In a prior article (see LIS Review & Outlook 2005), I addressed three myths about annuities in general: annuities are unsuitable for seniors, seniors aren't competent to purchase annuities, and long surrender charges are unsuitable for seniors. Indexed annuities (IAs), which first appeared in 1995, have become a hothouse for hatching some specific myths. Of course, it is entirely appropriate to discuss the best ways to educate consumers and to encourage full and fair sales presentations and suitable agent recommendations. In any such forum, however, facts should rule and uninformed or willfully skewed opinion should be avoided.
The Complete Indexed Annuity in Two Paragraphs
IAs are almost exclusively deferred annuities that, during their accumulation phase, offer the owner an option to allocate premium and earn credited interest at a rate (never negative) determined by reference to a financial index. Most policies also offer an annual option to receive the traditional company-declared interest rate. The policies all are designed to comply with state insurance laws and are exempted from federal and state securities regulation because they provide a minimum accumulation of premium with interest, e.g., 90% of premium accumulated with 3.0% interest or 100% of premium at 1.5% less a surrender charge.
Through indexing, the company effectively transforms the rate on funds in the indexed buckets from a bond-based, company-declared interest credit into a credit linked through formula to an independent index (such as the S&P 500). That formula tells what the period of calculation is; how to compare the index values to create an increase; how to apply any participation percentage, spread, or cap; and whether to put a floor of zero under the result.
The effect on a client's interest almost always is an increase in credit potential (both maximum and average), a decrease in minimum credit (potentially zero but subject to an entire policy minimum accumulation), and an increase in the volatility of the interest credit relative to non-IAs. This seems like a fair trade-off, and most people understand it when it is explained in this way. The IA retains minimum required accumulation values just like non-IAs. The concept clearly is suitable for money on which a client wants to take an increased risk of interest credit volatility (but no loss) in return for higher potential interest.
Myth One: Indexed Annuities Are Routinely Misrepresented by Insurance Agents
"I hate the way most (EIAs) are presented. Most people think when they buy these things that they are going to keep up with gains in the stock market, but they are not." -- Thomas Hamlin, CEO of Annuityfyi.com, quoted by syndicated columnist Humberto Cruz, July 2005.
"Some of the pitches (for IAs) are appalling. For example, 'Growth potential without market risk!' 'A win/win investment vehicle.'" -- Mary Schapiro, vice chairman, National Association of Securities Dealers (NASD), quoted by Kathy Chu and John Waggoner in USA Today, Aug. 11, 2005.
The whole purpose of IAs is to "... participate in equity-like returns, with the guarantee that they can't lose their principal." -- Thomas L. Menzel, Legacy Financial Advisors, as quoted by Joan Warner in EIAs: Behind the Hype.
Misrepresentation can occur with any product, financial or non-financial, sold anywhere at any time. The question is whether IAs are any better or worse than other financial products. If worse, what should be done? Strengthen regulations? Sales do not proceed in a regulatory vacuum today. It is the current duty of the state insurance departments and insurance companies to address any deficiencies, and they police them vigorously today under state unfair trade practices laws, advertising laws, state contract filing review procedures, and most recently enacted client suitability laws.
Neither Hamlin nor anyone else has any idea how each of the roughly 800,000 IA sales last year were presented. The only statistics of which I'm aware came from Jack Marrion of the Advantage Group. He has shown a rough parity between consumer complaints about IAs and complaints about variable annuities, which are subject to the stringent and vaunted federal and state securities regulations. He found one complaint for every $700 million of indexed premium versus one for every $600 million of variable premium.
This seems to be another case of "just saying it's so doesn't make it true." That being said, we need continuing analysis of data and monitoring to make sure consumers are not being misled disproportionately to other financial products.
Schapiro excoriates marketing materials that use such terms as "win-win investment" and "without market risk." I agree with her that this is vague terminology, but she goes on to imply that the materials are factually incorrect and concludes that securities regulation will solve all ills. She's sorely mistaken on both counts.
While some company materials could be written more clearly, there is nothing wrong in any industry with touting the benefits (and limitations) of your products to potential consumers. These products can be win-win to someone who desires to pursue a rate potentially better than fixed interest rates but with no loss to principal. The better rate can be a "win" compared to non-IAs and CDs and the guaranteed accumulation a "win" relative to stocks and mutual funds. Finally, while the volatility of the indexed interest rate remotely might be described as "market risk," the average consumer understands that term in the context of owning equities directly and experiencing the pain of an Enron implosion; in that sense, IAs are without market risk.
Menzel's comments about participating in equity-like returns are too typical of current media coverage. As an agent, it is critical to think about the product the right way so as to avoid creating false expectations for your client.
o Start by thoroughly understanding the simple explanation of an IA and, of course, your product-specific details in two unique features: how excess interest is credited and how the guaranteed interest works.
o Do not refer to participating in equity-like returns. There is nothing correct here. To be specific:
- Annuity owners are not participating in markets; they do not own stocks (neither does the insurance company generally). This is insurance. Owners pay premiums on which they receive interest.
- Results are not equity-like. Owners can't lose money because of index changes -- they don't get dividends. Participation rates, caps, and fees keep them from getting experience that matches the index.
