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Reversal of fortunes

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Only a few years ago, many within the advisor community viewed fixed indexed annuities (FIAs) as troubled products. Hybrid solutions that incorporate features of both traditional fixed and variable annuities (VAs), FIAs were shunned by financial professionals who desired the greater growth potential of VAs and other equity-based vehicles.

Many, too, were critical of the products’ seeming complexity, believing the plethora of moving parts a hard sell. Also, life insurance agents who don’t sell securities were uncertain of the products’ future because of the prospect of regulation by the Securities and Exchange Commission (SEC).

How times have changed. Today, FIAs are among the best-selling products in the annuities marketplace, as reflected in recent industry data. Market research firm LIMRA, Windsor, Conn., pegged FIA sales at $8.7 billion in the third quarter of 2012 and at $25.4 billion for the year-to-date. LIMRA expects that (once its tally is finalized) FIAs will have a “record-breaking” year, thanks in part to robust sales of the new players.

In contrast, the LIMRA survey shows, fixed annuity sales plummeted 13 percent, closing the third quarter at $17.7 billion and year-to-date sales at $54.1 billion — abysmal numbers not witnessed since early 2007, when investors were in thrall of equities.

The robust FIA sales, say experts, can be credited in part to increased industry competition and product innovations that have made FIAs more appealing to pre-retirees. Also a major factor is the FIA’s superior performance in recent years relative to alternative retirement vehicles, among them once high-flying VAs.

“The critics have been proven wrong, as the fixed index annuity has demonstrated an ability to perform better than what they thought possible,” says Tim Barton, a chartered financial consultant and principal of Future Financial Images, Pepin, Wis. “FIAs yielded an average rate of return of from three to five percent during the recent market turmoil. No other investment vehicle I know of has done this.”

The products’ signature features — principal protection, the ability to secure a guaranteed rate of return with the potential to capture a percentage of equity market gains—are proving increasingly attractive to producers who want to offer clients a safe alternative to variable annuities, mutual funds, ETFs, stocks, and other vehicles vulnerable to market fluctuations.

Tied to an index (typically the S&P 500), the FIA has credited a rate of return based on the allowed percentage of the gain in the index. This number, the participation rate, typically ranges from 50 percent to 100 percent of the index price gain, excluding dividends.

Some FIA carriers also place caps on the amount of interest that can be credited to an indexed annuity. Most FIAs additionally entail a surrender fee, assessed as a percentage of assets or as a charge to earnings. The latter, known as a market value adjustment, might kick in when the investor trades in one annuity for another paying a higher interest rate.

A burgeoning market

The surging demand for FIAs among consumers, experts say, are prompting more annuity manufacturers to jump into the market—among them providers previously dedicated to VAs. The new entrants include Genworth Financial, Oxford Life, The Phoenix Companies, Security Benefit and other carriers that are competing with the market’s traditional players: Allianz Life, American Equity, Aviva U.S.A. and Lincoln Financial Group.

The increased competition, say market-watchers, has engendered a wave of market innovations, starting with more appealing product designs. While today’s FIAs retain the signature components and indexing methods (e.g., annual reset, point-to-point, high-water mark) of earlier iterations to calculate account value gains, many of the new products offer shorter surrender charge periods, greater liquidity and less complex vesting schedules than in years past.

The new products now also boast guaranteed living benefits that FIA proponents say are superior to Guaranteed Living Benefits (GLBs) featured in more market-sensitive variable annuities. Whereas, for example, VA owners generally have to annuitize their products to secure the guaranteed minimum income benefit, many FIA products let investors stop and start income benefits to accommodate changed financial circumstances.

And, expert say, the products’ GLB riders generate more income than do their counterparts on VAs.

“The FIA’s income guarantee is significantly higher than on what you’d see on a VA,” says Dana Pedersen, vice president and product officer of The Phoenix Companies, Hartford, Conn. “Though the rate of return on a VA may be greater, the FIA’s living benefits are better able assure a lifetime income stream.”

Also favoring FIA sales is the certainty that producers can market the solutions as insurance products, free of regulation by the SEC. Credit for this goes to a July 21, 2009, decision by a three-judge federal appeals court panel that exempted fixed indexed annuities from SEC jurisdiction, as per the proposed Rule 151A, which would have classified the annuities as securities.

The favorable developments for FIAs come, observers say, at a time when interest in variable annuities is waning, both among consumers whose VAs were pummeled during the credit crisis of 2007-2009; and among VA manufacturers that have found supporting the products’ GLBs overly challenging under current market conditions.

Indexed annuities, say experts, also compare favorably with traditional fixed annuities, which are suffering from record low interest rates. Prevailing crediting rates, sources say, are little better than the payout on other fixed income vehicles like bank CDs, Treasuries, municipal bonds, money market funds and savings accounts.

Even if one assumes no equity market gains, says Barton, indexed annuities can produce a higher income or withdrawal rate than available through a straight fixed annuity, depending on how the FIA’s income or withdrawal benefit is structured. “That’s important when you consider that retirees face on average a one in five chance of portfolio failure — running out of money — if you assume a four percent annual withdrawal rate,” he says.

