These Products Offer Protection, but at What Price?

For investors, a useful exercise is to visualize who's on the other side of whatever trade you're making. If you're buying, that means someone else is selling. What are their motivations? What information do they have that you don't, and vice versa?

That's a valuable thought process if you're a stock investor: You might naturally assume that your case for buying or selling something is airtight. Thinking through the opposite thesis can help identify risk factors and set expectations. It can keep you from falling into the confirmation bias trap.

Likewise, thinking about the seller's motivations is a worthwhile exercise for buyers of financial products. Of course, not every purveyor of financial products is out to make a quick buck: The best firms, from a stewardship standpoint, know that they make money long term by ensuring that their shareholders make money, too. Some firms are even owned by their shareholders or policyholders (in the case of mutual insurance companies); that naturally aligns the interests of company stakeholders and product owners.

At the opposite extreme, product launches can have a mercenary motivation; investors can run into trouble when products are created because they sell rather than because they make good investment sense. For example, a desire to cash in on investors' then-boundless appetite for technology stocks motivated scores of fund technology and "Internet" fund launches in the late 1990s. Such funds reeled in investors at a time when most sober observers could see that valuations in the sector had gone insane. Similarly, a host of hedge-fundlike products hit the retail investment market in the period following the financial crisis. Such products were designed to shield investors from market volatility, but they were launched at a time when stocks were cheap by nearly any reasonable measure. In both cases, what was good for the fund companies--raking in fee-generating assets--wasn't so good for the investors themselves.

What's in It for Them? Asking "What's in it for them?" is even more valuable for purchasers of financial products with more permanence attached to them, such as life insurance and annuity products. After all, if for-profit insurers are willing to engage in a long-term relationship with you, as is implicit in them signing on to make good on your eventual claims, they must believe that relationship will make financial sense for them, too. Not each and every customer will be a moneymaker: Some insured parties and annuitants will make more than they paid in, and that's the nature of the risk pooling that goes on with insurance products. But insurers write policies that they believe will, on average, be profitable to them, once they've invested your premiums/assets and paid out any claims due.

Asking what the insurer is getting out of the deal is particularly important in the realm of products that protect you against a range of outcomes. The more scenarios in which you're eligible for some type of payout, the higher the implicit or explicit costs you should expect to pay.

Hybrid long-term care/life insurance and long-term care/annuity products are a perfect example. In contrast with pure long-term care insurance, which pays out only if an individual has a long-term care need, hybrid products cover you in a few different scenarios. If a purchaser of a long-term care/life insurance hybrid dies without needing long-term care, the full death benefit would be paid out to his or her heirs. On the other hand, if the insured has a long-term care need, funding such care would reduce the cash value of the policy accordingly. Long-term care/annuity hybrids, while less common, work similarly: If a long-term care need arises, those expenses reduce the amount of any eventual annuity payout.

Sales of the hybrid products have been eclipsing those of traditional, pure long-term care policies of late: Whereas the insurance industry sold more than twice as many pure long-term care insurance policies than hybrids in 2012, for example, that relationship had nearly reversed itself by 2016, with hybrid sales far outpacing pure long-term care policies. Many insurance firms have pulled out of the pure long-term care insurance marketplace altogether: Whereas there were more than 100 firms selling long-term care insurance in 2000, there were just 15 firms selling the products in 2014.

It's not hard to see why the hybrid products are an easier sell than pure long-term care policies. Whereas many purchasers of long-term care policies have confronted the unappealing choice of swallowing premium increases or reducing coverage (or dropping coverage altogether), long-term care insurance/life and long-term care/annuity hybrids offer the opportunity to pay fixed premiums or purchase coverage with a lump sum. The hybrids also have more lenient underwriting standards than is the case with pure long-term care policies. In addition, the hybrid products help consumers overcome a mental hurdle that many face with pure long-term care. Purchasers of long-term care (like purchasers of any pure insurance product) risk paying years of premiums for insurance they never use. Meanwhile, purchasers of hybrid policies are guaranteed to receive at least some benefit in the end--either life insurance that will go to their heirs, or annuity payments they can spend in their lifetimes.

Yet even as purchasers of hybrid policies gain benefits, they also face implicit costs. As Michael Kitces points out in this posting on his Nerd's Eye View blog, consumers face implicit costs. By plunking down a lump sum, the purchaser of the hybrid policy effectively cedes the right to earn a higher return on that money in a more favorable yield environment, turning it over to the insurer instead. Because the insurance company controls the cash value of the policy, it is under no obligation to increase cash value as prevailing yields trend up. Indeed, some of the policies don't promise any growth of principal at all.

Equity indexed annuities are another example of a product where the optionality afforded to the consumer might appeal, but it's far from a free lunch. With such products, the purchaser is guaranteed a minimum return amount while also participating in the equity market's gains. The products also offer tax deferral on the investment gains.

That all sounds appealing, but purchasers pay dearly for those protections. In addition to steep ongoing costs and high surrender charges, the purchaser typically forks over a portion of his or her equity portfolio's return to "the house," in that gains from the equity market are capped in some fashion. Thus, the all-in costs associated with these products--both explicit costs and implicit opportunity costs--can be high indeed.

That's not to suggest that these products are ill-advised in each and every situation. Hybrid long-term care/life insurance products, in particular, give consumers the chance to buy a baseline of long-term care protection when the alternative would be to go without. But there are trade-offs associated with these products, and the point is to go into any purchase decision with your eyes wide open to whatever benefits you're receiving as well as what you're giving up. If you're forking over a portion of your portfolio for protection, what are the costs? Who's on the other side of the table, and what do they have to gain? If you think through these questions, you'll have a better chance of making a decision that will ultimately be in your best interest.