contributions from current contributors.
As with Madoff, if and when the whistle is ever blown on this game of musical chairs, millions of investors (or their heirs) will be left standing, wondering what happened.
Investing lesson: 
There is no such thing as a free lunch.  Never has been, never will be.

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