Is the three-legged stool off-kilter?

All annuity transactions are intended to benefit three parties:

• The purchaser, via fair credited rates/caps/participation rates, etc.
• The agent, via a fair commission
• The insurance company, via a profit (a.k.a. spread)

Each of these parties represents one leg of our stool. When each of these parties is receiving comparable benefits, the three legs on the stool all are in equal height. But if one of those legs ends up longer than the others, we face an inequitable structure.

There are a few scenarios in annuity pricing that could result in an uneven distribution of benefits. Regardless, you must remember that when it comes to annuity pricing, there are only so many pennies in a dollar (meaning that rich benefits can’t be offered out of thin air; other features must be scaled back in order to compensate for inflated features). So if one of our legs on our stool is relatively longer, that means that one (or both) of the other legs is conversely shorter. (Remember that the insurance company’s leg on the stool will generally never be shorter. If the insurance company cannot make their required spread, the annuity product will not be offered for sale.)

Considering today’s miserably low interest rate environment, it is tougher than ever to garner interest in annuities. In fact, the average indexed annuity cap is a mere 4.04 percent (for annual point-to-point strategies only). This may sound pretty good to the guy earning a mere 0.94 percent on his bank CDs; but for seniors, 4.04 percent is likely equivalent to the minimum guaranteed rate on the fixed annuities they bought before the turn of the century.

However, did you know that there are indexed annuities with caps greater than 9 percent today? Yes, annual point-to-point caps (an apples-to-apples comparison with the aforementioned 4.04 percent cap). How can that be, when our average cap is more than 5 percent less than this rate?

Return to our three-legged stool. In this example, our annuity purchaser is receiving a relatively greater benefit. And since the insurance company’s leg won’t be cut short, in order to compensate for the purchaser’s longer leg on the stool, whose leg will be cut short? The agent’s. The commission paid on such a product is significantly less than comparable products with caps that are “average.”

The average indexed annuity commission paid today is 6.65 percent. You might be surprised to hear that there are actually indexed annuities that pay commissions as high as 12 percent. When you consider such an annuity, where the agent’s leg of the stool is relatively longer, who is getting the “short end of the stick?” Remember what I said about the insurer’s spread; they always make their profit. I think you get the idea.

If it looks too good to be true…

Many seasoned insurance professionals still don’t understand this basic concept of annuity pricing. There are many other examples where stool legs can be a little off-kilter: renewal rates, surrender charges, annuitization rates. Ultimately you need to ask yourself a simple question: