The fixed annuity industry is entering the most tumultuous time of its nascent history. The modern back-end loaded (declared rate or indexed) annuity has come under attack on multiple fronts, including uninformed, one-sided stories in the consumer and business media; class action lawsuits; and even the uninvited scrutiny of the National Association of Securities Dealers (NASD). Admittedly, a small minority of insurance agents have used unscrupulous or misleading sales methods, and their misdeeds have fueled the fires of criticism. Critics can be found for any industry, but many of these attacks falsely presume this behavior is widespread, and the vast majority of entirely appropriate sales actions are called into question.
This is not to say there are not legitimate issues to debate, but they are buried so deep in static that it's almost impossible to generate a rational discussion. Let's look at what I think are the top misconceptions about fixed annuities. One important note: The issues I discuss here are independent of whether the particular fixed annuity has only declared interest rate options or includes index-linked interest options. One characteristic of media confusion is to mix issues related to indexed interest with those that are supposed indictments of the features of any fixed annuity. I'll be careful not to make these same mistakes.
Myth One: Annuities Are Unsuitable for Seniors
Here are quotes from some recent articles.
"... And other seniors purchased equity-indexed annuities, believing the products would provide retirement income and other benefits. But in many cases, the maturity dates of the annuities were well beyond the seniors' life expectancies." -- The South Florida Business Journal, Exclusive Reports, July 29, 2005.
"The majority of annuity policies are going to seniors because those are people who have the money and are scared of the stock market and most susceptible to fear. But over a certain age it's not acceptable to sell someone a deferred annuity because they are going to pass away before it annuitizes." -- Ingrid Evans of Renne, Sloan, Holtzman & Sakai, a law firm in San Francisco, quoted in The New York Times, May 15, 2005, in an article by Gretchen Morgenson.
This "maturity" myth might be one of the most common refrains repeated by uninformed journalists. The truth is that "maturity date" means practically nothing in an annuity. This term carried over from when companies patterned annuity contract language after life policies, which paid a death benefit or endowment at maturity. All it means in a modern annuity is the date when the company automatically would convert the owner to income payments or full distribution from product. In fact, consumers usually want longer maturity dates, and most if not all carriers grant them upon request. Extending the maturity means the owner has a longer period to keep his or her options open.
The misconception about annuitization is that many older clients might die before they ever could annuitize the policy. Most annuity policies, however, allow early annuitization regardless of any stated date in the policy. The only question is whether the company allows the payout stream at full value or net of the stated surrender charge. In many cases, the policy is a good deal even net of the surrender charge. Many policies allow payout to begin earlier than the end of term (on a guaranteed or company practice basis) without any surrender charge. Many of these start as early as one year after issue.
Of course, the entire charge by attorney Ingrid Evans is false. An agent may recommend an annuity to an older client after determining through basic fact-finding that the client does not need an income stream and that the money is intended to pass to heirs at death. An annuity can pass full account value to the heirs or provide periodic payout to heirs; Ms. Evans apparently does not know about these options. In the case of payouts, it would be perfectly suitable to recommend a policy that provides full account value over five years or a lump sum net of any remaining surrender charge.
The real underlying concern of critics who ignorantly or maliciously promote the maturity and annuitization myths is that long surrender charges are bad, period. This is discussed in the last section of this article.
The key to an annuity is whether you can get the money out of it when a client needs it through annuitizing or withdrawal or at nursing home admission, terminal diagnosis, or death. Your job as an insurance or financial adviser is to inform your annuity clients about when and under what conditions they can get their money and educate them about the suitable match between client needs and product liquidity. Especially make sure if you have an older, potentially short-lived client that you determine what his or her desires are for passing money to beneficiaries. If a client is likely to want an income stream either greater than the free partial withdrawal or a lifetime income, make sure it is allowed (preferably guaranteed) by the product without surrender charge.
Myth Two: Seniors Aren't Competent to Purchase Annuities
"At the heart of the alleged scheme bilking Eddy out of her retirement money, according to court documents, (is the statement) 'key sociological demographics of the elderly show that they have a retirement nest egg and they are vulnerable, making them susceptible to undue influence and deception' ...
"The Eddy case is the second class action lawsuit filed in Florida by the Hargrove firm against a national annuity producer alleging wrongful annuity sales and marketing practices involving seniors. Hargrove has many more on his desk, waiting for consideration, he said. In the Eddy case ($155,000 premium), no damage amount has been set, but, '... there is no limitation to damages that can be sought in court.'" -- The South Florida Business Journal, Exclusive Reports, July 29, 2005.
The class action attorney's contention, provided with no attempt at objectively reporting the other side, is that seniors as a class (age 65 and older) are incompetent to make a purchase decision for this product. They are too subject to influence and deception to write the check for a product that is safe, secure, highly regulated (by the states) and fully disclosed on state-approved forms. Apparently these same seniors are competent, however, to purchase cars, houses, stocks, variable annuities, and other high-dollar items.
The class action plaintiffs' attorneys believe there is no amount of money too high to ask for as recompense for damages, no matter how small, even when there is no monetary damage to the clients and the clients simply want out of the contract. In this case, the showcase client judiciously used the 10% penalty-free withdrawal each year and still earned substantial annual interest. Lacking any apparent damage to its client, the Hargrove law firm believes it is pursuing justice by imputing this phantom harm to every annuity policyholder in Florida. The attorneys are requesting unlimited damages and of course will siphon off a large percentage of any recovery for their efforts.
