The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (28 page)

Buying an investment plus some insurance for that investment costs more than simply buying the investment directly, so whenever you hear the word
annuity
, it really means investment and
insurance
because that is the extra feature you are buying. Annuities can be complicated and come in many varieties, but the bottom line is that annuities are essentially investments with some level of insurance protecting those investments.

Many annuities are heavily invested in bonds. In the case of a fixed annuity, this is especially ironic because you are buying a bond and you are insuring your bond investment with some insurance that itself is an investment in bonds. The annuity uses the safety of one set of bonds (the bonds the insurance company owns) to insure the safety of another set of bonds (the bonds you own in your annuity).

Like all forms of insurance, your bond insurance is limited. It generally covers a relatively narrow range of conditions, such as only a certain change in interest rates. It does not cover you under all conditions. In the last few decades, that has not been a problem. Bonds have done very well as interest rates have dropped since the early 1980s. And even if interest rates rise a bit in the future, your annuity is still safe because that narrow range of change would still be covered by your bond insurance. As long as conditions do not significantly change, all is well for annuities.

Just as with whole life insurance, when you buy an annuity, you are buying a level of comfort. Rather than simply buying the investment directly at a lower price, you are buying an investment plus some investment insurance. You are paying a premium in order to feel safe.

Long-term care (LTC) insurance covers some of the costs of health care that is needed over an extended period, such as in old age, in particular, nursing home care. The younger you are when you buy LTC insurance, the cheaper the payments will be, but the longer you will probably have to make payments before you need it.

There are three basic types of LTC insurance: indemnity, expense-incurred, or cash policies. Indemnity plans pay a fixed daily rate regardless of what you spend on care. Expense-incurred policies reimburse you for actual expenses, up to a fixed amount. Cash-based policies pay you a fixed amount even if you incur no expenses (for example, if a relative provides your care). For an additional cost, your LTC insurance may also provide a limited inflation rider, a return-of-payment rider in case you don’t use it, and simple or compound interest earned on your payments.

Like whole life and annuities, buying long-term care insurance is purchasing a feeling of safety.

Conventional wisdom says absolutely yes! Their track records in the past have ranged from okay to great, in large part because their main underlying investment—bonds—have done so well, especially since the early 1980s. All that profit has helped insurance companies grow, adding to their “rock solid” image.

In addition to their investments growing, selling whole life and other insurance products has been quite profitable for these companies. With the sale of a whole life insurance policy, the company gets a customer for life. Even when that customer eventually dies and they pay the death benefit, most of that payout will come from the policyholder’s own premium payment. And even if the payments don’t fully cover it, whatever difference they have to make up will almost always be only a fraction of the total income the company made by investing their customer’s money over the life of the policy. In the case of annuities, the companies also do well, selling bonds plus bond insurance. So naturally, these companies push pretty hard to sell whole life insurance and annuities.

But are they a good deal for you?

While not fantastic investments, these policies have been okay investments (and even good investments) in the past, depending on your age, income, family situation, and goals at the time. And they are still okay investments now. These policies are generally very safe under the current conditions. And even in a deeper recession, there would be little reason for concern.

The question is will these policies continue to be okay going forward, as the economy continues to evolve and we approach the coming Aftershock?

Do you remember the recent television commercial in which a very large gorilla extols the virtues of annuities? A seemingly well-informed giant gorilla sits next to an average-looking American, perhaps on an airplane or in an open convertible, begging his bewildered human companion to consider the many must-have benefits of buying an annuity.

“You could have guaranteed income for life!!”
pleads the passionate primate, as the person stares off anxiously into the unknown. “But, hey, what do I know. I’m just the 800-pound gorilla in the room.”

Clever ad. However, the
real
800-pound gorilla in the room is actually a multitrillion-dollar monkey on our backs, in the form of the ballooning U.S. money supply (more than $2.8 trillion, as of mid-2012) and massive federal debt (nearly $16 trillion and continuing to rise rapidly). By this point in the book we probably don’t have to remind you that we believe this massive money printing by the Fed, driven in part by our massive debt, will eventually cause significant rising inflation. Rising inflation will cause rising interest rates. And rising interest rates will help pop what is left of our already falling bubbles—especially the dollar and the government debt bubbles—and bring on the Aftershock.

Conventional Wisdom (CW) on insurance is wrong because CW is making the usual mistake of assuming that inflation and interest rates will never significantly rise. As we said in the previous chapter on real estate, CW imagines low interest rates for as far as the eye can see.

As we mentioned earlier, one of the biggest misconceptions about whole life insurance, annuities, long-term care insurance, and the like, is that these are just insurance policies, and therefore they are somehow separate and protected from the dangers of the markets. But that is completely false. These instruments are
investments
and they must be analyzed and managed as such, as these markets evolve.

The safety of whole life insurance, annuities, and the like is directly tied to the safety of bonds, and to a lesser extent, the safety of stocks and real estate. This is not just our point of view. Even the credit rating agencies know this is true. Why else would the safety of these instruments be assessed and graded
using similar indicators to ones used to assess the safety of bonds
?

