I wrote an article last year titled "Annus Horribilis -- the Horrible Year." And it was; 2003 was the worst pricing market for index annuities since inception of the product, as a result of interest rates at 40-year bottoms and high option volatility producing high index-link costs. All of this resulted in record low caps on maximum interest earned and drooping index participation. Annuity products disappeared at a speed that rivaled vanishing props at a David Copperfield performance, and freefalling commissions meant producers needed to sell two or three times the previous year's production simply to maintain their income.
By contrast 2004 is Tempus Opportunitas -- a Time of Opportunity. The year will not be easy, but it will be much better than 2003.
One reason 2004 will be better for producers is because last year ended on an upward note for the stock market. For the first time in four years, the major stock indices all finished higher -- in fact, the gains were substantial -- and index annuity providers were able to expand their story of previous years, wherein they explained, "Index annuities protect principal from stock market risk," by adding, "and look, they also credit index-linked interest."
I surveyed index annuity providers and found index annuities using an annual reset design credited interest ranging from 4.64% to 13.87%, depending on the methodology used, for calendar year 2003. Whether you consider these index-linked interest rates competitive depends, I guess, on your perspective.
Some people try to classify index annuities as growth investments, and from this perspective one could say index annuities did poorly. The major market indexes were up 25% to 50%, the 40 largest stock and balanced funds gained 19% to 49%, and variable annuity stock and balanced sub-accounts rose on average 18% to 46%.1
The problem with this perspective is index annuities are not equity investments. Index annuities are not intended for a consumer's risk money. If a consumer wants high potential growth and understands the corresponding risk associated with this goal, he or she should not buy an index annuity. And although my published research shows that index annuities have outperformed equity investments in other recent times, this is not what they are designed to do. Index annuities are a safe money place, and they should be compared with other safe money places.
My definition of safe money is money someone cannot afford to lose. A safe money place is one where it is unlikely for the person to lose his original principal unless he chooses to lose some of it. A safe money place is the opposite of a risk money place, where principal can be lost as a result of circumstances beyond the person's control.
Here's what I mean: Although real estate in the United States usually has been a good investment and gone up in value, if someone buys a house today, could he sell it without a loss tomorrow? Maybe, maybe not; home prices are affected by mortgage rates, the local economy, changes in zoning, and many other elements, all of which are outside the homeowner's control. Real estate is a risk money place because principal can be lost as a result of events beyond the person's control.
Safe money places are:
o CDs
o Fixed annuities
o Money market
o Savings account
o Savings bonds
Risk money places are:
o Mutual funds
o Physical assets
o Real estate
o Stocks
Bonds can be either safe or risk.
A typical fixed annuity has a liquidity charge for early withdrawal. If someone takes money out of the annuity before the liquidity charge period is over, the charge could dip into the original principal and he could get back less than he put in. How does the person avoid getting back less than he put in? He should keep the annuity until the charge doesn't dip into the principal. A fixed annuity is a safe money place because principal is protected as long as the person follows the agreed upon rules.
In 2003, certificates of deposit yielded 1% to 3%, savings bonds averaged around 2%, and government bond funds returned 1.4% to 3.2%. For the same period, index annuity returns ranged from 4.64% to 13.87%. Index annuities did well when compared with other safe money places.2
The year presents certain advantages for annuity producers in competing against other safe money places. Although rising interest rates usually also will lift certificate of deposit yields, CD returns will remain dismal. Three years ago a CD owner considering an annuity was gambling the annuity would beat the 5% to 6% yield the bank offered. Today, that CD owner is risking 2%, so the gamble is much less.
Rising interest rates mean the value of issued bonds goes down. Rising interest rates means many bond mutual fund owners will see the net asset value of their shares decline as the year progresses. Annuity producers offer an alternative that guarantees no market loss to principal if rates increase.
Index annuity producers finally have annual statements showing index-linked interest. This is an excellent time for the producer to congratulate the index annuity owners on their wise decision that earned them four to ten times what they would have made in the bank (and to share these statements with prospects from a year ago to show what their procrastination cost them).
As the 10th anniversary of the introduction of the first index annuity approaches, index annuities have done what they were supposed to do -- provide the opportunity for higher interest while protecting principal from market loss. This year is a fresh time of new opportunities for index annuities.
Notes
1. Data Sources: Advantage Compendium, Lipper, Morningstar.
2. Data Sources: Advantage Compendium, Federal Reserve Bank, U.S. Treasury, Lipper.
Ignores sales or surrender charges. Mutual fund returns include reinvested dividends; index annuity returns do not include reinvested dividends. Information believed accurate, but not warranted. Past performance is not an indicator of future results.
Advantage Compendium does not sell, endorse, or recommend any financial product.
