How to Get an A on the Exam

In the last few issues of Research magazine, I have been “grading” different variable annuity products and focusing on the value of promises associated with guaranteed living income benefits (GLIBs). According to industry estimates, GLIBs now account for almost 80 percent of new sales of VAs, which were approximately $31 billion in the first quarter of 2010, according to Morningstar. The volume of this business is remarkable when you consider that GLIBs are an insurance rider that didn’t really exist a mere 15 years ago. If you missed some of these product evaluations, you can find links to previous Annuity Analytics articles and related in-depth information at my newly re-designed website www.MosheMilevsky.com.

As these columns have hit the newsstands, so to speak, many readers (and some manufacturers) have contacted me to ask exactly how I evaluate these products and specifically what it takes to get an A on this so-called final exam. Since I’m in the education business and am used to these questions from generations of anxious college students, in this month’s column I will discuss the factors that are likely to earn a product an A+ (a.k.a. the coveted 10/10.) Consistent with the exam analogy, however, I can’t quite solve all the questions for students in advance, but I’ll offer some guidelines. Allow me to focus on five general factors.

1. The Buyer

If I can play the role of financial psychoanalyst for a moment, I believe there are three distinct personality types for whom the variable annuity makes sense. Imagine the financial advisor as a parent with three types of children. The first child is concerned with income-tax risk, and specifically the fear that income-tax rates will be increasing (or tax cuts will be phased out) very soon. The second child is concerned with a lack of corporate pensions, guaranteed retirement income and the impact of longevity risk. The third child may or may not be worried about what scares the first two children, but is fearful about financial markets in general and the volatility of stock prices in particular. The third child is concerned about investments losing value and wants protection before wading back into the water. For the time being, the third child’s money is under the mattress. Occasionally these personalities are merged into one composite (and complicated) individual, but at a minimum, there is a distinct risk that worries them.

So, the ideal product makes it clear, in both design and description which personality (child) it is targeting. Products that perform well in targeting the proper fear score highly in my ranking. I am not a fan of products that take the “kitchen sink” approach to riders and confuse the phobias. Case in point is a so-called nursing home rider on a GLIB. At first glance it appeals to those fearful of dying penniless in a decrepit old-age home. But upon further inspection these only allow for an increase in your allowable withdrawal rate. Is this truly nursing home coverage? I don’t think so. The prescribed therapy does not match the client’s phobia.

2. The Rates

A 6 percent rate is always larger that a 5 percent rate. A compound return is better than a simple return, and stacking (i.e., giving you the best of both) is better than either a roll-up or a step-up, by definition. This is simple math and relatively easy to compare across products. Guaranteed payout rates that increase with age are better than flat constant ones, etc. Increases that end after 10 years are less preferable than those with 15 years to run, etc. Numbers lend themselves to comparison, but too often end up the only thing being considered. Numbers crowd out subtle but important differences that spreadsheets can’t evaluate. I would hate to pick insurance company A over insurance company B simply because they were offering a bonus of 5 percent versus 5.5 percent. There are myriads of other factors where they may differ. I doubt that a 50 basis point difference in a guaranteed payout, which is worth a lot less than you think on a present value basis, can reverse the tide. In fact, even 1 percent spreads may not be worth the hassle. Sure, a 30-year U.S. Treasury bond that pays a 4 percent coupon is undeniably preferred to a 30-year bond paying 3.5 percent. There are no ifs, ands or buts. But the same can’t and should not be said about VAs. The lesson here is that a product that screams “we pay more than the competition” — even if it is true — will not necessarily garner a top score. Sizzle might sell the steak, but it doesn’t satisfy the health examiners.

3. The Investments

While the consensus from wholesalers and other product experts seems to be that the promises and guarantees are what differentiate variable annuity products and companies from each other, I lament the ongoing marginalization of the investment and subaccount chassis.