There is a curse that frequently gets quoted when things get chaotic: “May you live in interesting times.” The first half of 2008 has certainly qualified as interesting for financial advisors and their clients. Oil prices are approaching $150 per barrel, fueling inflation, squeezing profits at many businesses and straining household budgets. Home prices continue to fall in many parts of the country, damaging real estate’s reputation as a reliable hedge against inflation. The credit market crisis continues to drag on and many of the world’s stock markets, including those in the U.S., have entered bear market territory or are hovering on the border. Interesting times, indeed.
Not surprising, volatile investment markets and low interest rates have benefited annuity sales. LIMRA International reports that sales of individual annuity sales increased by 9 percent over the first quarter of 2007, to a total $63.4 billion. Fixed annuity sales grew faster than variable annuity sales — not unexpected, in light of the market’s performance. Total fixed annuity sales, which includes fixed deferred annuities (book value, indexed and market-value adjusted annuities), as well as immediate annuities and structured settlements, reached $21.3 billion, up 31 percent compared to the same quarter from a year ago. Fixed deferred annuity sales jumped 34 percent to $18.0 billion while fixed immediate sales improved 21 percent to $1.7 billion. Structured settlements gained 7 percent, reaching $1.6 billion when compared to the same quarter a year ago. Sales of variable annuities slowed versus sales growth over the last two and a half years, rising only 1 percent over the first quarter of 2007, reaching $42.1 billion.
There are a few clouds on the horizon for annuity producers, however. Regulators and the media are paying considerable attention to sale practices, specifically the issue of client suitability. Additionally, the Securities and Exchange Commission has proposed to start regulating index annuities as securities, a move that could significantly disrupt agents’ and insurers’ business practices.
Unfortunately, some advisors sell annuities as a financial panacea that will work for every prospect they meet. That approach generates criticism from regulators, experienced advisors and the media. James Tyrpak (MSFS, CLU, ChFC, AEP), with Desmon Kohnstamm & Tyrpak in Williamsville, N.Y., completes a comprehensive review of a client’s finances before he recommends an annuity or any other solution. The current president of the Society of Financial Professionals, Tyrpak considers the types of accounts the client uses and any restrictions on the accounts’ liquidity. “For example, if they have IRA assets and are not quite age 60, they may not have access to those assets because of the potential penalties that the IRS would charge on withdrawals prior to 59 1/2,” he says. “If there are pension assets, do they have the ability to access them or are they tied up until they terminate from employment? Do they have bank accounts, do they have CDs that are about to mature? We look for liquidity availability beyond the annuity, because liquidity is a very important factor in determining if the person has resources to tap other than this annuity.”
Ray Benton, CFP, an investor advisor with Lincoln Financial Advisors in Denver, says most clients, regardless of age or financial situation, need cash and other assets that are not subject to market risk. For those clients with sufficient no-risk holdings to justify diversification (and who could benefit from tax deferral), Benton considers annuities. “It makes sense in almost any situation where you have the time to set these funds aside and the tax deferral is meaningful,” he says. “In the case of older people, it can allow you to do things like control the taxability of their Social Security benefits if they have a lot of CDs and things like that creating taxable income. If they’re re-investing it and it’s throwing them into a situation where their Social Security is taxable, the annuity can give them the tax deferral, safety of principal, and provide a rate that’s generally a higher yield than what they may be getting from shorter term CDs.”
Fixed and variable annuities play different roles in a portfolio, requiring advisors to take a holistic view of the client’s holdings. David Stratton, CLU, ChFC, with Stratton Turner LLC/Lincoln Financial Advisors in Anchorage, Alaska, follows a two-part fact-finding process developed by his broker-dealer, Lincoln Financial Group, to learn about the client’s finances. One part of the interview covers non-financial themes while the other focuses on financial topics. When asking about the client’s financial resources, Stratton asks for the details of any pension benefits that the client can claim. “We take a close look to see if the client has a defined pension plan, because today’s annuities work very similarly to defined benefit pension programs,” he says. “And we check to see if any of their retirement plans are indexed for inflation, and what the survivorship situation is going to be if they have a spouse. Of course, one of the questions always is whether or not they want to leave a legacy for their kids or possibly some type of charity. Once we get through that process and have a real good understanding of what the client already has to generate retirement income, that’s when we start to think about the possibilities that an annuity with the right riders could provide in their long-term retirement income plan.”
Proposed index annuity regulations
On June 26 the SEC shook up the index annuity market by proposing to regulate index annuities as securities. The new regulations would require companies that sell equity index annuities to provide prospectuses and other securities disclosure statements to prospective buyers. Insurance-licensed agents who had previously qualified to sell the products would be required to affiliate with a broker-dealer and obtain their securities licenses. (The SEC’s proposal is available on the agency’s Web site: http://www.sec.gov/rules/proposed/2008/33-8933.pdf.)
Reactions to the proposal from the advisors interviewed for this article were mixed. Several believed the SEC’s intervention was needed in response to reports of improper sales practices while others believed existing state-level regulations were adequate. Susan Voss, Iowa’s insurance commissioner, expressed disappointment that state insurance regulators were not involved in discussions with the SEC prior to the proposal’s release. Voss views index annuities as insurance products, not investments, and says she believes that state regulators can provide adequate supervision of the sales process. “As someone said to me the other day, which I think is a great kind of visual, yes, there is a very small part (of the annuity) where you have a fixed index for the additional funding that you would get on these products. But that’s like looking at a ham sandwich and saying just because there’s lettuce in it, it’s a salad.”
There would also be a business impact from the SEC’s proposal. Voss notes some insurance agents will decide against getting their securities license, and that decision could reduce index annuities’ sales. Because over 40 percent of index annuities sold in the U.S. originate from Iowa domestic insurers, that slowdown could have a negative impact on the state’s economy.
The consequences go beyond Iowa’s insurers, of course. Michelle Ross, a consultant with SEC Compliance Consultants, Inc., in Phoenixville, Pa., believes the SEC overlooked costs to the distribution channel in their proposal. The agency noted additional costs that would be incurred by the issuer — printing and mailing of prospectuses, registration statements, etc. — but ignored the increased costs some distribution channels will incur. “Where insurance companies have either networking arrangements or are affiliated with broker-dealers, it’ll be nothing new,” she says. “It will look and feel like a variable annuity and go through that same channel. But I read somewhere recently that a large portion of the individuals selling these are insurance agents and half are not registered (for securities sales). They will have to find a broker-dealer to become affiliated with and then register. Well, that involves licensing and exams and cost. Where there are insurance agents that are just pure insurance agents that are not registered who sell these products, it will have a huge impact.”
Back to basics?
Despite the controversy over suitability and proposed regulatory changes, it’s worthwhile to refocus on the role that annuities play in a client’s finances. Benton points out that it’s easy to overlook the contracts’ fundamental features and benefits that sustain the products’ viability. “For young people, annuities allow you to defer taxes for a really long period of time and then spend those assets over the course of your lifetime,” he says. “You continue to benefit from the tax deferral and you have some guaranteed floor under your income. For older people, who frequently want the income now, by using annuitization you might be able to provide 50 percent or 60 percent of your income requirement with 30 percent or 40 percent of your assets. That frees up the other 50 percent or 60 percent of the assets to be invested maybe more aggressively because you have taken care of such a substantial part of your income need. If it’s a fixed annuitization, you have guaranteed income for life, whatever that number turns out to be.”