My wife and I have an ongoing argument over a topic that any sensible husband would carefully avoid: Makeup. Cosmetics companies and retailers are constantly enticing shoppers with the nefarious "gift with purchase" promotion. Buy a certain amount of lipstick, rouge, eye shadow, etc. and receive a free bag of additional makeup. How much she must spend to qualify and the nature of the gift does not matter -- my wife finds these offers nearly irresistible. I have a very logical argument (the kind that has no place in marriage and fails every time, but I stick to it nonetheless): There's no such thing as a free lunch. Those cosmetics aren't truly free -- you're paying for them implicitly, so why buy what you don't need?
The same argument holds true for most products: Groceries, automobiles, electronics and fixed indexed annuities. Every true benefit has a cost (it's not always transparent, but it's always included). If every benefit has a cost, shouldn't clients only pay for those benefits they want? Of course, fixed indexed annuity benefits are not a la carte, so choosing the right benefits is not as straightforward as buying cosmetics. Fortunately, different annuities do emphasize different benefits, so at the very least, you can help your client decide which benefits are the most important and find an annuity that best fits their needs. The following is an examination of commonly available FIA features and benefits, their value and how they are "paid" for.
Premium bonus. A premium bonus is straightforward. It's an additional amount, expressed as a percent of premiums paid, credited to an annuity's accumulated value. The cost of a premium bonus almost always includes lower credited rates, which makes sense because your clients usually get interest credits on both the premium and the bonus amount. The less obvious cost comes in the form of higher surrender charges and/or bonus recapture charges. Insurance companies need to cover the expense of the bonus, which means they need your client to stick around while they recoup their costs. Hence, higher surrender charges.
Guaranteed Lifetime Withdrawal Benefits (GLWB). A feature that has made its way over from the variable annuity market, GLWBs have found a home with FIAs as well. GLWBs are one answer to the age-old question: "How can I receive guaranteed lifetime income while retaining control of my assets?" The good news about these benefits is that the costs are explicit, typically a percentage of assets, so its trade-off, lower accumulated cash values, is known. A word of warning on GLWBs: There are several moving parts used to determine benefit levels. Make sure you compare actual guaranteed payout levels for your clients rather than just one component of the benefit calculation such as the roll-up rate.
Free withdrawals. Liquidity options are becoming increasingly popular in FIAs, and therefore increasingly generous. As with the other features under examination, there is a cost, and it is difficult to pinpoint. In order to have funds available for such withdrawals, insurance companies have to invest in more liquid assets. More liquid assets mean lower yields, which in turn mean lower credited rates. There may also be higher surrender charges in an annuity with greater liquidity options. There may be a free withdrawal amount, but getting the rest of the money (a full withdrawal) may incur a stiff penalty. Also, most withdrawals from an indexed crediting strategy, free or otherwise, do not include an interest credit if withdrawn in the middle of a policy year. Clients can avoid this cost by allocating funds to a fixed interest strategy if they think they'll be taking a withdrawal during a policy year. Most fixed interest strategies offer interest crediting on a daily basis.
Guaranteed minimum contract values. Every fixed annuity has a minimum level of guaranteed cash value. Some are very strong; others are the lowest allowed by law. As many people have learned during the recent economic turmoil, guarantees are valuable and therefore costly. Strong guaranteed values on a fixed indexed annuity will come at the expense of lower long-term values. There are a number of ways to structure these such as using lower crediting factors or higher and longer surrender charges.
Market Value Adjustment. The Market Value Adjustment (MVA), in contrast to other features examined here, actually has an earnings component as well as a cost component. An MVA protects the insurance company from a policyholder lapse by lowering cash values if prevailing interest rates rise. It will also reward the policyholder if interest rates fall by raising cash values. The key here is surrender. If the policy is not surrendered during the published charge period or excess withdrawals are not made, there is no impact to the policy. The MVA is an insurance risk protection mechanism. Because less risk equals less expense to the insurance company, they can provide a greater level of benefit, usually higher credited rates, to policies with an MVA vs. those without.
In summary, your clients shouldn't pay for what they don't need. Help them choose their annuity and its features carefully and view a "gift with purchase" skeptically. (Unless that gift is a big-screen, LCD television -- then it makes very sound financial sense!)
Kevin Cloud is the vice president and product actuary of the actuarial consulting and product development services division of Creative Marketing, one of the foremost annuity and life marketing organizations in the U.S. He is responsible for overseeing the development of fixed and indexed annuities and heading carrier product consultations to create open dialogue between Creative Marketing and its partners.