Product showcase

To illustrate, Barton invokes a key product in his portfolio, the Allianz Life 360. The FIAs’ built-in Guaranteed Lifetime Withdrawal Benefit (GLWB) provides an interest bonus equal to 50 percent of the interest rate credited to the contract until withdrawals begin. When contract holders reach age 40, the product increase the income withdrawal percentage with every year they hold the contract before starting income withdrawals.

If another bonus option is desired Barton could, alternatively, recommend the Allianz 222 Annuity, which the company launched in January. The product offers a 15 percent bonus on premiums paid during the first three contract years, plus an interest bonus equal to 50 percent of interest earned from allocations.

When the policyholder starts receiving income, lifetime income withdrawals can increase based on interest earned. Additionally, qualifying policyholders can double their annual maximum withdrawal. And beneficiaries can receive the annuity’s accumulated value in a lump sum or the protected income value as annuity payments over five years.

“One of the benefits of the 222 contract is that it will double your income payments as long as you are confined to a nursing home or assisted living facility,” says Eric Thomas, a senior vice president of sales at Allianz Life. “The product can accelerate payments in situations where clients need more income because of higher health care costs.”

Other FIA providers are rolling out innovative new features to distinguish themselves from the competition. Case in point: the CapMax solution from Richmond, Va.-based Genworth Financial.

Indexed to the S&P 500, the option uses an interest crediting strategy that allows investors to “roll forward” a portion of their current year’s interest credits in exchange for a “CapMax Multiplier” that can increase the following year’s growth potential. Additionally, policyholders can take all of their available interest credit to further increase the contract value.

“You can forgo using the CapMax as an annual point to point strategy if you believe the market will not perform favorably the following year,” says Eric Taylor, national sales manager for annuities at Genworth Financial. “But if you do decide to use the crediting strategy for a CapMax-eligible annuity, you have the option to do so and compound your gains.”

Using a typical point-to-point strategy, Taylor adds, a hypothetical client who enjoys market gains of 3.5 percent in successive years would have only 7 percent at the close of year two. But by applying the gain of year one to year two (thereby securing the multiplier), the cumulative gain at the close of year two will be 10.5 percent.

Consider also Security Benefit Life’s new Foundations Annuity. Leveraging the general account capabilities of Guggenheim Investments, a subsidiary of New York-based Guggenheim Partners, the solution guarantees the investor’s principal and a one percent bonus on first-year premium payments. The product also features three interest-crediting strategies tied to equity market growth, plus a guaranteed withdrawal benefit rider.

“Simplicity, transparency in product structure, and reasonable expenses are critical to helping clients understand and embrace solutions to the retirement income challenge,” said Doug Wolff, President, Security Benefit Life, Topeka, Kan. “We’ve built these into the annuity, which I think will be the ‘go-to’ product for financial advisers and their retirement-oriented clients.”

Perhaps. But whether clients opt for Security Benefit’s solution or one from a different provider, there is growing body of evidence to suggest that making a fixed indexed annuity offering a GLWB part of an asset allocation strategy will yield greater retirement income than without the rider.

The research also reveals that combining a FIA with a GLWB rider and traditional mutual fund drawdown strategy is more likely to sustain annual income throughout retirement than either (1) a traditional mutual fund withdrawal strategy alone or (2) a combination of a variable annuity with GLWB rider and a traditional mutual fund drawdown strategy.

“A study from an independent actuarial consulting firm concludes the failure rate for running out of money during retirement is much lower with a FIA than without,” says Wolff. “With a traditional mutual fund spend-down strategy, one in five plans fails. The second option — a mutual fund portfolio combining equity, bonds and a VA with a GLWB rider — yields a failure rate of one in six. But the failure rate is only on in 40 when you couple a mutual fund strategy with an FIA offering a GLWB rider.”

Fixed indexed annuities, say experts, also fit nicely into a laddering strategy, wherein the client purchases multiple annuities, each of which starts income payments at different points in time and engenders a level of market exposure to match. The first “income bucket” of the ladder will typically include a single premium immediate annuity (SPIA) that pays out principal and a guaranteed minimum interest rate over, say, five years.

Subsequent income buckets may include a fixed indexed (or variable) annuity that pays income between years 6 and 10 and 11 and 15; and thereafter mutual funds, ETFs or alternative investments that entail a higher level of market exposure and, thus, risk. But because of these vehicles’ longer time horizons, they avail clients of the chance to recoup losses during the intervening years.

When recommending such laddering for his own clients, says Barton, he generally sources products from different annuity providers, the diversification serving, in part, as a hedge against  financial risk associated with any one carrier. A secondary consideration is suitability: Some fixed indexed annuity providers will allow an individual to invest in products up to a certain limit; if the benchmark is exceeded, then Barton will source the balance to be invested in a different carrier’s FIA or, if deemed appropriate, invest the full amount in a product carrying no investment limit.

Such suitability restrictions, says Barton, make sense for clients who have little in investable assets and who only need a FIA to cover basic expenses in retirement. But for high net worth individuals, Barton insists, such restrictions make little sense.

“Clients who have a net worth of $500K or $750K should be able to put 80 percent of this amount into an FIA,” he says. “What often results is that I end up shopping carriers based on their suitability requirements in order to find a home for the client’s money.”