The “Free Lunch” Theory As It Relates To Annuities

By September 20, 2018Uncategorized

The TINSTAAFL theory is an informal favorite rule among many economists and financial planners like me. TINSTAAFL stands for “There is no such thing as a free lunch”, and means there is a price for everything, whether you know it or not.

 

From an economic and financial standpoint, the best examples of this are found in rates on things like bonds, CD’s, and annuities. You may not realize it, but the Great Recession can be directly attributed to the TINSTAAFL theory.

 

Soon after 9/11, the Fed started cutting interest rates, and yields on Treasuries dropped like a rock. Prior to this, the World was used to getting a decent return on Treasuries. Then all of a sudden, those rates dropped to almost nothing. This created a carnivorous demand for higher rates on a guaranteed basis, similar to what the World had been accustomed to receiving from Treasuries prior to 9/11.

 

Wall Street and the mortgage industry responded to the demand with mortgage-backed securities and derivatives that they claimed would provide a guaranteed alternative to Treasuries, albeit at a much, much, higher rate of return. We all know now that it was too good to be true. The guarantee cratered once everyone realized these mortgages were not as safe as everyone had previously believed.

 

TINSTAAFL loves and adores complexity (like mortgage-backed securities). The more complicated a financial product becomes, the greater the likelihood that everybody misses the real cost of the “free” lunch! Variable annuities that include guaranteed income riders are a great example of both TINSTAAFL and complexity.

 

Just like the World had become accustomed to decent rates on Treasuries, risk-averse consumers had become accustomed to decent rates on CD’s and other fixed products. Demand for higher yielding safe investments motivated insurance companies to get creative with some of their products, just like the investment bankers did with theirs prior to the Mortgage Crisis. The most popular solution has been variable annuities with guaranteed income riders.

 

Guaranteed income riders come in many different flavors, but essentially they all provide the same thing: an assurance or guarantee from an insurance company that the purchaser will be allowed to withdraw a certain amount from their annuity every year for the rest of their life, regardless of the value of their account.

 

Sounds great, but when you dig deep into the complexities and associated costs, TINSTAAFL reveals itself. At the levels the guarantee is provided, it’s highly unlikely the value will crash to zero, and the costs associated with these products are so heavy they negate the guarantee. Most people would be better off investing their money at a much lower cost in order to reap the additional return, that would in turn further decrease the probability of spending thru the basis.

 

It’s not uncommon for a consumer to incorrectly believe their guaranteed minimum withdrawal is a rate of return. These riders only provide a guaranteed withdrawal amount, not a return, and there is a huge difference. A guaranteed withdrawal means that if you withdraw no more than a certain amount per year, the annuity company will allow you to continue to withdraw that amount even if your account balance goes to zero. This may sound great, but a comfortable fixed monthly amount today will probably not feel very comfortable twenty years from now. For example, just think back to when you were a kid and how much it cost to go to the movies, or buy a gallon of milk. This price increase is due to inflation and happens to everything, not just the price of movies and milk.  At least a guaranteed return has a chance of a least keeping up with inflation, a guaranteed monthly withdrawal does not.

 

Bottom line: you can buy guarantees on your money, but expect the return to be commensurate with the rates of other, similarly guaranteed products and debentures. If someone says they can guarantee a greater return, you need to be wary. If they continue to droll on with a myriad of complicated terms, numbers, and assurances; start running in the other direction. Complexity can be used very effectively to hide the actual value, guarantees, and costs associated with financial products. If anything, that’s what 2008 taught us.