Thursday, September 2, 2010

Misleading Financial Post of the Week

Today, I came across the following article on the Forbes website that made me want to scream.  Forbes is supposed to be one of the paragons of intelligent investing, which is why the existence of this article under their banner is all the more shocking to me.  It shows a total lack of understanding about how annuities work.

Why am I so worked up over this posting, you ask?  I don't have a problem with its general message of protecting against inflation.  In fact, educating people about inflation is something of a pet project of mine.  No, what has gotten my attention is the following statement that the author makes near the beginning of the article:

If you are a 70-year-old male, for example, you can get $630 a month for life from insurer New York Life by plunking down $100,000. That’s a 7.6% annual payout, a lot more than you could get from other relatively safe investments, like bank CDs and U.S. Treasury bonds.

A casual person would read this and conclude that an annuity is better than a CD because an annuity returns 7.6% while a CD only returns about 1% these days.  Of course, this is very misleading.

An annuity contract works something like this:  you give $100,000 to an insurance company and, in return, the insurance company gives you $7600 per year.  The key word here is give.  Just to be clear, when I say give, I mean that you give it to them and you don't get it back.  When you buy this annuity, after a year you have $7600.  That $100,000 that you started out with is gone, never to be seen again, except on the balance sheet of Insurance Conglomerate Incorporated.

On the other hand, a bank CD works something like this:  you loan $100,000 to a bank and, in return, the bank returns your $100,000 to you plus $1000 in interest per year.  The key word here is loan.  Just to be clear, when I say loan, I mean that there is an expectation that the bank will pay you back.  When you open a CD, after a year you have $101,000.  That $100,000 is still yours.  Even if the bank goes under, the Federal Deposit Insurance Corporation guarantees that you will at least get it back.

To say that the 7.6% annual payout of an annuity is a lot more than what you get from a CD is comparing apples to chickens.  You just can't compare the two since one is a loan and the other is a purchase.

The thing that makes me angriest is that fact that annuities are actually useful financial vehicles.  With an annuity, you are guaranteeing yourself that you will have a fixed amount of money every year, no matter how long you live.  For somebody who is worried about outliving his or her retirement nest egg, an annuity might make a lot of sense.  However, this article tries to sell an annuity on the basis of the fact that its payout rate of 7.6% beats the interest rate on a CD.  Why not just sell it on its merits rather than twisting the numbers in a confusing way in order to make it look attractive?  The scary thing is that there are many unsophisticated readers who will see this and jump on the annuity bandwagon without truly understanding what they are getting themselves into.

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