- Finally, owners don't get returns: annuities are not investable securities; they get an insured interest credit similar to CDs and savings accounts.
o Do not refer to gain, markets, equity growth, equities generally, investments, earnings, returns, upside potential, options, or derivatives. These are all terms borrowed from securities nomenclature. Even the terms stocks and bonds can mislead, other than describing for a sophisticated client how an insurance company invests for owner safety.
o Select products from a company that understands these issues and gives you sales materials that encourage a fixed annuity understanding of the product. These sales pieces should emphasize safety, security, preservation of principal, guaranteed payout (income stream), and tax deferral. Make sure their materials give examples of the interest credit calculation that are not skewed toward the extremely favorable end of possible results.
Myth Two: Indexed Annuities Are Too Confusing or Too Complex for the Average Consumer
"One of the basics of investing is to never put money in anything you don't understand." -- Eileen Ambrose, The Baltimore Sun, Aug. 21, 2005.
"There is a concern that ... annuities are being hyped to investors without fully pointing out the risks, including the possibility of losing money." -- Ambrose, The Baltimore Sun, same date.
"EIAs are particularly complex." -- Robert Glauber, chairman and chief executive officer, NASD, in a Nov. 11, 2005, speech to the Securities Industry Association annual meeting.
This criticism usually justifies an ulterior motive, in this case additional regulation of an already highly regulated product, a change of regulator, or perhaps a prohibition on the product. The latter would be a travesty. As proven throughout history, prohibitions do not result in a vibrant market and diverse choices for consumers. The regulators' goal should be to create an accurate, information-rich environment in which consumers can make informed choices in their own best interests.
In 2006, we will cross the $100 billion threshold of IA sales in a 12-year period. Most of it has been purchased $40,000 at a time. This is not a gimmick or a fad; there is no "smoke and mirrors." The product provides consumers with an unparalleled opportunity to achieve a higher interest credit than they might get from non-indexed products and get it on a safe, tax-deferred basis. The tradeoff is slightly lower interest guarantees and more annual volatility in the amount of interest credit. (See the chart on page 58 of the March 2006 issue of LIS.)
Ambrose's exhortation to understand what you're buying is of course appropriate, but how much understanding is necessary to make an informed purchase? An author of a recent white paper on IAs endorses a robust understanding of option mechanics, Black-Scholes option pricing theory, and extensive forecasting analysis of the effect of historical index movements on various crediting methods. How does this help a prospective buyer make an informed purchase of a product? It's like advocating a course in advanced electronics for a consumer to buy a DVD player. The only reason for presenting any of this kind of information is to assure the customer that the company is investing appropriately to ensure its promises. The important things for clients to know are:
o Is my money safe?
o What happens if I need to withdraw money or I die?
o What are the tax implications?
o Under what conditions does my money grow?
Glauber decries the particular complexity of IAs as one of the bases for considering their potential security status. Previous NASD memos had pinned this on the prolific nomenclature: caps, fees, participation rates, monthly averaging, monthly point to point, reset, ratcheting, and so on. As you know, all of these terms have to do with linking interest credited to an index. How difficult is this to understand? Is it more difficult than knowing how an insurance company's bond portfolio will change from year to year and how the company will independently declare an interest rate for a policyowner?
Uncertainty applies only to the credited rate and is based on something outside the insurance company's control. This additional uncertainty is present in universal life insurance with company-declared expense charges and mortality deductions, yet this does not impair the value of the product for consumers nor transform UL into a security. Even leaving aside whether the policy is really that "complex," complexity is not one of the criteria for determining securities status.
Ambrose repeats the canard that you can lose money in an IA. This implies that there is some hidden hook in the phrase "no downside." What she apparently means is that if you withdraw all of your money before the end of the surrender charge term, any surrender charge might exceed interest earned. But of course this is true of most financial accumulation products, including traditional fixed annuities, variable annuities, life insurance, and bank CDs.
Surrender charges ensure that when a financial company invests long term, after experiencing acquisition expenses and paying commissions, it can recover them if the owner surrenders his or her policy prematurely. That being said, it is critical that an agent highlight the level and duration of the charges that are disclosed in the contract and required company sales materials.
Frankly, there are a few IAs that are difficult to understand. I speak from experience, having attempted to explain them to agents one on one and in large groups. Two in particular are routinely misunderstood by agents and undoubtedly by their clients as well. One IA credits interest by using long-term, multiyear averaging with high water. It hides probable poor crediting performance under a guise of locked-in "perfect" adjustments (100% participation rate, zero fee, no cap). The liquidity feature of the product is nearly inscrutable even to industry experts. Other products have a crucial requirement (usually annuitization) to get the interest credit and bonuses.
These products do not represent the vast majority of the IA market, but their complexity does not justify blanketing the market with securities regulation. They can even be suitable products for the right liquidity situations. Insurance departments enforce full disclosure of all product features; still, agents should limit their sales of products to those they and each of their clients fully can understand, both now and years after the sale. In other words, agents should enforce their own "simplicity requirement." The most popular products lock in annual interest credits and compound these credits going forward. They are the most popular because agents and clients understand them well and post-purchase satisfaction is high.
IAs have been the most fertile ground for new ideas and innovation in the savings industry in decades. The consumer today benefits with a multitude of choices that should continue unless the marketplace is stifled by onerous and unjustified regulation.
Michael R. 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. Mr. Tripses has designed dozens of annuity products, has advised companies on market positioning and strategy, and is a frequent speaker on index 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.
