THE TRUTH ABOUT INDEX ANNUITIES
Michael Tove, Ph.D., CEP, RFC
(February 2016)
Over the past two decades, Fixed Indexed Annuities (FIAs) have emerged as one of the “hottest” products in the financial world. First introduced in February 1995, their popularity soared following the dot-com crash of 2000 largely due to their promise of market-linked growth without risk of market loss. This protection resulted in more than $20 Billion per year being transferred away from traditional market investments into Index Annuities. By 2015, that annual amount had more than doubled. Understandably, this escalating exodus from traditional investments has generated considerable alarm in the securities industry. As a consequence, securities representatives have pushed back with various negative, disinformation campaigns. In 2008, this culminated with an attempt by the SEC to regulate FIAs as securities (SEC Ruling 151A) – a move which would have meant securities dealers would be compensated for FIA sales. This ruling was simultaneously vacated by the DC Circuit Court and congressional legislation (Harkin Amendment within the Dodd–Frank Wall Street Reform and Consumer Protection Act, 2010) which officially defined FIAs as Non-Securities because they offer safety of principal plus previously credited gains.
To be sure, not all Index Annuities are the same and any would-be detractor could easily extract the least favorable elements from the worst products and hold them up as an example of the entire industry. Doing so is just as wrong as assembling a collage of the most attractive elements of multiple products and holding that up as though a single example of the entire industry.
To understand and fairly evaluate an Index Annuity, it’s important to first understand that, by definition, an annuity – any annuity is nothing more than an accumulated sum of money converted into a stream of income. As such, Social Security and Pensions payments are, essentially, annuities. Commercially, annuities are only offered by life insurance companies. Not only are insurance companies already in the business of calculating and paying incomes from actuarial tables, regulatory laws (including Dodd-Frank) specifically recognized the insurance industry as the proper authority for these financial products and reiterated (from the 1933 Securities Act) that their regulation fell to the states departments of insurance. Therefore, commercially, only an annuity can provide a guaranteed lifetime income from an initial sum of money.
Of all the myriad of things ever said about annuities, perhaps the most accurate is “If you’ve seen one annuity, you’ve seen one annuity.” There are thousands of different annuity products from scores of insurance companies. All have their own variations on how money is grown and returned to the policy owner and/or beneficiaries. They’re all regulated by states departments of insurance, are required to meet certain tests and adhere to certain basic requirements, many of which are uniquely imposed on the insurance industry. If nothing else, because of the broad diversity of products and very high levels of regulatory oversight and licensing requirements, nobody other than a fully licensed and appointed agent is legally authorized to advise a consumer about specific annuity products (more about this later).
Annuities in general may be classified in several ways
Variable vs. Fixed:
A Variable Annuity – by definition is a Securities product and issuers are regulated by the SEC (Securities and Exchange Commission) and FINRA (Financial Industry Regulatory Authority). The issuing company is required to hold a depositor’s money in a Separate Account meaning, the insurance company has no ability to make money off the money while in their possession. Even Variable Annuities which offer fixed interest accounts are held to this requirement. As such, the only way a Variable Annuity issuer can make money is through a fee-based structure. Variable Annuities offer growth through either a fixed interest component – essentially a money market account, or a menu of securities; typically mutual funds. Because no entity can control or guarantee future returns in investment markets, there are no baseline guarantees of minimum account value of a depositor’s money if invested. If market values fall, the underlying value of the investments in the Annuity Separate Account, also fall. Period.
However, some variable annuity products include secondary riders that makes it appear as though account values are guaranteed. These “enhanced guarantees” or GMWBs (Guaranteed Minimum Withdrawal Benefits) are more correctly regarded as insurance riders in which the issuing company in essence, sells the annuity owner an insurance policy against market loss. Often, these “guarantees” exist only as a death benefit and do not apply to account values for the owner. Other times, the company offers minimum growth guarantees to the account owner, but with rare exception, only as a fixed income stream (annuitization) and not as lump sum or even through periodic partial withdrawal, including Required Minimum Distributions if the annuity was funded with qualified money (IRA, 401(k), 403(b), etc.)
A Fixed Annuity is a pure insurance contract. Unlike Variable Annuities, an issuing company is not required to hold the money in a separate account and therefore has access to it to work for its own account. As such, they can make money off the money and do not require the complex fee structure. Also, because they are pure insurance products, they are required to provide minimum basic guarantees of safety for both Principal and Interest and are not permitted to expose the account to market risk. The term “fixed” is often misunderstood to refer to how interest is credited. It’s not. It refers to the fact that the depositor’s account value is fixed, meaning “secure,” not at risk. Because there is no investment risk, fixed annuity owners cannot lose account value due to declining financial or market conditions.
Fixed Annuities are further classified in sub-categories:
· MYGA (Multi-year Guaranteed Annuity), sometimes incorrectly called a “CD Annuity.” In a MYGA, the issuing company states at the outset, a specific interest rate for a specific term (e.g., 3% for 5 years). As such, they seem to mimic bank CDs but there are fundamental differences. For example, after the stated term, the annuity owner may but is not required to withdraw or renew the contract. Conversely, the issuing company is allowed to reduce the interest rate to the legal minimum.
· SPIA (Single Premium Immediate Annuity) these are products specifically designed to be a pension. A person has a sum of money to be converted into a lifetime of income. They deposit the balance in the SPIA and income begins. That income may be designated to last for a single life, for two lives (owner and spouse), with a surviving spouse either getting 100% or a reduced percent of the decedent spouses’ amount, or for a stated number of years (e.g., 10, 15, 20 years) or a combination of the greater of life or a stated number of years. The conversion of the sum to income payments is called “Annuitization” and different amounts are paid based on different payment schedules as well as the ages of the people receiving the money.
