Indexed annuities and dividends -- What brokers don't want your clients to know
By Kim O'Brien
The Annuity Advocate
Security brokers and the media who write for them make a lot of noise about the fact that fixed indexed annuities do not pay dividends. The National Association for Fixed Annuities (NAFA) thought a reality check -- that offers an explanation of the tradeoff between annuity benefits and paying dividends, and further explains why paying dividends would cause your clients to lose more than they would gain -- might be helpful.
Currently, no fixed indexed annuity (FIA) explicitly incorporates dividends into the calculation of interest credits. It is probably safe to say that since this has been true for the past 15 years or so, the topic rarely comes up any more during the product development process, making the exclusion of dividends a de facto rule. But "that's the way it's always been done" is not a good explanation. In fact, there are several consumer considerations why dividends are not and should not be explicitly included in FIA products.
First, there is no free lunch. Dividends could be included in FIA interest calculations, but if they were, what would be the result? Insurance companies would simply have to pay more to deliver the dividends, and the increased cost would result in lower crediting factors (i.e., caps, spreads, participation rates and fees). At the end of the day, the index return would be higher, but with a lower crediting factor. On average, the interest crediting remains neutral between a strategy that includes dividends and one that excludes them. In other words, the benefit of including dividends would be offset by lower credited interest.
The second consideration is one of simplicity for the policyholder. The inclusion of dividends would create a more complicated product. The interest crediting formula used by FIA products do not include dividends. For example, 100 percent of the index gain limited to a maximum of 7 percent is easy enough math for most school children, despite the opt-repeated claims of "complexity." Ironically enough, those that lambast the FIA for not including dividends, in the same breath preach about the product's "complexity." This is obviously disingenuous, because to include dividends, more formulas with more variables would need to be developed and incorporated into FIA policies. Would the dividends be reinvested? Would they simply be added to the return? Are index values with dividends reinvested readily available to most policyholders? Even if the extra complication is minimal, why include it when there is no financial benefit to the consumer?
The practice also provides more efficiency for insurance companies. Most companies hedge for index strategy credits by purchasing simple, over-the-counter options or other financial instruments that do not reflect dividends. Including them would require the purchase of more exotic financial instruments, which would be more difficult to buy and sell-- and likely more expensive, as well.
In the end, individuals should only purchase a fixed annuity when they desire to preserve and protect money from market downturns. This protection cannot and should not be compared to investments -- dividend producing or not -- because indexed annuities are first and foremost insurance. How do you know if a fixed annuity is the right choice for your client's money? If they want a guarantee of minimum interest earnings and the opportunity for additional interest when the market is strong, they should consider a fixed annuity. A fixed declared rate annuity will tell you how much additional interest you will earn in advance and for how long. A fixed indexed annuity will tell you how much additional interest you will earn based on the performance of an outside index (typically the S&P 500). What most media and detractors of indexed annuities don't know or fail to tell you is that most fixed indexed annuities offer a declared-rate option, in addition to the indexed option and policyowners can put some or all of their account value at designated times during the contract. This is a great benefit for anyone who just wants to lock in a guaranteed interest rate or not, at their discretion.
In short, the payment of dividends in a fixed annuity insurance contract is irrelevant, because the interest earned without dividends or the interest earned plus the dividend will not likely have any positive or negative difference. But most importantly, your client's should purchase a fixed annuity for the guarantees and insurance protection with the added potential of modest additional interest1 .
*For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.