The bottom line: There are no medical, psychological, emotional, or other reasons to assume that seniors cannot make informed financial decisions. A good adviser fully will explain and document the key annuity features that govern when and how clients can get their money. I recommend liberal use of highlighting, notating, and consumer initials on sales materials and disclosure forms, as well as a program of document retention to ensure that all parties have performed their duties as buyer and seller.
Myth Three: Long Surrender Charges Are Unsuitable for Investors
"... (The annuity is) not working very well for me. I'll be 86 and probably not alive (when surrender charges cease). They shouldn't even accept an old lady or old man." -- Marie Mear, 76, The Arizona Republic.
"Because surrender charges can apply for more than a decade, EIAs might not be suitable for elderly investors." -- USA Today, Aug. 11, 2005.
"An annuity purchase with a surrender charge period beyond remaining life expectancy is per se unsuitable." -- Ingrid Evans, Renne, Sloan, Holtzman & Sakai, San Francisco, The New York Times, May 15, 2005.
How long is too long for surrender charges, and how old is too old for any surrender charge? That depends. I've actuarially priced many annuities using current company mortality experience. A typical 65-year-old female annuity purchaser today can expect to live another 22.5 years. All companies have maximum ages for issuing annuities. Nevertheless, some 80-year-old clients have bought 15-year, high-surrender-charge products. Is there harm or unsuitability in such a sale? Contrary to the presumptive analysis in the news media, it's not that obvious. Let's analyze this from the viewpoint of consumers. What is their alternative in a tax-deferred, safe, fully insured, principal-protected product?
A typical 80-year-old female annuity purchaser, based on insurance company annuity mortality experience, will live another 10.8 years. Let's assume you have worked with her to determine she has no foreseeable income needs from the money that will purchase the annuity. She wants the money to pass to her heirs, her liquidity needs are nominal, and she doesn't anticipate a big change in the risk profile of this "safe" money. The most likely alternative she can think of is certificates of deposit (more about the CD alternative later). Also, assume you've proposed a full account value at death product, or that she likes the spendthrift protection idea of full account value over 60 months following death in the product you've proposed.
She could buy one five-year annuity and hold it as long as she lives. The usual problem is that insurers must match asset lengths with liability lengths. After surrender charges end, the insurer must drop interest rates to low, short-term rates (the guaranteed minimum rates, generally 1.5% to 2.5% today). The annuity has become similar to a demand-deposit. It will be difficult for a five-year annuity -- if it is ultimately held for 15 years -- to compete with a 15-year product, even more so because most 15-year products today enhance interest with significant up-front bonuses ranging from 3% to 10%. The client had better be fairly sure she will die within seven years, and because most five-year annuities are not bonused, the interest rate would need to be much higher than the 15-year product offers; otherwise the client has underperformed. Do you as the professional adviser want to rest all of your advice on that guess?
Perhaps three successive five-year annuities, each subsequent one purchased only if she lives, would be better than buying one 15-year annuity. Notice that the agent now has the potential to earn a commission three times. Since most five-year annuities are non-bonus annuities, the commission paid on the three successive annuities actually may be more than the commission paid on the one bonus 15-year product. That means a more expensive approach for the client in terms of her total interest over the 15 years. Also, the 15-year product will have an interest advantage in that the insurance company can invest over a longer period, assuming a positively sloped yield curve that would produce higher long-term yields.
Of course, the advantage of the successive annuity approach is that the client has full liquidity two more times at five and 10 years, should she want to reconsider where to put her money. Some clients, however, don't want to be bothered with those additional decisions. Should they be forced to make them?
The biggest financial effect of the successive annuity method might be the resetting of a different new money rate for each five-year period. This could be a boon if interest rates have risen or a boondoggle if they have fallen. Perhaps the client wants to take that risk because she wants to gamble on interest rates or believes rates are so low today that they only can go up. Again, do you as the adviser want to tie the success of your recommendation to that guess?
Why not just purchase a successive series of government-insured CDs? There is no 15-year option with CDs. All of the issues raised previously apply to the CD purchase. There are no real bonus CDs, of course, and CDs are subject to current taxation and impose penalties for early withdrawal. Am I saying no senior money belongs in CDs (or stocks and bonds for that matter)? Certainly not. Here is where a professional insurance agent can help clients categorize their money by aversion to risk.
What do consumers need? They need a high-quality financial professional who will help them with basic financial education, help them determine how they feel about risking their money, analyze a range of opportunities, and give them product choices. In addition to being an actuary, I also am a licensed insurance agent. Would I sell a policy with a 15-year surrender charge to an 80 year old? In today's environment, even if I determined it was suitable, I would be extremely cautious about making this sale. It would require a lot of client education and clear signoffs from my client and, if appropriate, the beneficiaries. This is how insurance professionals earn the commissions these products pay.
Michael Tripses, FSA, is executive vice president and chief actuary of Creative Marketing International Corporation. His 28 years of industry experience include four years as chief actuary at Integrated Resources Life and six years as chief actuary at American Life and Casualty. He joined CMIC in 1996. Mike has designed dozens of annuity products, has advised companies on market positioning and strategy, and is a frequent speaker on indexed annuities. He is a Fellow of the Society of Actuaries and a member of the American Academy of Actuaries. He also serves on the board of directors of the National Association for Fixed Annuities.
