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Why I'm bearish on annuities

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Ok, yes I might have stolen my title from the investment guru Ken Fisher (If I only knew how to use hashtags, then I could make this so much cooler). I’m sure you’ve seen the Forbes’ columnist’s advertisement stating “I hate annuities, and so should you!” Interestingly enough, as of 6/30/2014 Fisher Investments was the 6th largest shareholder of American Equity.

Although Mr. Fisher clearly doesn’t think much of annuities, he could assume it’s a great money maker for insurance companies. However, how many companies are successful if the product they produce isn’t worthwhile or competitive? I’m not sure Sir Ken really “hates” annuities as he proclaims. I think he’s just bearish on them. Maybe he sees an annuity industry full of bullish propaganda and thus hasn’t looked fully at all the positives.

Are you bullish on annuities or bearish? I love annuities (fixed annuities, but that’s a different post) and I’m bearish because of the mechanics most of us ignore.

Last year I sat in a conference where the attendees were able to ask questions to some of the top agents of one particular carrier. The conversation led to index strategies: which one was the best, how do they explain it, when do they switch to this one or that one. I was astonished at how many agents felt they could pick the right strategy at the right time.

Different strategies capture different gains during different market styles. Thinking you can pick the right strategy at the right time is no more insane than thinking you can time the market correctly.

So which is best? Uncapped, capped, spread, average, participation rate, etc…they’re equal despite what some marketing pieces might allude to. The key here is to understand the underlying concept. The insured gives the insurer $100 dollars. The insurer invests $92-$93 in bonds with a maturity date very close to the surrender schedule of the annuity purchased. The remaining goes to overhead, to commissions and to options.

How do you know how much is going to purchase options? Simple. What’s the fixed interest rate in the annuity? If it’s 2 percent, then $2 out of every $100 went to options. In English, this simply means the insurance carrier has $2 to spend for any of the indexing strategies the insured chooses. This is very important.  

If one strategy is capped whereas another is uncapped, then does the insurer pay different amounts for different options? No! If there are five indexing strategies, they spend the same amount on any chosen. Don’t agree yet.

Think about it this way, an insurer has a desired spread, which is what they earn on the general account minus what they spend on the annuity. They’re not going to enter into an agreement whereas one particular indexing strategy they will achieve their desired spread while another strategy they do not. This concept would not be actuarially sound.

Thus, the insurer spends the same for each index strategy. Now let’s look at this from the viewpoint of the company selling the options.  Again, let’s use the $2 example. No matter which option they sell the insurer, they’re only going to receive $2.

Obviously, some options are likely to credit more frequently but at a lower amount, whereas some have the opportunity to have big returns but less frequently. It’s sort of like betting. Let’s say you have $100 and you want to bet on one particular team to win the BIG10 title. If you put your $100 on Michigan State, you’re payout is going to be far lower than if you put your $100 on the University of Michigan (that was hard to write being a lifetime U of M fan).

So, if your bet on MSU is 2:1 and U of M is 10:1 does that mean betting on U of M has a higher upside potential? Not in the long run (bearing in mind you take out your favorite team bias). Be bearish, stop promoting what a strategy can do and start focusing on what the annuity will at least do.

What will an annuity at least do? It’s simple. An annuity will never do worse than its guaranteed minimum cash surrender value. The GMSCV should be discussed with every client at purchase and at delivery. Why? The contract cannot ever do worse. You must build a plan on what you know the product will at least do, rather than what it might do. 

Back to my story about the annual conference I attended. After the conversation and heated debates about indexing strategies, I wondered if we were doing something wrong. I took a home office rep aside, why they all get the title VP now is beside me, but I asked him, “We don’t spend any time on which strategy will do or could do what.” He replied, “Well what do you focus on?” to which I went on to explain how we discuss two values.

The first value is the guaranteed cash surrender value. How it represents the index never crediting a single penny and how even if this unlikely scenario occurs, they will still have earnings (albeit quite small). The second column we discuss is the annual income. 

Maybe you’re thinking this is where we promote rollups, or stacks, or income value rates. Don’t pay attention to these — once again, they are marketing gimmicks. It’s not about the rollup, or the stack, or the IAV rate, it’s about the guaranteed income. People hear an agent say 6.5 percent rollup and they hear 6.5 percent interest. Instead try, “Mr. Client, your income will increase by 6.5 percent each year you defer this contract.  Your guaranteed income then will be no less than this per year at this date or that date.” 

Why does someone surrender an annuity policy? Why do they complain? Do they do either of these if they have received everything they expected to receive? Of course not. People change course or file a complaint when they’re dissatisfied with the results experienced. I read a column recently that said each sale is when current dissatisfaction, plus future promise, which is greater than cost plus fear.  

If someone is a right fit for a fixed annuity, you don’t have to promise bullish gains, rather, you promise bearish gains. Promise the safety of principal and credited interest. Promise guaranteed income. Promise what you can promise. Don’t set yourself up to lose a client you worked hard to get because you gave them bullish promises that becomes their future, current dissatisfaction.