Response: FINRA Investor Alert/Equity-Indexed Annuities—A Complex Choice

July 7, 2010 by Sheryl J. Moore

PDF for Setting It Straight with FINRA

ORIGINAL FINRA ALERT CAN BE FOUND AT: Equity-Indexed Annuities- A Complex Choice

 My corrections to the FINRA Alert are as follows:

1. These products are not called “equity-indexed annuities” or EIAs. Indexed annuities have not been referred to as “equity indexed annuities” since the late 1990’s. The insurance industry has been careful to enforce a standard of referring to the products as merely “indexed annuities” or “fixed indexed annuities,” so as not to confuse consumers. This industry wants to make a clear distinction between these fixed insurance products and equity investments. It is the safety and guarantees of these products which appeal to consumers, particularly during times of market downturns and volatility.
2.  More than one company has used the word “simple” in the name of their product.
3. Indexed annuities are actually quite simple; they are just fixed annuities with another way of crediting interest. In fact, complexity is relative to your audience. Some would say that fixed annuities are complex. However, if someone can understand that they have the ability to deposit their money with an insurance company, defer taxes on the monies until they begin taking income, receive 10% withdrawals of the account value annually without being subject to penalties, and have the ability to pass on the full account value to their beneficiaries upon death- then they can understand nearly every indexed annuity sold today.
4. Historically, there were a couple of crediting methods (which were not prevalent or used on many products), which gave the indexed annuity market an allusion of complexity. These crediting methods are no longer used today. In fact, 97.6% of indexed annuities offered have crediting methods based on the simple formula of (A – B)/B.
5. The only way that indexed annuities present more of a risk to the consumer than a fixed annuity is that there is a potential to earn zero interest on an indexed annuity when the market declines. Most fixed annuities credit a minimum guaranteed interest every year.
6. There is A LOT less risk on an indexed annuity than on a variable annuity (VA), as the client can never lose any of their original principal or gains on an indexed annuity, where they most certainly can on a VA.
7. The minimum guarantee on an indexed annuity is not a guaranteed minimum return. It is a minimum guaranteed surrender value, which applies in the event that the index does not perform, or if the client cash surrenders their annuity. They typical minimum guaranteed surrender value on indexed annuities today is 87.5% credited at 3% interest.
8. The average surrender charge on indexed annuities today is ten years. The average first-year penalty on indexed annuities is 10.61%.
9. It is disingenuous to allude that insurance companies selling annuities are not stable. So far, 219 banks have failed since the stock market collapse in March of 2008. It is also interesting to note that the Federal Deposit Insurance Corporation (FDIC) fund has recently been in danger. Interestingly, state guaranty fund associations (which insure the safety of insurance purchaser’s values) are not experiencing the same difficulties. In addition, NOT A SINGLE INDEXED ANNUITY PURCHASER HAS LOST A PENNY AS A RESULT OF THE MARKET DECLINES, BANK FAILURES, OR GENERAL WEAKENING OF THE ECONOMY.
10. It should be made clear that anyone purchasing an indexed annuity is not invested directly in the stock market index, but merely receiving excess interest crediting based on the performance of that index. With an indexed annuity, the insurance company puts the client’s premiums into a general account, where the policyholder’s monies are never subjected to the risks of a separate pass-through account.
11. Indexed annuities have a minimum guarantee, and in order to provide that minimum guarantee the insurance company must limit the interest credited to the indexed annuity. (Were the interest not limited, there would be no minimum guarantee, and that is a variable annuity.) The options seller will not pass-on unlimited gains on a product that does not have unlimited risk. The three ways in which an insurance company may limit the interest credited to these products are by using a cap, participation rate, or spread (also referred to as a margin or asset fee). All three of these pricing levers are merely a way to limit the indexed interest on an indexed insurance product. Regardless of whether the interest is limited by a cap, participation rate, or spread- all indexed annuities are priced to return about 1% – 2% greater interest than fixed annuities and certificates of deposit (CDs) are crediting. So, if fixed annuities are crediting 5% today, an indexed annuity sold today should earn 6% – 7% over the life of the contract. In some years, the indexed annuity will earn zero (in the event of market declines); in other years it may receive double-digit gains. What is most likely to occur on a regular basis is something in between. Indexed interest on indexed annuities sold today could be as much as 11.5% or even more.
12. Although insurance companies reserve the right to reduce rates on indexed annuities, they can never reduce it prior to the first policy anniversary. In addition, the company cannot lower the rates below the guaranteed minimum caps/participation rates and maximum spreads that are filed with the state insurance commissioner. This is NO DIFFERENT than how an insurance company can reduce the rates on a fixed annuity, or increase the mortality and expense charges on a variable annuity. Insurance companies must price these products appropriately, and that means building-in the ability to reduce rates, should the volatility of the markets require it. However, just because the insurance company has the ability to change these rates, does not mean that they DO.
13. The insurance company never receives the benefit of the dividends on the index on an indexed annuity, because the client is never directly invested in the index. The insurance company invests the indexed annuity client’s premium payment in the general account, which protects them from declines in the index. The premiums are never invested in a pass-through account, which would provide the benefit of the dividends, but also expose the client to risk should the market decline. For this reason, the dividends cannot be passed on to the consumer. So, the insurance company cannot pass on the dividends if they do not have them to begin with.
14. All annuities have surrender charges, not simply indexed annuities. In fact, indexed annuities are available with surrender charges as short as three years. Furthermore, indexed annuities are some of the most flexible, liquid products available today. All indexed annuity purchasers are given access to 10% of their annuity’s value, annually, without being subject to surrender penalties (some even allow as much as 20% to be taken annually). In addition, 9 out of 10 indexed annuities provide a waiver of the surrender charges, should the annuitant need access to their money in events such as nursing home confinement, terminal illness, disability, and even unemployment. Couple this with the fact these products pay the full account value to the beneficiary upon death, and I think anyone would have difficulty implying that these products are illiquid.

