In Most Cases, Extended Product Service Plans Don't Benefit Consumers

By Terence O'Hara
Washington Post Staff Writer
Sunday, October 1, 2006

You buy a $119 cordless phone system at Wal-Mart. As you're checking out, the cashier asks if you'd like to put another two years on the manufacturer's warranty. Cost: $29.

What do you do?

While consumer groups and common sense would urge you to resoundingly reject the offer, an entire industry has been built on the likelihood that you will act on impulse and say, "Yes."

Each year, millions of people gladly pay an additional 10 to 50 percent of a product's original price to extend a warranty. These snap purchases help fuel a booming, $15 billion-a-year business and feed a lucrative profit stream for retailers that sell the warranties and companies that underwrite them. Many consumers do so because they say the plans provide them with peace of mind.

The decision to buy an extended warranty, however, defies the recommendations of economists, consumer advocates and product quality experts, who all warn that the plans rarely benefit consumers and are nearly always a waste of money.

"The things make no rational sense," Harvard economist David Cutler said. "The implied probability that [a product] will break has to be substantially greater than the risk that you can't afford to fix it or replace it. If you're buying a $400 item, for the overwhelming number of consumers that level of spending is not a risk you need to insure under any circumstances."

Extended warranties, first introduced in high-pressure fashion by big electronics stores in the late 1980s, have become a core product sold by all kinds of retailers, covering everything from bicycles to wedding jewelry.

The warranties, often marketed as service plans, are technically insurance products on which the premiums are paid in a lump sum at time of purchase. Extended warranties generally lengthen the coverage provided by the manufacturer's own warranty on a product. The plans are backed by an insurance company that promises to repair or replace the covered item should it break or malfunction. While terms vary widely, the plans typically last from one to three years.

In terms of service, most warranty providers use third-party contractors to repair broken items, and consumers do not get to choose who performs a covered repair. Many policies do not cover accidents or normal wear and tear -- the most common causes of breakdowns in common household goods.

But most important, consumer advocates say, the vast majority of extended warranties are never used, simply because most products do not need a repair or, worse, the extended-warranty provider refuses to cover the repair or makes it such a hassle that it makes more sense to pay for it on your own.

"All you have to do is see how aggressively these things are sold at the point of sale," said Jean Ann Fox, director of consumer protection for the Consumer Federation of America, a District-based nonprofit association of 300 consumer groups. "It's not a good buy under most circumstances."

Under Pressure

Many consumers who normally would resist the hard sell on the warranties occasionally give in. Adam Weiner, a 24-year-old computer engineer who lives in Arlington, last month bought a 37-inch Sharp LCD television for $1,644. He paid $450, or an additional 27 percent, for a five-year extended service warranty.

"I usually don't buy" extended warranties, he said. "But the [television] cost so much. It's impossible to buy a decent flat screen for less than a grand. I wanted to protect my investment."

Weiner's desire to safeguard his new television speaks volumes about how extended warranties play upon a basic human trait to avoid loss, even if it means sacrificing a possible future gain. In this case, the gain is all the other things of value that a consumer could buy with the money that was spent on a warranty.

The instinct to protect what we have and forgo the obvious benefits of another course is one long studied by behavioral economists. Kevin McCabe, an economist and director of the Center for the Study of Neuroeconomics at George Mason University, said that even without knowing from experience that a product will break, many people insure it anyway.

"I suspect that this behavior is in part due to our sensitivity to uncertainty in general," he said.

That reliance on gut instinct points to an inherent disadvantage for consumers in the purchase process, economists and consumer advocates say. Buying an extended warranty is vastly different from selecting most other insurance products. When buying car insurance, for instance, it's relatively easy to make an informed decision by comparing terms and prices among different carriers. The power struggle between buyer and seller is relatively balanced.

But when deciding whether to buy an extended warranty, it is nearly impossible to comparison shop from the checkout counter. And, because the insurance and service companies are invisible at the time of sale, consumers can't verify their financial health or reliability.

Then, there's the obvious question that may not occur to many buyers.

"Why do I need an extended warranty on a phone I'm going to replace in two years anyway? Or one year?," said Greg Brue, a quality consultant and expert on product life cycles who runs Six Sigma Consultants Inc. in Albuquerque.

Making a Claim

To find out more about how extended warranties are sold, a Washington Post reporter recently visited several big-box retailers and asked sales personnel about plans offered at those stores. None of the salespeople would speak on the record, and each referred the reporter to a spokesman for the store's parent company.

