In an investing world full of risks, everyone wants to have their cake and eat it, too. But before you buy financial products that aim to give you good returns while providing downside protection, make sure you understand exactly what you're getting -- and how much you'll pay to get it.
The knee-jerk response to volatility
Whenever the stock market starts to jump up and down, risk-averse investors inevitably look for ways to get the returns they need without having to endure the roller-coaster ride that the stocks in their brokerage accounts take. The huge drop in the stock market during August and September definitely set the stage for those risk-aversion trades, and despite the big move up for stocks in October, uncertainty about the future is still at heightened levels.
One popular investment that offers guarantees is the variable annuity. During the third quarter, MetLife (NYSE: MET) reported that sales of variable annuities rose 22%. Lincoln National's (NYSE: LNC) Lincoln Financial subsidiary saw variable annuity deposits jump 7% in the quarter.
What makes variable annuities popular is that they let you invest in a wide variety of different asset classes, including various types of stock and bond investments. At the same time, you can pay an additional fee to get protection from falling markets in the form of guaranteed income after you retire. In essence, the guarantee is designed to ensure that you're able to take out at least a certain minimum amount of income from your annuity even if the underlying investments don't perform well enough to provide it.
When guarantees get tough
But guarantees actually hurt the insurance companies that made them quite badly during the financial crisis. A tough environment prompted Genworth Financial (NYSE: GNW) to stop selling variable annuities entirely, while Prudential (NYSE: PRU) ended up raising its prices on annuity products by a modest amount.
In addition, many insurers are limiting investment options to reduce risk. MetLife and Hartford Financial (NYSE: HIG) offer products that combine different asset classes to build diversified miniportfolios that aren't as volatile as more focused annuity products. Other companies require investors to keep certain minimums in bond funds.
The problem for investors is that if you have to keep a lower-risk portfolio, then you shouldn't have to pay as much for guarantees that protect you from big drops. Yet annual fees still outpace what you pay on mutual funds and similar investments outside the variable annuity realm.
The better choice?
With high fees and new investment restrictions, guaranteed variable annuities give you even less value than they used to. Especially after stocks have already fallen substantially, the protection they offer doesn't necessarily match up with their cost in lost returns over the long haul.
In particular, if you're going to have to invest with a balanced strategy anyway, using low-cost ETFs to build your own portfolio makes a lot more sense. For instance, the combination of the iShares Barclays TIPS Bond ETF (NYSE: TIP) for inflation-protected, fixed-income exposure and Vanguard High Dividend Yield ETF (NYSE: VYM) for income-producing dividend stocks lets you balance your stock and bond exposure in whatever proportion you want -- and at a fraction of the cost that variable annuities would charge.
Granted, investing in ETFs doesn't give you a guarantee, and for many investors, that's what they really want. But what I'm suggesting is that if the guarantee comes at too high a cost, it's not worth having. Successful investing involves risk, and trying to get rid of it can take away most of the benefits of investing.
Wait for the right time
If there's ever a right time to buy variable annuities, it's when markets are soaring and no one's thinking about needing portfolio protection. Seeking guarantees after a substantial market drop is like closing the barn door after the horse is gone -- most of the time, you've already taken the losses you're trying to avoid.
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