In the first 9 months of 2005, indexed annuities continued making impressive sales gains and claimed an increased share of overall fixed annuity sales compared to the same year-earlier period. But 3rd quarter 2005 data shows indexed annuity sales actually fell from the prior quarter and the same quarter last year. (See Charts 1 and 2.)

There are several possible reasons for the 3rd quarter’s decrease. A lot of negative publicity has come out regarding these products, including a series of lawsuits arising from allegedly unsuitable sales of indexed annuities to senior citizens.

Some of this negativity also has arisen from public comments by National Association of Securities Dealers officials.

The NASD’s expressions of concern have not been limited to public statements. In August 2005, NASD issued its Notice to Members 05-50 advising that members are responsible for supervising indexed annuity sales by their registered representatives.

The many repercussions of NTM 05-50 reportedly have included considerable confusion and trepidation among dually licensed independent producers.

On an anecdotal basis, it appears that many of these producers have stopped selling indexed annuities and turned to variable annuities as a replacement. These anecdotal accounts gain some credibility by the fact that sales of VAs increased in the 3rd quarter even though the S&P 500 essentially moved sideways–an unusual occurrence.

It is estimated that some 60% of all independent producers hold a securities license. Since the vast majority of indexed annuity sales are generated by independent producers, any reluctance to sell these products on their part would inevitably have a significant impact on overall indexed annuity sales.

Other factors may be having an effect, as well. One is a trend toward shorter-duration indexed annuity products. Shorter surrender periods tend to lower caps on rate of participation in the increase of an index. This is the case because carriers invest in shorter-term fixed income instruments to back the product’s minimum guarantees. The lower the cap or participation rate, the less upside potential an indexed product appears to offer.

Shorter-term interest rates also may have had an impact. Rates rose steadily in 3rd quarter 2005. Rate increases might actually be expected to have had a positive effect on indexed annuity sales. Insurers are able to offer higher participation and cap rates as rates rise because they need to reserve less money to back minimum guarantees. From 2003 through September 2005 there was a .71 positive correlation between 5-year Treasuries and indexed annuity sales.

So, why did 3rd quarter sales drop as rates rose?

Keeping the 3rd quarter’s flat yield curve in mind, short-term Treasury rates may have reached the point where indexed annuities compared unfavorably to Treasuries and bank certificates of deposit. Investors expect to receive a risk premium from an indexed annuity. This risk premium is reduced as shorter-term rates rise.

In terms of indexed annuity sales by distribution channel, banks are the big story. Their share of indexed annuity sales more than doubled from 3.35% in 3rd quarter 2004 to 7.85% in 3rd quarter 2005, according to our studies. (The independent producer channel’s share of sales declined by a corresponding percentage, from 93% in 3rd quarter 2004 to 87.5% in 3rd quarter 2005.) Bank sales also rose in absolute terms, among our study participants. Sales peaked in March 2005 but were still considerably above 2004 levels.

This sales growth is attributable, in part, to concerted and successful efforts by several insurance companies to market indexed annuities through banks.

Captive agents’ share of indexed annuity sales has risen modestly, from 2.67% in 3rd quarter 2004 to 3.4% in 3rd quarter 2005. On a dollar basis, sales have been rising slowly but steadily since 2003.

The broker-dealer market share is small and virtually unchanged, hovering slightly above the 1% level. It is interesting to note that independent broker-dealers’ share actually declined to 0.55% in the 3rd quarter 2005 from 0.72% in the previous quarter.

Looking ahead, some shifting in indexed annuity sales from the independent producer channel to independent B-Ds is likely to occur in 2006. This is as a result of NASD Notice 05-50.

The impact of this shift on overall indexed annuity sales is difficult to predict. In the near term, the effect probably will be somewhat negative as independent broker-dealers go up a learning curve regarding how to select, distribute and supervise the sale of these products.

Longer term, there may be a negative effect because of reduced incentives to dually licensed producers. Independent broker-dealers seem to be choosing shorter-duration, lower-commission indexed annuities for their product lines. They also tend to keep a larger portion of commissions than organizations distributing nonregistered insurance products.

Because independent broker-dealers also distribute variable annuities, they may themselves have less incentive to encourage the sale of indexed products than insurance marketing organizations do. On the other hand, the shift may well stimulate indexed annuity sales if there is closer, more effective supervision on the part of independent broker-dealers.

Such supervision probably would result in fewer unsuitable sales and less negative publicity for these products.

Yield curves are likely to get steeper in the future, but the impact on indexed annuity sales is hard to predict. Carriers will be able to offer higher participation rates and caps. But indexed annuities also will face more competition from traditional fixed annuities and other fixed rate investments as a result.

Jeremy Alexander is president and CEO of Beacon Research, Evanston, Ill. His e-mail address is jeremy@beaconresearch.net.