Fixed index annuities: A viable option for some seniors, Pt. 1Article added by Mason Dinehart on May 30, 2014

Mason Dinehart

Los Angeles, CA

Joined: April 18, 2008

I felt compelled to write this piece in support of a much needed alternative product for savers, when structured and marketed properly. Many securities salespeople do not sell or have even heard of this product since it has always been a pure insurance vehicle, requiring an insurance license only, to sell it. I am proud to have good-quality, principal-protected FIAs as an additional arrow in my quiver to offer to my client base as an alternative to stock market uncertainty and volatility.

Fixed index annuities (FIAs) are financial instruments in which the issuer, an insurance company, guarantees a stated interest rate and some protection against loss of principal and provides an opportunity to earn additional interest based upon performance of a measured index.

Recently, the FIA, a pure insurance product with fully guaranteed and protected principal, has come under close scrutiny from the NASD/FINRA and other regulatory entities. Insurance annuities are exempted securities under Section 3 (a)(8) of the Securities Act of 1933, which states, "The provisions of this title shall not apply to the following class: Any insurance or endowment policy or annuity contract or optional annuity contract issued by a corporation subject to supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any state or territory of the U.S. or District of Columbia."

Rule 151 of the 1933 Act provides a safe harbor:
    a.) Any annuity contract or optional annuity contract (a "contract") shall be deemed to be within the provisions of section 3(a)(8) of the Securities Act of 1933, provided that:
      1.) The annuity or optional annuity contract is issued by a corporation (the "insurer") subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia;

      2.) The insurer assumes the investment risk under the contract as prescribed in paragraph (b) of this rule; and

      3.) The contract is not marketed primarily as an investment.
    b.) The insurer shall be deemed to assume the investment risk under the contract if:
      1.) The value of the contract does not vary according to the investment experience of a separate account;

      2.) The insurer for the life of the contract
        i. guarantees the principal amount of purchase payments and interest credited thereto, less any deduction (without regard to its timing) for sales, administrative or other expenses or charges; and

        ii.  Credits a specified rate of interest (as defined in paragraph (c) of this rule) to net purchase payments and interest credited thereto; and
      3.) The insurer guarantees that the rate of any interest to be credited in excess of that described in paragraph (b)(2)(ii) will not be modified more frequently than once per year.
    c.) The term "specified rate of interest," as used in paragraph (b)(2)(ii) of this rule, means a rate of interest under the contract that is at least equal to the minimum rate required to be credited by the relevant non-forfeiture law in the jurisdiction in which the contract is issued. If that jurisdiction does not have an applicable non-forfeiture law at the time the contract is issued (or if the minimum rate applicable to an existing contract is no longer mandated in that jurisdiction), the specified rate under the contract must at least be equal to the minimum rate then required for individual annuity contracts by the NAIC Standard Non-forfeiture Law.
See Beverly S. Malone v. Addison Insurance Marketing, Inc. 225 F. Supp. 2d 743,*; 2002 U.S. Dist. LEXIS 18885,**; Fed. Sec. L.Rep. (CCH) P91,990, a case showing that a properly structured fixed index annuity is an insurance product rather than a securities product.

In spite of these facts, in December 2008, the SEC, in a 4-1 decision, voted to securitize equity indexed annuities. This means that in addition to an insurance license, one would need a Series 6 securities license to sell and recommend fixed index annuity products. However, this ruling has been reversed, and currently, as a pure insurance product, only an insurance license is needed to sell an FIA.

As always, insurance-licensed agents must take great care with how these products are sold. It is my opinion that it is the abusive sales practices with FIAs and lesser-quality products offered by some inferior insurance companies and not the product itself that has prompted this regulatory action to require dual licensing of agents who sell the product.