So far, the rating agency we mentioned earlier, A. M. Best, has had a good track record for rating the stability of insurance companies. But just like the other rating agencies, such as Moody’s and S&P, they have never really faced an Aftershock-type situation in the markets, and their ratings do not reflect how a given company might hold up under the enormous pressures of multiple collapsing asset bubbles. Even under minimal stress, ratings have not always been so accurate. As you may recall from Chapter 5, bonds from the global financial services firm Lehman Brothers had a very high rating from both Moody’s and S&P until a few days before it went bankrupt in 2008.

Since insurance companies are so heavily dependent on bonds, what happens to bonds when inflation and interest rates rise (see Chapter 5) will happen to insurance and annuities, as well. Rising inflation will mean rising interest rates. Rising interest rates will mean falling bond values—and insurance and annuity companies, which are so heavily invested in bonds, will be in trouble.

In a rising interest rate environment, whole life insurance has a bit of a buffer. As their bond investments begin to fall, whole life insurance companies can still pay out for a while, dipping into their large reserves. But as inflation and interest rates continue to rise, whole life policies will be worth less and less.

Annuities have less of an initial buffer than whole life insurance. They are basically just bond investments with some added bond insurance. At first, when interest rates start to go up and bond values falls, the bond insurance will kick in. But it will only cover a small rise in interest rates, after which your annuity’s value falls. As pointed out earlier, that bond insurance is itself mostly just bonds. So don’t count on it holding up when interest rates rise and bonds fall. Also, many annuities have market adjustment clauses that adjust the cash value of an annuity if you take it out early.

Please understand that the value of an insurance company’s assets dose not have to fall to zero in order for the company to no longer be able to pay full value on your insurance policy or annuity. There is a fairly sensitive balance between inflow and outflow in these companies. If their bond investments fall, this balance will be undone and they won’t have the resource to pay you as promised. Remember, they don’t have a big pile of money stashed away somewhere; the money you have been paying them all these years is invested in bonds, stocks, and even real estate. A significant drop in those assets will have a big impact.

Please also don’t make the mistake of thinking that your insurance or annuity company is “too big to fail” or has been around so long that it is “too safe to fail.”
Whatever is the fate of bonds is the fate of insurance and annuity companies
. Please see Chapter 5 for details about the fate of bonds in the Aftershock. Rising interest rates will decimate bonds. Most insurance companies invest mostly in bonds.

And even if your company can somehow escape all of this and is fully functional and can continue to pay on your policy in full, you still have another very big problem: With rising inflation the value of that payout will be worth far less.

The bottom line: There will simply be no way to come out ahead on your whole life insurance or annuity policies when serious inflation and interest rates rise.

For a while, yes they will. In the early stages, when only one or two insurance companies are in trouble, the state tax funds that we mentioned earlier will protect policyholders within that state. The problem will come when more companies need help or even go under. Quite quickly, state funds will get tapped out.

At that point, the federal government will surely step in to bail out insurance companies. But that will quickly become too large a task. Hence, as it becomes more difficult to bail out the entire insurance company, the government will focus on helping policyholders. They won’t have the money to pay insurance plans in full, but they will be able to make hardship payments that are means tested. If you have few assets or little income, you will likely qualify for some type of hardship payment from the government. The payments are low because at the same time that the insurance industry will need big backup by the government, many banks and other government-insured entities will clearly need backup, too.

And, even worse, just at the time when the government will be so badly needed for backup in so many financial industries, the government itself will be in financial trouble, as well. They will continue to print money for as long as they can (more borrowing at this point will be impossible), but eventually the money printing will have to end due to the rising inflation that it will cause. At first they can ignore rising inflation and will. But after a while people will adjust wages and prices for inflation more quickly, and the government will find less and less positive impact from printing more money

Eventually, with borrowing and money printing over and income tax revenue declining, the federal government simply will not have the money necessary to cover your insurance or annuity policy. They will do all that they can, for as long as they can. But there will be a limit. Not every need will be fulfilled.

The first step, as always, is to face reality. No matter how much you may want to believe in the safety and comfort of these policies, how can you believe in them if you also believe that massive money printing will cause future inflation and that rising inflation will cause rising interest rates? If you believe our macroeconomic point of view—even if only partially—then how can you continue to trust that bonds will do well over the next several years? And if bonds don’t do well, how can your policies be worth what you thought they would be worth? All insurance is an investment in bonds because that is what these insurance companies primarily own.

This isn’t rocket science, as they say. It’s just a matter of logic. So let’s be logical and figure out what to do about your whole life insurance and annuities. Remember that the Aftershock is likely still a couple of years away, so there is no need to panic and nothing has to be done immediately.

If you want to protect your financial dependents during your income-producing years, then term life insurance is preferable over whole life insurance. Whole life costs more, and when the Aftershock hits, your whole life policy will be worth a lot less than it’s worth today.

If you have whole life insurance, now is a good time to explore your options for cashing out of it. Learning about exit options is a very important first step to protecting yourself.

Another option is to borrow against the cash value of the policy. Often, this money never has to be paid back and is simply subtracted from the death benefit. If you invest wisely, this is not much of a penalty. Borrowing might be difficult with certain policies, and it is valuable only if the proceeds are properly invested and not consumed.

If cashing out of or borrowing against your whole life insurance policy now seems a bit rash, there is no significant harm in waiting a while longer until you see more evidence that we are right. Keep an eye on interest rates, particularly mortgage rates. When you see mortgage rates climbing to 5 or 6 percent, that is a very good indication that interest rates are heading up and bonds are heading down.