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As the stock market sinks, many people turn to safer investments to protect their capital. Unfortunately, that also means investors are more prone to buy costly variable annuities that are sold as a safe alternative to stocks. And now, insurance companies are making changes to those annuities that will make them an even worse deal for investors.
Earlier this week, The Wall Street Journal reported that insurance companies are planning to make adjustments to variable annuities they offer to investors. Those changes will reportedly increase charges for some popular features of these annuities, while making those features less beneficial to investors.
The ABCs of annuities
As a way of guaranteeing a steady income for life, annuities serve a useful purpose for some investors. But the variable annuity market, which is led by companies like MetLife (NYSE: MET ) , AXA Equitable (NYSE: AXA ) , and ING (NYSE: ING ) , typically appeals to investors for a much different reason: the prospect of protecting their income and principal.
To provide protection, variable annuities often come with special features that offer guarantees against some event happening. Some of them include:
- A guaranteed death benefit that your heirs will receive, even if investment losses have cut your annuity's value below the benefit level.
- Protection against losses in your accounts, as long as you own the annuity for a certain number of years.
- Minimum income payments once you decide to start taking distributions from your annuity, even if your annuity balance has fallen to levels that wouldn't normally support that level of payments.
All that sounds great. So what's the catch?
There's no such thing as a free lunch
The problem comes from the fees you pay. When you consider just the costs of investment management and insurance, variable annuities charge a hefty price -- nearly 2.5% annually, according to Morningstar. Each guarantee you decide to add on usually comes with an additional charge. The average death benefit guarantee, for instance, adds another 0.4% to that annual cost.
When the market goes up, those guarantees go unused, adding to the insurance company's profits. But the recent troubles in the markets have caused problems for insurers. Hartford Financial (NYSE: HIG ) , for example, posted more than $100 million in losses in the third quarter tied to the fact that the company hadn't adequately hedged its exposure to the financial markets.
With the cost of hedge protection increasing as the result of market volatility, insurers have to pay more to cover themselves -- and they want to pass on those costs to their customers. Manulife Financial (NYSE: MFC ) officials specifically cite trying to increase profitability as the motivation for cutting benefits and increasing charges.
The best move for your portfolio
As attractive as variable annuities may sound, the latest actions from insurers should remind you that variable annuities are designed to ensure profits for the companies that sell them. Right away, that should tell you that you're paying a premium for whatever protection you're getting. Otherwise, the company wouldn't sell annuities to you -- or would try to cut back on those benefits, as the industry is doing now.
More importantly, buying variable annuities with principal protection now is like taking out an auto insurance policy after your car has been stolen. With the market already down so far, the odds that you'll ever collect on those guarantees -- which you'll pay for year in and year out -- are incredibly low.
Even if variable annuities that customers bought last year turn out to have been a good investment -- something that's far from certain, given the long-term nature of the guarantees -- buying them for the guarantee protection now just doesn't make sense. You're far better off assessing your risk tolerance and buying a good portfolio of blue chips like Johnson & Johnson (NYSE: JNJ ) or Procter & Gamble (NYSE: PG ) . That way, you'll save on high fees and pocket more of the profits for yourself.
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