While critics make many salient observations about this annuity, they seem to forget that the product is really nothing more than a savings vehicle with a principal guarantee, providing an equity kicker. They continually focus on the ways it's marketed, along with the uncompetitive and substandard versions of a basically solid insurance product. Perhaps a real life story would answer many questions.
In the year 1995, I sold the product to a dear friend's wife who was retiring after many years with a property and casualty insurance company. I placed the product in her rollover IRA in the amount of $135,000. The term of this FIA was five years, and she was guaranteed the receipt of 3 percent compounded annually on her fully protected principal or the growth in the S&P 500 index, without dividends — whichever was greater. In the year 2000, her IRA had grown to over $438,000 net, and we rolled the total amount over on a tax-deferred 1035 exchange basis into several annuity companies with new 5 to 7 year FIA contracts. Several points are important here:
  • The product was appropriate for an IRA only because 100 percent of the principal was guaranteed by an A+ rated insurance company.
  • If the insurance company failed, the value of the annuity (up to $100,000 or more in many states) is guaranteed by the state's insurance guaranty fund.
  • 100 percent of her money went to work in the FIA, since all commissions were paid by the insurance company. The product also avoided the costs and time delays of probate.
  • The commission I earned, payable by the insurance company and not the client, was 5 percent, an amount that was equal to the surrender period, also five years! Note: The fact, not the amount of the commission, must always be disclosed. The commission average of all FIAs is 6.37 percent and lower for older-aged seniors.
  • The FIA had no management fee whatsoever, since the potential growth was measured against a published index, requiring no management time or expense. Penalty-free withdrawals of 10 percent annually were permitted after year one. Additional benefits with the multi-company laddered approach include:
    • The growth in the FIA accumulates on a tax-deferred basis, outside of an IRA. Between 1997 and 2007, FIAs averaged an annualized return of 5.79 percent nationally. For the same period, the five-year CD rate was 2.23 percent.
    • The FIAs had a declining surrender charge beginning at 5 percent and 7 percent, declining each year. After the first year, 10 percent withdrawals were free and not subject to this penalty. This feature should be appropriate for any person willing to hold the annuity for 5 to 7 years, similar to growth positions like mutual funds. While less attractive contracts have beginning surrender charges of up to 20 percent, the average first-year surrender percentage for all contracts is 10.77 percent and only 9.69 percent for elderly purchasers.
    • Several insurance carriers were utilized to ladder the vehicles, spread the risk and add flexibility and diversification to the portfolio.
    • You were able to annuitize the FIA contracts after one year and eliminate all surrender charges whatsoever. Be careful of companies that require a five-year wait to annuitize or reduce the amount by the bonus received up front. Quality companies also offer a guaranteed withdrawal (income) benefit that assures the return of original principal, less withdrawals.
    • There were living benefit riders including terminal illness and nursing home care built into each contract without additional cost. Better contracts include surrender free withdrawals for disability and unemployment, as well.
  • From the year 2000 on, she kept her principal safe during the worst market downturn since the Depression.
Critics who lambaste this product refer to the complexity of the vehicle due to its "moving parts," as it's known in the trade. Many of these complexities are abusive and typically come from lower-tier insurance companies trying to compete with quality companies in the marketplace. Examples are bonuses, low caps, spreads and high asset fees. Most of the higher-quality companies simplify or eliminate the need for most of these.

Let's deal with the major concerns of FIA critics in order.

"These annuities aren't risk-free growth opportunities."

I beg to disagree. They really are equivalent to that with the principal fully guaranteed (minus withdrawals) as a living benefit, plus 3 percent compounded annually. Visualize two stacks of money. One is your principal plus 3 percent compounded annually. The total of that stack after 5 to 7 years is compared to the other stack. That second one increases only by the the growth component of approximately 75 percent of the S&P 500 index, without dividends, for that same 5 to 7 years. If the index declines, the account stays level, without decreasing whatsoever. Each year, the growth potential starts over, measured from a new basis. At the end of the term, the two stacks are compared and the customer receives the larger stack. This of course assumes the customer is willing to stay in the annuity (10 percent emergency withdrawals are permitted) until the 3 percent guarantee on principal is greater than the the surrender charge.

However, this could be a shorter time period if the market experiences gains. To put it another way, the client has the upside potential of approximately 75 percent of the stock market growth with their downside totally protected, with guaranteed principal plus 3 percent compounded annually. To me, unquestionably, that's equivalent to a risk free-growth opportunity. The current guarantee average in 2011 is 3.15 percent.
"The stock market returns are as flimsy as a Hollywood stage set. This is because of limited participation rates and the elimination of the index's dividends."

