Fixing The Fixed Indexed Annuity
Let’s start this post with a word-association test. Get ready to record your immediate, instinctive, reflex reaction to the following phrase:
“Fixed indexed annuity”.
I’m going to guess that your response was not the warm & fuzzy security-blanket comfort of having guaranteed monthly income for the rest of your life.
Why do indexed annuities have such a bad reputation? They seem like a great idea for financial independence: you buy a contract from an insurance company that will pay you an income for the rest of your life. The value of the contract is tied to a stock market index. If the index goes up then your contract value goes up. You won’t lose principal when the market goes down. You’ll have a lifetime guaranteed minimum income, you’ll still enjoy some of the benefits of the (rising) stock market, and your returns will hopefully keep up with inflation.
Yet fixed indexed annuities are regularly vilified by the media (and in some parts of the personal-finance industry) as overpriced products with high expenses, unfavorable terms, and complicated contracts. So who’s selling these, and why would anyone buy one?
Jim Poolman is all too familiar with these issues. He’s the Executive Director of the Indexed Annuity Leadership Council, and he spent seven years before that as North Dakota’s insurance commissioner. He has the privilege of representing the annuity industry in its work with federal agencies and the states. He’s trying to make fixed indexed annuities do a better job for their buyers, as well as be better products for the insurance industry. I managed to tap into a FinCon connection to interview Mr. Poolman about what the IALC can do for the industry’s reputation.
Insurance companies sell annuities because they’re just another form of risk management like auto or property policies. Unfortunately (for the insurance companies) the people who buy annuities tend to live longer but luckily (again for the insurance companies) people still die at a statistically predictable rate. The insurer can’t predict when a specific client will die, but they can predict how many of their clients will die each month. The deceased clients’ annuity premiums (euphemistically known as “mortality credits“) become part of the pool of assets that pay the annuities of the living clients. Actuaries can do math, they’re very familiar with the longevity data, and insurance companies generally make a profit on their basic annuities.
As an annuity client, your goal is to live as long as you can because you won’t outlive your assets. Every retiree needs some form of longevity and inflation insurance to prevent running out of money, and a fixed indexed annuity is just one tool for the job.
Longevity insurance has many forms. For most Americans, Social Security is one of the world’s best inflation-adjusted annuities. However, it’s supposed to be a safety net (not the majority of a retiree’s income), and the program is currently paying out more revenue than it’s taking in. A military pension is very similar to Social Security, although the military pension system is in a slightly better financial condition. A few people with millions of dollars may be able to self-insure their longevity risk by investing for income from low-risk/low-return assets like TIPS, I bonds, bond index funds, or even CDs. (All of those asset classes have their pros and cons.) A very few do-it-yourself investors build equity portfolios with dividend income that hopefully grows faster than inflation, and they never touch their principal. (Their equities can be volatile, but their dividend income is relatively stable.) Some retirees will have employer pensions, and many more will have 401(k)s or other tax-deferred accounts that can be converted to an annuity.
All of these assets (even Social Security) require the investor to spend time on monitoring and management, or to pay someone to help with those chores. Most Americans don’t devote the time to become capable of (let alone “proficient in”) managing their money. Their blissful ignorance leaves them vulnerable to biased information, unsuitable assets, high expenses, and even fraud.
The clients have enough problems, but fixed indexed annuities have a few of their own. That starts when the “longevity insurance” part is blended into the “investment” part. Insurance companies can usually count on a steady series of client deaths, which diversifies their risk. However, when insurers start guaranteeing investments, they’re now concentrating their risks. Clients rely on their annuity’s market-performance guarantees when the stock market goes down. Unfortunately (for everyone) when the stock market goes down, it can hurt the insurance companies as well as their clients– all at the same time.
It’s easy for sales staffs to overburden a straightforward annuity contract with extra guarantees and riders. The trick is to balance the concentrated risk of a bear market with the contract’s guaranteed returns, and to charge the right price for the annuity. Actuaries can still do math, but there’s less market history to work with. The insurance companies are still figuring out the best way to price these types of contracts (and to explain their pricing).
