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Zweig: Safety Carries a Price of Its Own

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

I'm here today at the Wall Street Journal's office, and I'm talking to Jason Zweig. Jason is a personal finance columnist for the Wall Street Journal and he's also author of several books about money and investing.

Jason, thanks so much for being here.

Jason Zweig: Glad to be here. Actually, thank you for coming here, Christine.

Benz: Well, it's our pleasure.

Jason, you've written several columns and this is kind of an ongoing theme for you. You look at new investing innovations, and you talk about ones you like, or maybe more frequently, ones that you're skeptical of.

Zweig: Correct.

Benz: So, you recently wrote a piece about equity indexed annuities. These are not new products, but they have gained some traction amid sort of a skittish stock market over the past several years.

Let's talk about those products, what you perceive as weaknesses in the products, and you also gave an idea for how investors could create their own synthetic equity indexed annuities.

Zweig: Sure.

Benz: So, let's start there.

Zweig: Yes, I mean, equity indexed annuities are certainly not novel. They've been around for roughly 15 years now, and insurance agents love them. Insurers really like them. They do have some advantages for investors, which shouldn't be overlooked. Obviously, they're an attractive way of generating lifetime income. Your principal generally is protected against loss, and those are very good things and are a large part of the appeal in these products.

However, like most investment products that are marketed on the basis of safety in a time of danger, they are not quite as safe or as foolproof as they look. The main problem is liquidity. Equity indexed annuities generally, if you sell them within the first five to 10 years, you'll pay a surrender charge, if your redemption is substantial, and that charge can take a big bite out of your returns. And one of the problems is that less scrupulous insurance agents make a specialty out of selling products like these to quite elderly people. For example, people over the age of 80, it's quite common, and those people don't have a very long life expectancy and may well incur a surrender charge, when they sort of make the ultimate surrender. And I would argue that's really not fair or appropriate.

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So, as a general rule, any investor should be very, very cautious, when the pitch is based on safety because safety carries a price of its own, just as danger carries an obvious price, safety also carries a price, and someone is paying to ensure you against some kind of risk, and you ultimately have to pay.

Benz: Right.

Zweig: Because they have to cover their costs. And on balance, these products are probably something you can do cheaper. I call it rolling your own. I mean, you could simply buy a CD and combine it with a small stake in something like an equity index fund that will expose you to the whole stock market. And you can do that at very low cost and essentially zero risk, and have complete control over it yourself, and that could be at least as attractive for somebody who cares about safety and income.

Benz: Now, you wrote another column about a product called structured factored settlements?

Zweig: Yes, Factored structured settlements.

Benz: Factored structured settlements, and the idea there again is pretty nice yield and safety, that's the pitch. But you are also skeptical about what investors might be getting there.

Zweig: Yeah, these are sometimes called secondary market income annuities. It's quite a small market by the way, and they're not all that widely available, and these, too, have some advantages that shouldn't be neglected. As a general rule, they have been safe and the required payments have been made. The danger you get into here is these are backed by the settlements in lawsuits. Generally, either personal injury lawsuits or health-care-related lawsuits, and there have been at least two court cases in which it turned out that the person who sold the income stream to the insurance company, that turns around and creates the annuity from it, had actually already sold the income. So that the person who bought the insurance product suddenly found himself or herself owning a guarantee that was no longer backed by income. So, they do carry their own risks. And that risk is very, very hard to get rid of completely. So, as a general rule here, I would say, this is something you should own probably only if you can afford to hire someone to do due diligence on it for you.

Benz: So, are there any other products out there that are making you nervous, and in particular in the area of things that promise safety and a higher yield?

Zweig: Well, I mean a time of falling interest rates, as we've been in now for quite some time, is historically always a period when the bugs start to come out from under the floorboards. I don't blame investors for feeling a sense of desperation. I mean, when you open your mutual fund or brokerage account, whether it's an envelope or you're clicking on your account online, and you see that you're earning an average income of say 0.05. It really hurts especially for people who are living on a fixed income.

You need to be especially wary of anyone who is selling you anything that promises you a much higher yield at low or no risk. There really is no such thing. Bonds don't generate more income than they generate. And you can't get 10% income out of an 8% bond market; you can't get 6% income out of a 4% bond market; and you can't get 1% income out of a 0.1% money market fund.

And now is the time, when what you really need to do, if you're an income-oriented investor, is you really just need to grind your teeth and wait, because interest rates will go up, they have to, sooner or later, and when they do, your income will go up with it.

The only other consolation I can offer is in real terms, when you factor in inflation, the return you're getting is really about the same as you were getting five years ago or even 10 years ago in real terms after inflation.