Consider these two in reverse order. The suggestion usually is that the dividends you're giving up are usually in the 4 percent range. Let's look at recent history, as provided by Standard and Poor's. The dividends between 2000 and 2007 were as follows:
    2000: 1.16 percent
    2001: 1.38 percent
    2002: 1.69 percent
    2003: 1.70 percent
    2004: 1.64 percent
    2005: 1.75 percent
    2006: 1.79 percent
    2007: 1.80 percent
    2008 to 2010: 1.00 percent to 1.50 percent
    2011 to 2014: .75 percent to 1.25 percent
These percentages for dividends actually indicate an average of just 1.60 percent over the last 12 years, only about 40 percent of the suggested 4 percent average that the participant is giving up. And by the way, savers who want risk-free growth of their principal are not looking for returns of 1.6 percent at all. They're hoping for real returns without risk!

Further, when you think about it, if insurance carriers were to include dividends, there would be a corresponding cost to do so. That increased cost would result in lower crediting factors (i.e. caps, spreads, participation rates and fees). Then, of course, the index return would be slightly higher, but with a lower crediting factor. Paying dividends would also make the product more complex. Would the dividends be reinvested? Would they simply be added to the return? And even if the extra complication is minimal, why include it when there is no meaningful financial benefit to the customer? Remember, there is no such thing as a free lunch.

With respect to the second area, returns are in fact limited by participation rates, only one of those "moving parts." This was done to guard against the unusual windfall of 25 percent average market growth rate in the mid-1990s, which would be difficult for any guaranteed vehicle to pay out to savers. However, a number of quality companies offer up to 75 percent participation rate in the S&P 500 index, absent the dividends, without bonuses, caps, spreads, asset fees or other non-competitive limitations. And remember, there is no reduction in a down-market year. That's a very important factor along with the elimination of principal risk. As an alternative, other quality companies offer a "spread" or annual fee of 0.95 percent (just under 1 percent) with a 100 percent participation rate.

"The percentage savings guarantee is only paid on 87.5 percent or 90 percent of your principal."

Again, this is true with some lower-tier companies, but not with the quality insurers. There are, in fact, a good number of companies that guarantee the full percentage compounded on the full original principal. And that full savings percentage is competitive with most bank savings rates in today's economy. The quality insurers will, of course, adjust the guaranteed return as interest rates rise or fall. Currently, due to low interest rates, that guaranteed floor has declined to about 1 percent with many companies from as high as 2 percent to 3 percent of the total premium several years ago.

"Agents are rewarded with commissions in the 10 percent to 15 percent range."

Remember the formula: Commissions are closely related to the number of years in the surrender period. Yes, it's true that some FIAs, issued by the more aggressive, lower-tier companies, extend surrender periods out to 12 to 15 years and advance the accompanying 10 percent to 13 percent commission directly to the agents. While those products do exist, they are clearly not appropriate for everyone. In fact, some of the good companies offer both long and short surrenders with commissions adapted to the varying ages of the annuity holders.

I have personally been selling FIAs since 1995 and have never sold one with a surrender period beyond nine years. Even then, that nine-year surrender period was to younger clients, who, due to their age, would be holding the annuity for more than 10 years, with its built-in flexibility. For older clients, there are quality products that have only three-, five- and seven-year declining surrender periods, which are much more appropriate. These, of course, carry only a 2 percent to 6 percent commission. I would be wary of selling a 12 to 15 year product mainly because of the fact that they should never extend beyond the senior's life expectancy and because there are plenty of good ones that have far shorter and more appropriate surrender periods and commissions. And consider that a fund manager or investment advisor could charge 2 percent each year in fees on an investment account. Over a 10-year period, that equates to an approximate 20 percent cost to the customer. On the other hand, an average 10-year fixed index annuity has an 8 percent commission. That commission is to compensate the producer for servicing the client over the next 10 years. Furthermore, this commission is paid by the insurance company — not the customer.
"If another agent analyzes your FIA, he or she would probably want to earn another commission by rolling you into a new and 'better' FIA."