Fixed indexed annuities are hard enough for the insurance industry. The clients are usually not as educated on the pros & cons. Now let’s add human emotions and investor behavioral psychology to the mix!
The problem starts with every bear market. Some investors are emotionally ravaged by the volatility, so they seek an asset with a guaranteed income that won’t lose money. Investors may already be vulnerable from their financial losses (and their emotional trauma) and they probably lack the knowledge and experience to design a better portfolio. A few unhappy people may seek a trusted financial professional who can reassure them with advice… and an attractive product with slick marketing.
In this emotional turmoil, customers can be easily misled. The contracts for fixed indexed annuities are long, complex, and confusing. The examples and illustrations are optimistic or (at best) based on inadequate data. The funds that the annuity invests in may come with high annual expenses. When sales commissions are high, the contracts have long lock-in periods with stiff penalties for early redemption. Buyers may be suffering from decision fatigue, and a few of them just want to be told what to do. The “guarantee” sounds great, but the it comes at a very high price.
Mr. Poolman’s all too familiar with the situation, and his salary comes from helping the industry improve its reputation. Here are some of the solutions:
- Companies are required to assess their customer’s suitability through risk profiles, extensive disclosures, and a review of the agent’s sales.
- Commissions are dropping, which reduces the incentive for inappropriate sales.
- Surrender periods are shorter (<10 years instead of 14-16 years).
- Contracts can allow a penalty-free cashout for long-term care expenses.
Insurance companies are also improving their annuity financial designs:
- Rising interest rates support higher guaranteed contract interest rates.
- The markets offer more options on indexes with lower fees.
- Clients seem willing to pay an extra fee for lower volatility.
The IALC could be making progress. Data from annuity lobbyists showed only 84 complaints about annuities in 2011, and only seven of those concerned fixed indexed annuities. During the same period, the Wall Street Journal reported over 1200 criminal complaints and enforcement actions in the stock market industry. Cynics in the personal-finance business might point out that many owners of fixed indexed annuities (and other unsuitable financial products) are either too blissfully ignorant to complain, or too embarrassed.
The progress is encouraging, although the industry and the IALC have a long way to go with their other goals:
- Simplicity: creating standard contracts with a two-page summary.
- Credibility: requiring more continuing education for financial advisors.
- Reputation: showing that advisors have explored all options with their clients and are only using annuities as part of a balanced financial plan.
Everyone needs some annuity income in their investment portfolio, but should you buy a fixed indexed annuity?
You have better choices. In my opinion, right now the only “winners” in this business are the sales staff who get the commission. Investors pay an extremely high price for their ignorance and their peace of mind. If a fixed indexed annuity seems attractive to you, then it’s a warning sign that you need to research several insurance companies with a trusted financial advisor. That advisor should adhere to a fiduciary standard, with their fees only coming from you, and not from selling investments on commission. You also need to understand why you’re so unhappy with volatility and the risk of losing some principal, because as you gain knowledge then you’ll also gain the understanding and comfort level to handle more of your own investments.
Military retirees, and their families receiving survivor benefits, already have enough annuitized income. A military pension offers enough longevity insurance (especially with Social Security) and military retirees can afford to diversify into other assets.
If you’re still seeking annuity income with an upside then consider the lower expenses of a combination of a single-premium immediate annuity with a cheap Vanguard equity index mutual fund. You can lose money on the mutual fund, but if you only harvest the gains and don’t touch the principal then you’ll have the rough equivalent of a fixed indexed annuity. Best of all, you’ll pay much less in fees.
For those of you who want your own cheap fixed indexed annuity with no commissions and almost no fees, that link will take you to the blog of a financial industry expert. (He has the résumé and the financial independence to merit his credibility.) He’ll show you how to whip up one on your own for about $20 in annual expenses with no tricks or gimmicks. Once you see what it involves, however, you may decide that you’re not quite so interested in a DIY FIA.
TSP annuity options
Survivor Benefit Plan
The Reserve Component Survivor Benefit Plan
“Present value” estimate of a military pension
Tailor your investments to your military pay and your pension
Asset allocation considerations for a military pension
So where should I invest my money now?!?
Living with inflation
TIPS and I bonds for military retirement?
Financial myths of retirement (part 1 of 2)