When a columnist on LifeHealthPro recently spoke out against indexed annuities (IAs), IA proponents fiercely defended the product, stirring up a heated debate over what is essentially an insurance contract—a complex one, but an insurance contract nonetheless. In baseball terms, the debate may not be hot as the rivalry between fans of the Yankees and Red Sox, but it’s pretty close.
Since every issue has two sides, LHP contacted people who hold viewpoints for and against IAs to understand why this is such a hot button topic.
Coming out against IAs are financial planners (mostly registered reps) who rail against the product’s high fees that cut into the investor’s return.
“If I had to give a number-one bottom-line critique of annuities in general, it’s that costs are very high,” said Jeff Feldman, Ph.D., CFP, owner of Rochester Financial Services in Pittsford, N.Y. Feldman is a fee-only, independent RIA.
“With the indexed annuity, they are guaranteeing you are not going to lose money or your losses will be minimized,” Feldman said. “[But] there is no such thing as a free lunch. You are paying for that.”
Feldman asserts that the safety and guaranteed money an indexed annuity promises can be structured in non-annuity vehicles. For example, an investor can split their money between 80 percent in conservative bond funds and the remainder in stocks. The bond funds “will appreciate over the 10-year period, so even if the stock funds do very poorly, you know after that 10 years the bond funds will compensate for that loss and you will be made whole,” Feldman said. “But you will have to be satisfied with lower rates of return, because you are exposing yourself to much less risk in that situation.”
Feldman further maintained that the major selling point of an IA—a guaranteed rate of return—is something of a mirage.
“They are not really guaranteeing 5 percent on your principal, they are guaranteeing 5 percent on what they call an income base,” he says. “The income base is what in 10 to 15 years you can draw on. They bring in life expectancy and other factors to be able to promise a certain payout in retirement. So they are not really guaranteeing your principal, they are guaranteeing an income stream at retirement. People don’t realize because they have a limited life expectancy you don’t have to have your principal grow in order to promise a certain amount of a payout.”
Complexity, illiquidity and lack of upside potential are Michael J. Hardy’s main objections to indexed annuities. Hardy, a CFP, is a partner at Mollot & Hardy, Inc., which has offices in Buffalo, N.Y. and New York City.
“My hang up with indexed annuities is that they are awfully complicated for the average person to understand,” Hardy said. “If you have an investor going into one of these products, are they truly going to understand what they have five to 10 years later? It’s also the illiquidity, the fees and penalty issues. And also a lack of upside that one has in the contract. I’m not against annuities. I think they certainly have their place for certain people and I do use them for clients. But I’ve never been able to fully find the reason to use indexed annuities.”
Rather than an indexed annuity, Hardy said he steers client towards fixed annuities or a variable annuity.
“[For a] retiree who wants a portion of his retirement portfolio in something fixed or guaranteed we might use a fixed annuity,” Hardy said. “Or for a client who may be in his 50s who is maximizing his retirement plan and needs another tax-deferred place to place income, a variable annuity would be a great product for somebody like that.”
Sheryl Moore, president of Annuity Specs.com, in Des Moines, Iowa, said the primary reason for the negative reaction against indexed annuities is a misunderstanding about how insurance-only agents, who sell IAs, and registered reps, who sell securities like variable annuities, are compensated. Insurance agents get an upfront, one-time-only commission for an IA, while registered reps are paid yearly on how well a client’s portfolio performs.
Consequently, a registered rep sees the commission on an IA and assumes it’s too high a price for a policyholder to pay, Moore said. However, when spread over the life of an IA contract, that one-time commission equates to what a registered rep would get on an annual basis. “You’re comparing 1.5 percent a year every year for four years to 6 percent upfront on a four-year product which is exactly the same,” she said. “They don’t understand the commission works different than theirs, so automatically it’s a high commission product and that means it’s not good for the client.”
Further, Moore said that she believes much of the disdain for indexed annuities stems from past suitability issues with one company and one product in particular. “The whole index annuity industry got a bad rap because of it,” she said.
High commissions are also a thing of the past. When IAs first came on the scene in 2000, some advertisements touted indexed annuities with commissions as high as 16 percent. Yet Moore pointed out that due to state regulations, surrender charges have gone down, and with them, so have agent compensation. She cited three IAs that currently offer double-digit commissions in the 10 percent to 12 percent range, which don’t account for much in the way of sales. The highest commissions tend to be around 8 percent, she said.
“Indexed annuities are far different today than they were even four years ago. Today, there is no such thing as an indexed annuity with a 16% commission,” Moore said.
Currently, insurance agents receive an average commission of 6 percent on an indexed annuity contract, according to Moore. “That commission is paid one time and he has to service the contract for life.”
With that said, Moore agreed that indexed annuities are not for every investor and, yes, upside potential is limited. For that reason someone who doesn’t mind having their portfolio rise and fall on the gyrations of the stock market would be better served with a variable annuity.
“The indexed annuity is more for the person who says, look, I don’t feel comfortable losing a single penny of my money,” Moore said, “and if that means I don’t get the whole 20 percent when the market goes up 20 percent, that’s OK with me. I just want to be able to outpace my CDs or fixed annuities.”
Not all registered reps are anti-indexed annuities. Matt Golab is a registered investment advisor and a licensed insurance agent at Aaron Matthews Financial Resources in Elk Grove, Calif. He said that in certain instances, particularly for older clients, IAs make perfect sense. The problem may lie, he asserted, with salespeople not fully understanding the product and therefore, misrepresenting its attributes to potential buyers.
“There are people who are presenting these as stock market equivalents but there is a reason 151A didn’t pass and it’s because the risk and the income potential just isn’t there,” Golab said. “These index annuities are designed to compete with savings products, jumbo CDs, high-yield CDs, and give a little bit better return. They are designed to compete with themselves, with a fixed annuity. They are not designed to be giving a 20 percent to 30 percent [return]. I think maybe the lack of education from some salespeople gets these presented to people in the wrong way, which leads to some of the negative publicity.”
As for the lack of upside potential, Golab said that due to stock market upheavals in recent years, some investors are fine with earning less on their money even when the market has a steep rise. “Because of what the market has done to their balances the past 10 years, they are very comfortable with [that],” he said.
And for some investors, the income riders on IAs are particularly appealing, Golab said. “Whether it’s an IRA or a non-qualified account, if people are looking for income, guaranteed at an absolute minimum, the income rider that is offered on these equity indexed annuities is just unmatchable,” he said. “It comes back to education. These are either being offered incorrectly or not offered at all. And that leads to negative publicity. But they are such useful vehicles for accomplishing what retirees are truly saying [they want], not how we fit it into what we know.”
Yet, income riders must be explained to the buyer properly, Golab stressed. “Too many times we hear that that income rider percentage is a real interest rate. That’s not what it is designed for. It’s not an interest rate. It’s something to guarantee people an extra pension sometime in the future,” he explained. “In that way, these equity index annuities are very fitting for people’s retirements, based on what they need.”
It all comes down to selling the most appropriate product to each individual. Criticizing any insurance product is wrong when it turns off potential buyers who may benefit from the contract, Moore said. “Every product in the insurance industry is suitable for somebody.”
Can the two sides ever get along? There are some signs of a thaw between the two parties. As Moore pointed out, several carriers have recently introduced IAs to be sold via banks and wirehouses. “So that disposition about indexed annuities being a ‘bad’ product‑that is going to go away,” she said, “and we are not going to see the badmouthing of the index annuities that we used to.”