What is a Guarantee Worth?

What is a guarantee worth?

For as long as I have been in the business, using the word guarantee meant one of two things:

[1] The investment police were going to come through the ceiling tiles, because no investment is guaranteed.

or

[2] You were selling expensive insurance.

Sure there are ways to guarantee or insure your investment portfolio. You could use an annuity with a living benefit [please don't accuse me of promoting annuities; I don't sell annuities, this is just an example].

You could use options[1] to protect your portfolio.

You could use a stop loss[2] that follows the market up. I’m sure there are other ways, but they all have at least two things in common:

One, they will cost you, and two, most financial advisors view that cost as far too expensive.

But what is a guarantee worth?

What is your home owner’s insurance worth if you knew your house was going to burn down once every 5 years?

We know that the market is going to get killed on a fairly regular, but totally unpredictable, basis. We know that the cost of getting killed is huge. We know that it takes a long time to dig out from being killed. We also know that if we could avoid being killed, it would be a huge benefit to us financially, not to mention emotionally.

What we don’t know is if the benefit would outweigh the cost…

Annuities and living benefits have a particularly bad reputation[3], and it might be well deserved, but try telling that to the client-to-be that I met with the other day that has a guaranteed benefit, base valued about the same place as it was at the market high. What about another lady I know that would be living in her son’s basement if she had followed my advice to asset allocate and buy and hold. Instead, she bought a annuity with a living benefit, takes home the income she needs, and has a guarantee [only as good as the insurance company][4] that she will have the income she needs for life, even after the market fell.

I also know people that have made a habit of buying put options every year to protect their portfolios. Their portfolios are worth close to what they were at the market top, and they didn’t lose ten years of their lives from the stress. Try telling them that it was too expensive…

So again, I ask, what is a guarantee worth?

Sources:

[1] Options Strategies: Protective Put, The Options Industrial Council

[2] Stop price, Wikipedia

[3] Long Derided, This Investment Now Looks Wise, Wall Street Journal

[4] Insurers Are Retooling Annuities, Wall Street Journal

By Carl on 10.27.09 > Link

Tagged as: annuities, guarantee, insurance, put options, stop loss

  • We know that the market is going to get killed on a fairly regular, but totally unpredictable, basis.

    We know of no such thing.

    There have been only four occasions since 1900 in which stock investors have suffered significant losses that remained in place a significant amount of time. The first time was when the P/E10 level went above 25 the first time. The second time was when the P/E10 level went above 25 the second time. The third time was when the P/E10 level went above 25 the third time. The fourth time was when the P/E10 level went above 25 the fourth time.

    I am beginning to detect a pattern. I am beginning to wonder if perhaps it isn't such a hot idea to put large amounts of money into stocks when they are selling at insanely dangerous prices.

    Could it be that stocks are like everything else that can be bought and sold -- that price matters? That Passive Investing is 100 percent dangerous nonsense, that just about all of the risk associated with investing in stocks has its roots in the unfortunate human inclination to believe in the Passive Investing fantasy that stocks offer a good long-term value proposition regardless of the price at which they are being sold?

    This is what I believe. It is a controversial idea. But it is a controversial idea that I have explored in great depth. I have found a mountain of evidence supporting it. I have never discovered a single rational argument cutting the other way (I don't view the observation that millions of people believe in Passive Investing during times when stocks are selling at insane prices to be an "argument" -- it is an accurate observation, nothing more and nothing less).

    Rob
  • >What about another lady I know that would be living in her son’s basement if she had followed my >advice to asset allocate and buy and hold. Instead, she bought a annuity with a living benefit, takes >home the income she needs

    How can the insurance company survive if their annuities return more than a reasonable asset allocation for a retiree? Their risk tolerance can't be that much higher than a retiree, and they have overhead and profits their investments must cover as well. Or is it that she gets no cost of living increases, so today she is fine but any significant inflation will be a disaster? What factor would allow the insurance company to provide her guaranteed income that she couldn't do herself?
    I'm curious- just how bad did a portfolio with the asset allocation you would recommend for a 65 year old retiree fair? Say starting with $1,000,000 in 2007 taking 4% distributions and rebalancing quarterly?

    -Rick Francis
  • Rob Wood
    The worth of a guarantee can be, if we use a expected value calculation to determine the value of product, equal to the difference in aggregate potential payoffs between two options.

    In other words, if we have option (1) which will be $100 net at the end of 5 years, and option (2) which is 95% likely to be $100 at the end of 5 years, and 5% $90, then the guarantee is worth $0.50.

    ($100 x 1) - [($100 x .95) + ($90 x .05)] = $0.50

    So if option (1) costs $10 and option (2) costs $10, (1) is worth more than (2) because $10.00 < $10.50. The value of the guarantee here being added as a cost to the non-guaranteed option.

    The idea is that the value of a guarantee is worth the potential cost you would otherwise incur in a worst-case scenario.

    Of course, that's excluding the cost of so-called intangibles (usually very tangible, like health, happiness, etc, the stuff you actually feel) that so many financial planners forget in planning the tangible (usually intangible but all the more easily quantifiable like net worth in dollars).

    However, these intangibles can be build in by treating the client's side of the transaction like work they could otherwise be paid for, or services that they could otherwise be consuming.
  • Serious question: And I am not talking about you - because you get it.

    Do financial advisors really believe these ideas are too expensive (I believe it), or they just ignorant and don't understand how to use them properly and at a very reasonable cost?
  • Dylan
    Mark, the problem with your question is that it assumes there are only two possible outcomes.

    A) The ideas presented are not too expensive and advisors just don't believe it.
    B) The ideas presented are not too expensive and advisors are ignorant as to their use.

    Is there no room for possibility that the ideas presented may be too expensive, at least in some cases?

    Whether or not something is too expensive is usually relative its benefits. If costs are determined to outweigh benefits, the logical conclusion is that it is too expensive. The economics behind these guarantees means that, in aggregate, tangible benefits cannot exceed costs. Sometimes it'll come down to the value of peace of mind.
  • evolutionofwealth
    Another great post but unfortunately your question can only be answered when you take a perspective. You look at the insurance company and they answer the question for you with their cost of the living benefits. Of course this year has shown us that the original answer was wrong so they pulled half the benefits to reprice them. Maybe they'll get it right next time around.
    From an investor prospective it's going to vary too much from person to person and becomes a perception of value. I did a post on this but focused it more specifically on if 1% of your return is too much? http://evolutionofwealth.com/2009/09/30/at-what...
    As for the questions regarding financial advisers I would say the answer is yes. Yes to both. Advisers get caught up in math and math is not money. Financial planning definitely is not math. Advisers loose track of value and focus on numbers such as fees. Then you have to deal with that fact that most advisers are ignorant. They are overwhelmed by the sheer amount of information. Most of them try to be a one-stop shop and be good at everything. Instead they end up not fully understanding anything, probably because their just isn't enough time. Thanks for the post idea. I think I'll go write it now.
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