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Do’s and Don’ts of Index Annuities

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Beacon Research recently reported that fixed index annuity sales hit a record $14.4 billion in the third quarter of 2015, up 14.5% versus the previous quarter. While this is still well below the $32 billion in variable annuity sales that Morningstar reported for the same quarter, the industry is taking note that index annuity sales continue to grow, while variable annuity sales drift downward.

Morningstar calculates that variable annuity sales dropped 10% quarter over quarter. The increased sales in index annuities is partly due to more consumer-friendly product designs that have made the product more acceptable to broker-dealers and banks, and partly due to demographic trends that are making the product more appealing to baby boomers, who continue to put increasing value in the return of their money versus the return on their money.

Generally, when a financial product of any kind experiences significant growth, it is not uncommon for the product to be misunderstood or incorrectly positioned. In hopes of keeping that from happening, I have outlined my Do’s and Don’ts when recommending index annuities as a potential solution for your clients. While each investor’s financial situation is different, below are some general guidelines you can consider when discussing these products.

1. Don’t suggest that an index annuity is an alternative to equity investments. Do suggest that the product is designed as a potential alternative to investments designed to protect capital.

If your client maintains a 60/40 equity/fixed income portfolio, the index annuity fits into the 40% fixed income portion. It does not belong in the 60% equity portion and should NEVER be described as if it gives the client the upside (or even most of the upside) of the equity markets without the downside.

Ultimately, an index annuity is a fixed annuity with an uncertain rate of interest each year. In exchange for giving up a guaranteed return, the client should get, on average, 1%–2% more per year over the long run. While the ultimate interest rate, if any, may be determined by an equity index such as the S&P 500, that does not mean the annuity is designed to provide equity type returns.

2. Don’t ever compare historical (or hypothetical) index annuity returns to historical returns on the S&P 500. Do compare historical returns to historical returns on CDs and traditional fixed annuities.

This one is really more No. 1a than No. 2, but I thought it was important enough to highlight separately. Given the poor equity performance of the previous decade, it would not be difficult to find a time period where index annuities would have returned more than the S&P 500.

However, any such comparison automatically causes the client to view an index annuity as an equity alternative. Sure, such a comparison will make it easier to sell an index annuity, but do you really want to create that expectation in the client’s mind?

3. If you are recommending an index annuity with a living benefit, don’t overstate the potential income from that benefit. Do make sure the client understands that the income guarantees on the date of issue are the most the client will receive.

On the day the index annuity with a living benefit is issued, if the client can tell you when she wants to start the income, you can tell her exactly how much she will receive each year for life. That certainty is one of the attractive features of the product.

Think of it as a deferred income annuity with more liquidity. Technically, most product designs say that if the account value ever exceeds the income benefit base, the client will get a “step-up” and the income will increase.

But let’s be realistic here. Given the cap rates and spreads required by today’s interest rates, the account value will never grow faster than the guaranteed growth in the income base. Therefore, unless you are working with a living benefit design that calculates the income on the account value, rather than the income base, there will not be an increase in income beyond what was guaranteed on Day One of the policy.

4. Don’t let the client believe that the income benefit base is real money. Do make sure the client understands that the guaranteed growth in the income base is only used to calculate the amount of income and has nothing to do with the return on the policy itself.

I’m continually amazed at how often we find index annuity policyholders who insist that their policy is guaranteed to return 5%–10% per year. It’s important that you go to great lengths to make sure your clients understand that the income base is not real money.

I would suggest you follow the advice of Johnna Chewning, Raymond James’ index annuity product manager, and refer to them as income sky miles. Just as your sky miles are only used to translate into free flights, the income base is only used to calculate guaranteed income.

Your job on this score would be much easier if the insurance companies would quit putting a dollar sign in front of the income base. After all, the credit card companies don’t put a dollar sign in front of your rewards points. So, for those of you with insurance companies reading this article, please help us out here.

As I finish writing this, the equity market continues to exhibit volatility and negative short-term performance. While an index annuity might not belong in the 60% sleeve, it is a viable alternative if the client wishes to reduce his equity sleeve from 60% to 50%.

It’s also a good alternative if he wants to reduce his interest rate risk within his 40% fixed income sleeve. It’s these two facts that will continue to drive index annuity growth for years to come.

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