Suppose you went to a casino and were told at the door, "You can gamble all evening, and we guarantee that when you leave to go home, you'll have no less money in your pocket than when you came in." It sounds like a great deal, doesn't it?
It would be, and for many annuity companies, this has become the pitch for products providing downside protection in the market. While nobody is offering these guarantees for free, the comfort of principal protection is alluring, even at a price. That peace of mind can come in the form of the inflation risk of a traditional fixed investment, the flat performance of an equity index annuity (EIA), or the mortality and expense fees associated with living benefit riders.
Clients who lost substantial money in the technology crash, aging baby boomers who are concerned more with asset protection than accumulation, and conservative investors who are looking for some upside potential with lower volatility have flocked to products offering a chance at higher returns with limited risk of loss. Let's take a look at the benefits and risks of those three ways to invest and protect.
Traditional Fixed Annuities
These tax-deferred fixed instruments offer principal protection through a guaranteed minimum rate of return. In the past, this rate almost universally was 3% on 90% of principal. But with rates falling to their lowest levels in the past few years, many states have allowed products to be filed with a significantly lower floor -- in some cases less than 2%.
Many of these annuities offer a locked-in rate for the duration of their contingent deferred sales charge (CDSC), making them attractive alternatives to certificates of deposit (CDs). Others offer an inflated first-year rate followed by several years of renewal rates. While there is potential for renewal rates to rise, odds are that they will hover around the stated base rate. These products offer solid downside protection with little upside potential beyond their stated rate and most often are employed by the very conservative.
Equity Index Annuities
EIAs have become increasingly popular and, as a result, have come under scrutiny. Like a fixed annuity, these products offer downside protection using a guaranteed minimum rate of return. But, unlike traditional fixed annuities, these designs link their performance to that of a market index, such as the S&P 500. This index linking offers something fixed annuities do not: upside potential.
In an up market, additional interest beyond the guarantee may be credited, allowing EIAs to outpace the performance of their traditional counterparts. Clients' premium dollars are used first to cover the minimum guarantee through the purchase of bonds and similar fixed instruments; the rest of the premium goes toward sales expenses and purchase options in the linked index. The performance of these options is what fuels the upside in EIAs.
Because clients are not investing in the market, the insurer can use the index only as a tool or benchmark to help determine what, if any, excess interest to credit. At preset intervals, the issuer will evaluate performance using one of several methods, credit any excess interest, and set a new participation rate, cap, or spread. These three moving parts are used to limit an investor's upside and to protect the insurer.
Although there are no fees in these products, these limitations are, in effect, the price clients will pay for the downside protection afforded by EIAs. Long surrender periods, steep penalties for early withdrawals, and severe restrictions on withdrawals often are associated with these products, making them ineffective tools for clients with liquidity concerns, short investment horizons, or immediate income needs. EIAs best are used for clients who are concerned with principal loss, have a desire for returns above those offered by fixed annuities, and can defer the income stage for five to 10 years.
Variable Annuity Living Benefit Riders
Perhaps the most popular form of downside protection, these annuity riders offer a wide array of protection options. About 40% of annuity contracts in 2003 included some kind of living benefit rider, and in 2004, that number had increased to almost 70%. The demand clearly is there, and with more and more products adding these riders, it has become increasingly difficult to wade through the choices.
Adding to the confusion is their complexity -- often the result of complicated pricing in an effort to stand out from the sea of competitors jockeying for their share of some $16 trillion in retirement assets about to hit the arena. Regardless of design, these riders fall into three basic categories: those that provide for income now, income later, and income never.
Income now: The "income now" client usually is at or near retirement and is looking to address distribution requirements. The basic guaranteed withdrawal benefits provide for an immediate income stream and principal return through a series of structured withdrawals. These can be structured to provide income for a set number of years -- or even over a client's lifetime -- without annuitization. A step-up feature usually is included to lock in any gains and to help keep pace with inflation.
These riders restrict withdrawals to specific percentages; it's important, therefore, to make clients aware of the consequence of taking out money in excess of those parameters. The cost of these benefits can run anywhere from 25 to 65 basis points.
Income later: The "income later" client is 10 to 20 years away from retirement and is looking for creative ways to guarantee income during his or her golden years. If a variable annuity is used for a portion of retirement assets, a consideration might be a guaranteed income benefit. These riders offer a compounding rate of return during the contract's first seven to 10 years. The client still benefits from market exposure during this time period, but there might be fund restrictions or a requirement that clients use preset model portfolios.
If, at the end of the holding period, the client's hypothetical "rider value" is higher than the actual contract value, that larger dollar amount can be annuitized. Contracts with income benefit riders can have costs in excess of 3%. Knowing that a rider provides for a 5% to 7% compounded return, the client will have to average better than 8% to 10% a year to come out ahead. Therefore, it's essential that the client understands the annuitization requirements.
Even contracts that allow clients to base lifetime withdrawals off the higher dollar amount without annutization still place restrictions on how much a client can take, and the consequence of excess withdrawals has to be disclosed.
Income never: Even if a client doesn't have a foreseeable need for income, a portion of his or her assets usually are intended for beneficiaries. Knowing the investment will go to an heir, the client might be interested in growing this money. Usual annuity death benefits always have provided for at least the return of principal less any withdrawals, but riders such as guaranteed accumulation benefits put a living benefit spin on those.
Unlike income benefit riders, these are simple "buy and hold" strategies that usually require investment into a predetermined asset allocation model and guarantee the principal as a walk-away value at the end of the holding period. The heirs are guaranteed no less than the higher of the contract value at the time of death or the premiums less any withdrawals. And, should the client's goals change, he or she can withdraw the lump sum of the investment with no annuitization. Of course, guarantees are subject to the claims-paying ability of the associated insurance entity.
You're the Expert
In 2011, the first group of the anticipated 76 million baby boomers will turn 65, bringing close to $16 trillion of assets into the retirement arena. These clients will look for income solutions that provide for an enjoyable retirement and protection from both loss and the stress that comes along with investment risk and exposure.
By understanding these protection tools and implementing them where appropriate, you will have defined yourself as a distribution expert on whom your clients can rely when constructing their individual retirement income plans.
Disclaimer: Variable annuities (VAs) are long-term investment products designed for retirement purposes. Investors should consider the investment objectives, risks, charges, and expenses of the investment company before investing. VAs are sold by prospectus, which contains more complete information, including risk factors, fees, surrender charges, and other costs that might apply. Early withdrawals are subject to surrender charges. Withdrawals of taxable amounts are subject to ordinary income tax and, if made before age 59 1/2 , might be subject to an additional 10% federal income tax penalty. Withdrawals reduce the death benefit, income benefit, and cash surrender value. VA contract values will fluctuate and are subject to market risk, including the possibility of loss of principal. VA contracts have limitations. VAs are not a deposit of any bank, are not FDIC-insured, are not insured by any federal government agency, are not guaranteed by any bank or savings association, and might go down in value.
Ethan Young is an annuity product manager at Commonwealth Financial Network. He joined Commonwealth in 2002. Mr. Young's main focus is providing marketing support for fixed, variable, and equity index annuity products. He also provides product and illustration support for variable life, universal life, and whole life products. Prior to joining Commonwealth, Mr. Young worked at several insurance companies, including Hartford Life, MassMutual, and John Hancock, in positions ranging from customer service to direct sales. He holds NASD Series 6, 26, and 63 licenses and obtained the Wealth Management Specialist designation in 2004
