Response: Index annuities: Some tricks among the treats
November 16, 2010 by Sheryl J. Moore
PDF for Setting It Straight with Humberto Cruz
ORIGINAL ARTICLE CAN BE FOUND AT: Index annuities: Some tricks among the treats
Dear Mr. Cruz,
I am an independent market research analyst who specializes in the indexed annuity and life markets. I have tracked the companies, products, marketing, and sales of these products for over a decade. I used to provide similar services for fixed and variable products, but I believe so strongly in the value proposition of indexed products that I started my own company focusing on IAs and IUL exclusively. I do not endorse any company or financial product, and millions look to us for accurate, unbiased information on the insurance market. In fact, we are the firm that regulators look to, and work with, when needing assistance with these products.
I recently had the occasion to read an article that you wrote, which was published by The Chicago Tribune, “Index annuities: Some tricks among the treats.” While your efforts to inform your readers are appreciated, your article had some grossly inaccurate information in it. Such misinformation reflects poorly not only on you, but also on The Chicago Tribune. So that you will have access to accurate information on these products in the future, and so you can make an appropriate correction to this article, I am reaching-out to you as the foremost authority in the indexed annuity market.
First of all, it is inappropriate to refer to indexed annuities as an “investment.” Variable annuities are the only type of annuity that can be called an “investment,” as these products place the purchaser’s principal and gains at risk due to market volatility. Stocks, bonds, and mutual funds are also investments. The Securities and Exchange Commission (SEC) is responsible for the regulation of such investment products. Fixed and indexed annuities, by contrast, are insurance products- similar to term life, universal life and whole life. Insurance products are regulated by the 50 state insurance commissioners of the United States (collectively referred to as the National Association of Insurance Commissioners, or NAIC). Insurance products do not put the client’s money at risk, they are “safe money products” which preserve principal and gains. Investments, by contrast, can put a client’s money at risk and are therefore appropriately classified as “risk money products;” they do not preserve principal. The NAIC does not permit the use of the word “investment” when referring to indexed annuities, as such.
In the future, it would be more appropriate to refer to indexed annuities as ‘retirement vehicles’ or ‘insurance contracts.’
Second, indexed annuities are not marketed as an “investment…that goes up with the market but doesn’t go down.” Indexed annuities are marketed by the insurance companies that sell them as ‘insurance products that provide the purchaser with a guaranteed lifetime of income whilst allowing them to have LIMITED participation in the stock market’s upside, while also avoiding the downside risks associated with the stock market.’
As an FYI- indexed annuities are intended to be compared with fixed annuities and certificates of deposit (CDs), not securities products such as stocks, bonds, mutual funds, or variable annuities. Perhaps it would help if I gave some further explanation about how indexed annuities are intended to work? Because indexed annuities are a “safe money place,” they should be compared against other safe money places. Investment products such as stocks, bonds, mutual funds, and variable annuities subject the purchaser to both the highs and the lows of the market. It is inappropriate to compare any safe money place, such as an indexed annuity, to risk money places and it is most certainly not appropriate to compare safe money places to the market index itself. Indexed annuities are not intended to perform comparably to stocks, bonds, or the S&P 500 because they provide a minimum guarantee where investments do not. Indexed annuities are priced to return about 1% – 2% greater interest than traditional fixed annuities are crediting. In exchange for this greater potential, the indexed annuity has a slightly lesser minimum guarantee. So, if fixed annuities are earning 4% today, indexed annuities sold today should earn 5% – 6% over the life of the contract. Some years, the indexed annuity may return a double-digit gain and other years it may return zero interest. However, what is most likely to happen is something in between. Were the indexed interest NOT limited, the insurer could not afford to offer a minimum guarantee on the product, and THAT is a variable annuity- not an indexed annuity. On the other hand, the client is guaranteed to never receive less than zero interest (a proposition that millions of Americans are wishing they had during that period of 03/08 to 03/09) and will receive a return of no less than 117% worst-case scenario on the average indexed annuity. In addition, no indexed annuity owner has ever lost a penny as a result of market downturn. This is a strong value proposition that cannot be offered by any securities product, and the primary driver for increasing sales of these products. Hopefully this explanation will assist you in gaining greater insight into the mechanics of indexed annuities.
Third, I am curious to know why didn’t you publish any commentary from insurance agents that sell indexed annuities? You appear to have only requested comments from investment advisors; a group who generally compete against insurance agents that sell indexed annuities. Investment advisors sell investments, Mr. Cruz. You need to speak with someone who actually sells indexed annuities to receive credible feedback on their value. I cannot comment on Larry Swedroe or Robert Carlson, but I can tell you that I have had to correct Allan Roth on numerous misstatements he has made publicly about indexed annuities. For your reference, I am attaching three recent corrections I have had to make on three different columns Mr. Roth has written about indexed annuities. As you can see, Mr. Roth still has much to learn about indexed annuities before he can be considered knowledgeable enough to give an opinion on the products.
In the future, if you need contact information for insurance agents that sell indexed annuities, please do not hesitate to reach-out to me. I would be more than happy to provide you with a referral to an agent in your area of interest.
Fourth, your explanation of how indexed annuity purchaser’s products work is not quite accurate (or perhaps I am misinterpreting your explanation?). While the insurance company does purchase options to provide the indexed-linked interest on the annuity contract (and bonds to cover the guarantees), the purchaser’s money is never directly invested in the market or securities products. Instead, the indexed annuity purchaser’s premiums are allocated to the insurance company’s general account, where they are protected from market volatility. Investing in high-quality bonds is how the insurance company is able to afford a principal guarantee with a minimum interest rate as well.
