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Is the three-legged stool off-kilter?

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Be wary of annuity pricing that appears unequal. One of the parties to the deal may be benefiting at the expense of the other.

Since entering the insurance business 13 years ago, I have attended many training sessions and scores of seminars. Often, speakers at these meetings will make reference to a “three-legged stool” as an analogy for the pillars of financial services transactions. This allows the speaker to create a more vivid image in the minds of their listeners while they instruct.

Let’s use that same reliable three-legged stool example to explain fixed and indexed annuities.
In this example, 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. Our stool stands firm when we sit on it. But if one of those legs ends up longer than the others, we are likely to face injury when relying on its inequitable structure.

What would result in such a calamity? 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 the legs on our stool is relatively longer, that means that one (or both) of the other legs is conversely shorter. (Remember, 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.)

? CDs vs. annuities

Let’s look at an example. 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). Indexed annuities’ value proposition doesn’t seem so attractive when the offer is “worst-case scenario, zero percent; best case scenario, 4.04 percent.” 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.”

? Commissions

Take another example: commissions. 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…

Every day I speak with seasoned insurance professionals that have been doing business for 30-plus years and 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 and annuitization rates. Ultimately you need to ask yourself a simple question:

? “Does this product look too good to be true?”

Let me plainly state my message: “If it looks too good to be true, it is.” Not probably, it is. This is an annuity, folks. Like a peach pie, there are only so many ways to slice it. So, the next time you see an ad for an annuity offering a 50 percent bonus ask yourself, “Is this three-legged stool sturdy or off-kilter?”