First of all, a reputable agent would wait to do a 1035 exchange until the surrender period was over. Even first-year bonuses on the new contract used to offset the old FIA's surrender charge can and should be avoided. That bonus has a cost and is usually going to be in the form or a lengthening of the surrender period or higher surrender charges or both. That's just another moving part, and the quality companies that do not have to overreach for business typically don't offer them. One insurance carrier offered a 10 percent upfront bonus product in October 2009. However, it was a two-tiered equity index annuity and required annuitization, meaning the policyholder could take the premium bonus and any indexed gains only if the product were annuitized for a stated term after a specific deferral period. The 65-year-old retiree went to court and a jury ruled that the carrier had used a misrepresentation or deceptive sales practice in selling its two-tiered annuities and that it had intended that others would rely on its misrepresentation or deceptive practice, according to the verdict.

While bonuses should be avoided in most cases, there are always exceptions. In some cases, the bonus can be used effectively as a jumpstart for those who lost money due to market declines.

When I rolled my friend's wife into that second annuity, I only did so after the original policy had matured; the new one had hardly any of those "moving parts" and only a seven-year declining surrender period. And of course, the contract offered, without any penalty, the minimal withdrawal of $43,000 per year (10 percent of the accumulated value).

Critics invariably complain about the complexity of FIA products. However, the average fixed index annuity contract contains 26.7 pages versus 200 pages for a variable annuity prospectus. The key to the FIA issued by quality companies is flexibility. Each year on the policy anniversary, the insured can select a different mix or combination of indexes or choices to measure the growth of the product. This is critically important during times the stock market is cycling downward, sideways or in a highly volatile fashion. Alternatives to tracking the S&P 500 include the Dow Jones Industrial Average, the Russell 2000 Small Cap Index, the NASDAQ, the Barclay's Aggregate Bond Index or even a fixed rate declared each year by the board of directors of the insurance company. The individual can allocate on an annual basis percentages of the FIA between the various options offered. If the product is carefully tailored to the age and needs of the insured, the equity indexed annuity has significant advantages.

For example, there is typically a no-cost nursing home/terminal illness plus disability/unemployment rider that comes automatically with the quality company policies. The surrender charge is fully waived if a life-threatening illness occurs or waived by between 25 percent to 50 percent after a 60-day confinement in a qualified nursing home or assisted living facility, depending upon the insurance company offering the FIA. Some companies offer these benefits to seniors, up to age 85.

Two very competitive policies currently available are from Forthright Life (A-), which offers a three-year product with a 20 percent cap, and American Investors Life (Aviva) (A), offering a six-year product which combines a growth account (50 percent), measured against the S&P 500, without a cap with a fixed account (50 percent) with up to a 2 percent fixed return.

Along with great flexibility in the living benefits, there are important advantages to the guaranteed death benefit. Critics argue that this feature is overrated and has little value. They couldn't be more wrong. Consider someone who has retired or been fired from his employment with only nominal group insurance, which is neither portable nor sufficient in size. How about someone who is uninsurable or is rated for health reasons, making typical cost life insurance unaffordable. Here the death benefit, without additional cost, is guaranteed to be no less than the original amount invested, less any withdrawals. If the market increases, the death benefit increases to the greater of original cost or accumulated market value. Again, quality companies automatically "step-up" the death benefit at periodic intervals as stated in the contracts.

As beneficial as this vehicle sounds, one should avoid placing more than 15 percent to 20 percent of their tangible net worth in the fixed index annuity. For further diversification, more than one annuity should be considered in a laddered approach (with declining surrender periods) for added flexibility and spreading the risk of insurance carriers. Finally, since the vehicle is principle guaranteed, it would be appropriate for an IRA, even though the tax-deferral benefits are wasted. Look though for a compelling need of the guaranteed death benefit and health riders to justify an IRA investment with the FIA. Properly used, it can be a lifesaver for suitable individuals as a "safe money place" or retirement savings vehicle.

Stay tuned for part two of this article, coming next week.
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