I’m not certain what Mr. Carlson was referring to when he said, “It’s not unusual for [investors] to be unpleasantly surprised at returns.” It is made very clear to indexed annuity purchasers that worst-case scenario is zero percent interest crediting and best case scenario is something a little more than what fixed annuities are paying. That being said, I have actual policyholder annual statements on my desk, showing one-year gains as high as 47.65%. Are indexed annuities intended to return this much on a consistent basis? No. However, sometimes purchasers do “hit a home run” with these products. For a more realistic review of general gains on these products, I do believe that you should consider the study that was done by Jack Marrion. Sure, the study has its flaws (i.e. small sample size), but this “Real World Returns” study is compelling. The study looked at actual returns of inforce indexed annuities and shows that from 1997 to 2007, the five-year annualized returns for actual indexed annuities averaged 5.79%. Interestingly, this is precisely the expected return for products over this period. I find it hard to believe that you would mock an average return of 5.79% following a period when the market declined nearly 50% in a single year. Keeping in mind that fixed annuities are currently averaging a mere 3.24% interest, I think that this return is respectable. Personally, one of my indexed annuities returned a gain of just over 7% this year, while my grandmother’s variable annuity had a loss. You must remember- indexed annuities are primarily purchased by those more concerned with a return OF their money than a return ON their money. These annuity owners are not willing to risk losing 50% on the offset that they may also make 50%; they want the safety and guarantees that indexed annuities provide.
Fifth, I believe you are misrepresenting the “typical” commission paid on indexed annuities. As of 3Q2010, the average commission paid to agent on indexed annuities was a mere 6.50% (and even lower for annuities sold to older-aged purchasers). Keep in mind that this commission is paid one time, at point of sale only, and the agent services the contract for life. By comparison, many securities products such as mutual funds pay generous, consistent commissions annually. So, in context, I think that you’ll find that the commissions paid on indexed annuities are actually quite reasonable.
Sixth, surrender charges are not necessarily a “drawback,” Mr. Cruz. 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’ premium (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.
Notwithstanding, the average surrender charge for indexed annuities as of 3Q2010 is ten years and the average first-year charge is less than 11% (even less for older-aged purchasers). In fact, indexed annuities are available with surrender charges as little as three years and as low as 5% in the first year (declining annually thereafter). Despite your comments, there are no indexed annuities available today with surrender charges as long as 17 years or as high as 22%. You must also realize that every indexed annuity permits penalty-free withdrawals of 10% of the annuity’s value annually. Some even allow as much as 50% of the annuity’s value to be withdrawn in a single year! Plus, 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 that these products pay the full account value to the beneficiary upon death, and it is clear that these are some of the most liquid retirement income products available today. This is not the picture that you would paint of them though, Mr. Cruz. Please take note of how liquid the products truly are.
In my attached communications to Mr. Roth, you will see my comments about trying to duplicate an indexed annuity with a combination of CDs and index funds. I guess the question I have is: WHY WOULD SOMEONE WANT TO DUPLICATE AN INDEXED ANNUITY WITH A LESS SUPERIOR STRATEGY, WHEN THEY COULD JUST PURCHASE AN INDEXED ANNUITY? It doesn’t make any sense.
Seventh, you comment that dividends are excluded from the indexed calculation on indexed annuities as if it were a detriment; it is not. 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 purchaser’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. By not directly investing in the index (which would pass-on the dividends), the insurance company is protecting the purchaser from losses. So, you see- this is a benefit to the indexed annuity purchaser, not a disadvantage.
Mr. Cruz- you are in a position of influence, working for a reputable newspaper. You have the power to sway your readers’ opinions about financial services products during a time when they need the guidance more than ever. I just want you to understand indexed annuities better, so that your reporting of these products will lead to accurate information being disseminated to your readers. Did you know that indexed annuities have many benefits, including (but not limited to):
- No indexed annuity purchaser has lost a single dollar as a result of the market’s declines. Can you say the same for variable annuities? Stocks? Bonds? Mutual funds? NO.
- All indexed annuities return the premiums paid plus interest at the end of the annuity.
- Ability to defer taxes: you are not taxed on annuity, until you start withdrawing income.
- Reduce tax burden: accumulate your retirement funds now at a [35%] tax bracket, and take income at retirement within a [15%] tax bracket.
- Accumulate retirement income: annuities allow you to accumulate additional interest, above the premium you pay in. Plus, you accumulate interest on your interest, and interest on the money you would have paid in taxes. (Frequently referred to as “triple compounding.”)
- Provide a death benefit to heirs: all fixed and indexed annuities pay the full account value to the designated beneficiaries upon death.
- Access money when you need it: every indexed annuity allows annual penalty-free withdrawals of the account value at 10% of the annuity’s value; some even permit as much as 50% to be withdrawn in a single year. In addition, 9 out of 10 fixed and indexed annuities permit access to the annuity’s value without penalty, in the event of triggers such as nursing home confinement, terminal illness, disability, and even unemployment.
- Get a boost on your retirement: many indexed annuities provide an up-front premium bonus, which can provide an instant boost on your annuity’s value. This can increase the annuity’s value in addition to helping with the accumulation on the contract.
- Guaranteed lifetime income: an annuity is the ONLY product that can guarantee income that one cannot outlive.
Isn’t it possible that you have a misunderstanding of how these products work and how useful they can be for the right purchaser? If so, I would love to be a resource to you on indexed annuities. In the meanwhile, I would suggest that a correction be issued on this article that you wrote. I know that neither you, nor The Chicago Tribune, would want to have your journalistic integrity questioned over such misinformation. I will look forward to hearing from you on how I can be of assistance to you on these matters.
Thank you so much for your time and attention to this matter.
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