If more people understood surrender charges, they would see that they actually benefit from the surrender charge on an annuity. The surrender charge on a fixed, indexed, or variable annuity is a promise by the consumer not to withdraw 100% of their monies prior to the end of the surrender charge period. This allows the insurance company to make an informed decision on which conservative investments to use to make a return on the clients’ premiums (i.e. 7-year grade “A” bonds for a seven-year surrender charge annuity or 10-year grade “A” bonds for a ten-year surrender charge annuity). Investing the consumer’s premium payment in appropriate investments allows the insurance company to be able to pay a competitive interest rate to the consumer on their annuity each year. In turn, it also protects the insurance company from a “run on the money” and allows them to maintain their ratings and financial strength. I personally appreciate the value of the surrender charge on an annuity and if more consumers understood them, they would too.

15.  Although indexed annuities do not provide for a reduction in the owner’s current taxable income like 401(k)s do, they also do not provide any opportunity for loss due to market declines. I think the millions of Americans who traded in their 401(k)s for 201(k)s  in 2008 would appreciate this difference. Also consider the numerous other benefits of indexed annuities, which 401(k)s do not, and I think anyone would see that this is not an apples-to-apples comparison. Indexed annuities are insurance and as such should be most appropriately compared to fixed annuities.

16.  With a minimum guarantee of 90% @ 3%, the policyholder would receive a return of premiums paid before year four of the contract even if there were no gains credited to the annuity. At the end of the typical product’s surrender period, this minimum guarantee would provide the client nearly a 121% return even if there were absolutely zero gains in the contract. So, the only true risk in an indexed annuity is no different than the risk of a CD- will I get back less than I put in, if I cash-out during the penalty phase?

17.  For the reasons stated in #16, it is impossible to lose money on an indexed annuity as long as you do not withdraw more than the penalty-free amount.

18.  There is only one product available in the entire indexed annuity market which will not credit any indexed gains in the event the annuity is surrendered early. This product accounts for less than 1.5% of sales as of 4Q2010.

19.  People selling indexed annuities do not need to be registered with FINRA, as a securities license is not required to sell these products. For this reason, it is very deceptive to suggest that consumers check to see if the person selling them an indexed annuity is registered with FINRA. The majority of salespeople selling these products are NOT securities licensed, and are not required to be, so this is very misleading.

Thank you.

Sheryl J. Moore

President and CEO

AnnuitySpecs.com

LifeSpecs.com

IndexedAnnuityNerd.com

Advantage Group Associates, Inc.

(515) 262-2623 office

(515) 313-5799 cell

(515) 266-4689 fax

Originally Posted on April 22, 2008 by Sheryl J. Moore.