· FIA (Fixed Index Annuity) – These are contracts that credit growth derived indirectly from performance in one or more market indexes; most commonly the S&P 500. However, by contract only positive returns in the index can affect the account value. Losses do not apply and at worst, count as zero meaning nothing gained and nothing lost. This is fundamentally different from Variable Annuities where market losses can reduce the true account value, even to invasion of principal and only when an annuity contract includes GMWB Riders, is there loss protection. The biggest difference between a MYGA and an FIA is simply when the issuing company declares the amount of interest to be credited. In a MYGA, it is stated in advance of the contract. In a FIA, it is determined after a stated measurement period (often one year).
· Hybrid Annuity – This term is sometimes tossed about but basically, there is no such thing as a “hybrid annuity.” The term improperly refers to a FIA but mistakenly assumes that a FIA is somehow a “hybrid” between fixed and variable annuities. This is simply not true. FIAs are fixed annuities meaning they’re pure insurance contracts entirely regulated by states departments of insurance and not securities which are regulated by the SEC. There’s no middle ground.
Annuity Basics:
All Annuities share certain features that make them very attractive, particularly for Retirement Planning:
· Tax-deferred Growth – When an account gets to grow deferred of income tax, the net result is a “triple compounding” (growth on principal + growth on growth + growth on amount that would have been taxed). The value of this is often substantially under-estimated. For example, take a dollar and double it each year for 20 years. The resulting amount is an amazing $1,048,576.00. But withdraw just 20% per year for tax, and that resulting account value is only $127,482.36. The difference is due to tax-deferred growth.
· Automatic Bypass of Probate – Probate is a public court proceeding of “proving the will.” It can be time consuming and expensive. Getting assets, especially “cash money” to designated beneficiaries quickly and privately is quite important when settling estates. Few things are more efficient than payments to named beneficiaries from annuities or life insurance.
· Named Beneficiaries of equal or unequal benefit at the sole discretion of the owner. The annuity owner gets to specify with irrevocable (after the owner’s death) certainty who gets what and how much that nobody can dispute.
· The ability to generate income for a specified number of years, for life, or a combination of both. Nothing other than an annuity can guarantee a lifetime of income regardless of how long someone lives. In the past, life-only annuitization payments were (unfairly) criticized because “If I die early, the insurance company gets to keep the money.” Multiple different annuity payment schedules have always existed, including life-only but to characterize all annuity payments by one of many possible schedules, is incorrect. However, some “modern” annuities provide dual benefits of generating guaranteed lifetime income without automatically giving up the death benefit.
· The ability to generate personal income that is not 100% taxable. When a non-qualified (not IRA) annuity is annuitized (converted to a permanent source of income), each payment is a pro-rata portion of principal (not taxable) and interest (taxable). Thus, for example assume a person opens an annuity with $100,000, and later when it is worth $200,000 annuitizes the contract. Half of every check received will be non-taxable.
In addition to the above, annuities may be classified as:
· Single Premium vs. Flexible Premium - A Single Premium Annuity is one that can be funded one time only. Additional contributions are not permitted (although there is no limit to how many annuities a person may own). A Flexible Premium Annuity is one that permits repeat deposits for up to a specified number of years, including unlimited. Flexible premium annuities offer a depositor a place to make repeat or even scheduled deposits without having to open a new contract or repeat the minimum deferral period.
· Deferred vs. Immediate - A Deferred Annuity offers tax-deferred growth on a parcel of money, usually for a stated minimum time before income may be generated; a “waiting period.” An Immediate Annuity has no deferral (waiting) period. The income starts as soon as it is funded. In some cases, a single annuity product may be held in deferral or used to generate immediate income. Such products are “Deferred Immediate” annuities.
· Single Tier vs. Two Tier - All annuities offer a full array of income options (called “annuitization”) as well as annual free withdrawal privileges. Many include multiple other ways of accessing one’s money. A Single Tier Annuity also offers the option to withdraw the deposit plus all net gains in lump sum after a stated minimum hold time; Two Tier annuities do not. Generally speaking, two-tier annuities are a thing of the past; few products today lack a provision to withdraw everything penalty-free.
FIA Indexing Strategies and Terms:
With the myriad of different index annuities in the marketplace, a broad understanding of the different indexing strategies and components is warranted. Ultimately, this makes the field seem far more complex than it really is, much the same as if someone wanted to evaluate a specific mutual fund investment by in depth investigation and “research” into every form and permutation of investment in existence in the world.
One caveat though, few people would personally seek to duplicate medical school training before visiting the doctor; or even complete ASE (Automotive Service Excellence) Certification training before taking their car to the repair shop. Why then would someone want to duplicate professional insurance training licensing and certification so they can “second-guess” the knowledge and expertise of an insurance professional? None-the-less, the following terms will help with broad understanding.
· Participation Rate – Some Index Annuities offer partial participation rate (e.g., 70%). This means that if for example the index rose 10%, the account would be credited 7%. Others offer 100% participation and occasionally one sees products that offer more than 100%.
· Caps – In exchange for the promise of market-linked gains without market risk, the issuing company generally limits the annual growth potential in some fashion. Growth caps specify a maximum amount of credited return that will be offered for a given period of time. For example, an annual cap of 5% means that if the market index returns more than 5% in a single year, the Index Annuity will only receive 5% interest for that year. Conversely, a monthly cap of 2% means that the monthly gain will be limited to 2% in a given month meaning, theoretically, a potential maximum of 24% (but don’t count on that nearly much in any “ordinary” year).