Bill Cimino, a spokesman for Circuit City Stores Inc., said that extended warranties may not be right for every customer.

"It's an individual customer decision," he said. "It's something we offer customers in the same way we offer any other product."

Three years ago, Circuit City eliminated commissions for salespeople to sell extended warranties, though they are trained to make sure customers know about the warranties and their benefits, he said. "You can take the literature home," he said. "You don't have to buy it at the time of sale."

Many consumers heed that advice. Ivan Strasfeld, a 56-year-old government lawyer, recently bought a high-priced refrigerator at Foremost Appliances in Washington and he held firm against buying an extended warranty, despite the hard sell. He said he would never buy such a service plan unless he knew that the product he it protected was guaranteed to break.

"If all these stores are pushing them so hard, it means they're only making a lot of money off them and repairing very little," he said.

By the industry's own calculations, Strasfeld is right. Warranty Week, an industry publication, last year estimated that of the $15 billion in premiums charged consumers in 2004, $7.5 billion went straight into the pockets of the stores that sell warranties as their cut.

Of the remaining $7.5 billion, the publication estimated that $3 billion was paid in claims by the insurance companies that back the plans. On the other hand, according to the Insurance Information Institute in 2004, the U.S. auto insurance industry paid out $66 in claims for every $100 in premiums.

Neither Circuit City nor Best Buy discloses how much of its bottom line comes from extended warranty sales. But analysts have estimated that at least 50 percent and in some lean years 100 percent of profits at the electronics retailers come from extended warranty sales.

Those profits are made possible by third-party providers such as N.E.W. Customer Service Cos., a Dulles private company that has grown 35 percent annually in recent years to become the largest independent extended service provider. This summer, it was sold to a private investor group for $1.2 billion.

N.E.W.'s chairman and founder, Fred Schaufeld, acknowledges that his industry has a history of being unfriendly to consumers. He said, however, that one of the reasons for N.E.W.'s success is the way the company has been "revolutionizing" the business by providing real service and value to customers -- a kind of "product care" service rather than an insurance product -- such that extended warranties become a loyalty-enhancing tool for retailers.

And after gaining huge amounts of business managing extended-service plans for dozens of retailers and other consumer goods sellers, he is not done yet.

"I can see a day when you'd buy an extended service plan for your expensive Italian shoes," Schaufeld said in a recent interview.

Sales Insurance

For a wide variety of consumer goods makers, from Ford Motor Co. to Dell Inc., extended warranty revenue has become as important a part of business as the cars or computers themselves. And several major appliance makers in recent years have scaled back their standard manufacturer's warranty to one year, leaving an opening for third parties to capitalize by offering extended warranties.

That trend troubles Six Sigma Consultants' Brue. The heavy reliance on extended warranties as a significant source of short-term profit can have the perverse effect of rewarding quality lapses, he said. Plus, Brue thinks such warranties are bad for consumers.

"It's a legal way of stealing from people," he said. "Good companies will fix their products."

Brue, a longtime consultant on manufacturing processes who helped implement General Electric Co.'s renowned quality programs in the 1990s, said that most basic electronic components are so well made "they won't fail in 100 years, much less three." According to quarterly customer satisfaction surveys compiled by the University of Michigan, consumers generally agree: Buyers of cars, computers and other durable goods are generally happier with their purchases now than at any time since 2000.

For these reasons, as well as the ever-falling replacement cost of most consumer products (just look at the collapse in DVD prices in the past five years), Consumer Reports recommends almost never buying an extended warranty, especially on automobiles.

But even Consumer Reports has made a few exceptions. Last year, for the first time, the magazine found that repairs on some products -- laptop PCs, treadmills and plasma TV sets -- were common enough and expensive enough that a decently priced extended warranty would make sense. Plasma televisions, the magazine said, run hot and are still considered a relatively new consumer technology.

Plus, dragging bulky, large-screen televisions into a repair shop is impractical for most consumers. Many extended service warranty programs offer in-home repairs.

For Weiner, the owner of a new LCD television set, a deciding factor on the extended warranty is that the package included home repair, saving him from the possibility of having to haul the set to the shop.

"I don't want to hassle with that," he said.

Cimino said that customers should always consider how -- and by whom -- a product will be used. For example, the basic electronics that run a Nintendo Game Boy will last until a child loses interest. The buttons, however, are a different matter altogether and can break far more easily. Usually, on such products, Circuit City's extended warranty will simply replace the item.

Even cynics such as Strasfeld buys extended warranties on some products.

"Just the fax machine," he said. "Ours get such heavy usage, they always break."

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