Free Energy and Free Lunches

The famous economist Milton Friedman is attributed the quote "there is no free lunch". Say a salesperson offers you a free lunch just for coming to his seminar. Obviously, he hopes to sell his wares at the seminar. The profits on those sales pay for the "free lunch" and so collectively, the free lunchers are paying for their own lunch- hence it is not really free.

Suppose someone offers you a perpetual motion machine. Obviously this can't really exist, because the universe conserves energy as described in the laws of thermodynamics. The machine must have energy to overcome effects of friction otherwise it will eventually grind to a halt.

Now further suppose you were offered the opportunity to buy a special financial product. This unique product allows you to invest money in the stock market, defers taxes on all gains and income until retirement, 100% of the purchase price is invested and guarantees that you won't lose money over the life of your investment. Sounds pretty good right? Well, this product does exist, it is called an "equity-indexed annuity" (EIA), but is it a perpetual motion machine in that you get all these benefits for free or can free money really exist?

By now you know that we don't get something for nothing. We get certain benefits in exchange for some cost, but what exactly is that cost? First, the EIA is an insurance product and the money goes to the insurance company rather than actually being in an actual account like at a brokerage firm. (An annuity is a promise or obligation of the insurance company.) The insurance company then credits your "account" based on the market's performance. Deep in the fine print is the explanation of how the stock market gains are applied to your "account".

While the crediting formula varies from product to product, there are some typical techniques used to decrease your gains. One technique is to cap the annual increase so if the market rises 30% and the cap is 20%, you only get 20% credited to your investment. Had the insurance company taken your whole check and invested it, they would get to keep the extra 10% (an alternative means of achieving this is to simply 'participate' in only 90% or 95% of the market's appreciation). Another technique is to credit only the price appreciation component of the market's performance sans dividends. The 2% or so dividend yield is kept by the insurance company. The net result is that you don't actually get 100% of the market's upside and protection from the downside- the insurance company keeps some of the upside as compensation for the downside guarantee.

The problem with this is not the guarantee itself. Rather the problem is that most people do not know how to examine what the cost of the guarantee really is and whether it is worth the cost. What is the probability of losing money in a ten year stock market investment? What is the average rate of return and with what volatility? What do other hedging techniques cost? Once all these factors (and more) are accounted for, there is an expected return to the purchaser and an expected return to the insurer. For example, if the insurer reasonably expects to earn 10% per year on the money and expects to create an obligation to the customer of 6% per year, the insurer gets to keep that 4% per year difference at the end of the day. Recall that mutual funds charge an average of 1.5% per year, so this product would be highly profitable. Such a product could be priced at 2%, 3%, 4%, 5% or more- how much is a fair exchange of risk for reward?

Such are the vagaries of complex financial products. Whether a free lunch or free energy analogy suits you better does not matter. When confronted with any complex financial decision always examine what you actually get for the cost. Take the emotion and sales pressure out of the decision and don't stop asking questions until you can figure out the true cost. If you can't clearly arrive at the answers, it is probably best to get better advice or simply say no.