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Sunday, January 17, 2016

Part 8, Equity Indexed Annuity Due Diligence and Compensation Practices ("Who Moved My Cheese" Series - The Future of Financial Advice)

[At the risk of insurance company backlash (the last time I wrote about equity-indexed annuities (EIAs), an insurance industry "consultant" made accusations against me, to the President of the college at the time, where I had taken a position), I again offer my observations on equity-indexed annuities. These perspectives are offered from the view of a fiduciary adviser, considering whether EIAs should be recommended to his clients, and applying the heavy due diligence obligations imposed by the fiduciary standard of conduct.]

Equity-indexed annuities (EIAs), also known as fixed indexed annuities, are an investment (and insurance) product that, in my experience, many investment advisers and the clients who purchase them do not fully comprehend. EIAs have been heavily criticized by many advisers (including this author), due in part to the often-high surrender fees (and, hence, commissions) paid upon the sale of this product, the insurance company’s control over the cost structure of the product over time (and hence, the returns the client actually receives), and the misrepresentations often made to clients in connection with their sale – particularly when EIAs are equated to be similar to investing in stock indexes (i.e., the sales pitch: “Participate in the stock market’s upside while escaping its downside.”)

Waiting for the "Good" EIA Product.

Yet, in theory, the concept of EIAs is a good one, if several attributes were to become present.

1. Correct Marketing. The EIA was emphasized as a fixed income alternative (and not as an alternative to stock market investing). This may be a difficult move for insurers to undertake; even in their July 21, 2015 comment letter to the U.S. Dept. of Labor, The Committee of Annuity Insurers noted that the principal guarantee of EIAs “provides assurances against market losses but also access to equity-like return.” Likewise, the Indexed Annuity Leadership Council’s comment letter of July 20, 2015 stated in part: “Fixed annuities offer protection against market loss as the insurance company assumes the market risk.”

2. Financially Strong Issuer. An insurance company with a very high financial strength rating issues the EIA (many of the insurance companies issuing such products today possess relatively low financial strength ratings, leading to an assumption of default risk by the client, even when tempered by state guaranty funds that might be available up to certain limits).

3. Fully Transparent Fees and Costs; Stripped-Down Features. The EIA fully transparent with the expenses associated with the product, providing a reasonable return to the insurance company (similar to the return provided to for-profit mutual funds found in many lower-cost actively managed mutual funds today). In the absence of riders such as a GMWB rider, and with only a small interest rate floor (in the fixed account option of the EIA), the insurance company possesses little exposure to equity or bond market risks in these products. Hence, in theory there is little reason a low-cost EIA could not be constructed, with a fixed return provided to the insurance company (and disclosed to the investor).

It should be noted that all current EIA products I have reviewed appear to cede significant control to the insurance company (which control could be abused) in the setting of caps, participation rates, and spreads; it would be better for the insurance company to state up front the compensation it will receive from the product, and let the remaining returns (whatever they might be, given the index chosen and the amount of funds available to purchase options on such index) flow to the investor.

4. No Sales Load; No Surrender Fees; Always Liquid. The EIA possesses no sales load, and no surrender fee (thereby permitting the investment made in the EIA to remain fully liquid). Unfortunately, most EIA products sold today have a surrender charge period of ten years or less, and a surrender charge of ten percent or less, although some products possess surrender charges of 16% or even higher.

In essence, from the standpoint of a fiduciary, EIAs are a good concept, but one that has to date been poorly executed. In fact, I have yet to meet a fee-only investment adviser who has recommended an EIA to her or his client.

Still, hope remains that better EIA products will emerge, as they do appear to provide an alternative to other fixed income investments, especially in a rising interest rate environment (should such occur) in which significant interest rate risk is present.

(*If you know of a no-load EIA from a financially strong insurer, please drop me a line. There have been recent predictions of the emergence of no-load EIAs, but I have yet to see them from a high-quality insurer.)

Understanding the Fundamentals of EIAs

I recommend several resources to advisers to gain a fundamental understanding of EIAs.

Craig McCann, PhD and Dengpan Luo, PhD, An Overview of Equity-Indexed Annuities (concluding, in part: “Equity-indexed annuities are complicated investments sold to unsophisticated investors without the regulatory safeguards afforded to purchasers of similar investments. If brokers and agents told investors of the effect equity-indexed annuities’ shaving of index returns and extraordinary costs the market for these products would dry up.”

Examining “Real-World” Returns of EIAs

Given that EIAs have been in the marketplace since 1995 (i.e., for up to two decades, as of the writing of this post), increased analysis has occurred of the returns of EIAs in the “real world.”

Babbel, David F. and VanderPal, Geoffrey and Marrion, Jack, Real World Index Annuity Returns (December 27, 2010) (The authors note that their analysis is subject to several limitations, including that the historical are derived from 15 carriers that chose to participate and that chose the products for which they reported returns.) Their study was criticized by Robert Huebsher in his article at Advisor Perspectives, “Fantasy-world Returns for Equity Indexed Annuities” (May 31, 2011). Larry Swedroe also discussed the 2010 study, noting: “The fact is that, after analyzing these products, there’s almost always a more efficient way to accomplish an investor’s objective of reducing the risk of large losses. If you’re a risk-averse investor looking to protect yourself against black swans, a more efficient way to do so is through the use of what can be referred to as a low-beta and high-tilt strategy.” Larry Swedroe, Swedroe: Looking Under theAnnuity Hood (Sept. 17, 2014).

Dr. John R. Brock, Equity-Indexed Annuities – Look Before You Leap (2014). (“Using a hypothetical EIA that included representative-to-generous contract provisions, my analysis showed that equityindexed annuities do appear to offer the promised reduction in volatility compared with stocks. The real question for potential buyers of these products seems to be whether the reduction in volatility is worth the corresponding price paid in lower returns … As one analyst put it, ‘The upside to an equity-indexed annuity is that there is no downside. The downside to an equity-indexed annuity is that there is very limited upside.”)

A recent article addressing adherence to an insurance agent’s suitability obligations under state insurance regulation, as well as a broker’s suitability obligations under FINRA rules, is:
Lazaro, Christine and Edwards, Benjamin P., Suitability Obligations Applicable to Securities andAnnuities (May 11, 2015), Practicing Law Institute Securities Arbitration, 2015; St. John's Legal Studies Research Paper No. 15-0024. The foregoing article provides a good discussion of the adviser’s obligations under the suitability doctrine (which the SEC has said forms a small part of a fiduciary’s obligations).

Ensuring Client Understanding.

However, I have observed that most purchasers of EIAs gain little understanding of many of the material facts surrounding these products. A fiduciary advisor possessing a conflict of interest relating to the sale of an equity indexed annuity must not only disclose material facts to the client, but must also ensure client understanding of them. These facts might include (but are not limited to) the following:

1) That the EIA imposes a penalty, similar to a surrender charge, for early withdrawals from the annuity, whether any portion of the funds can be withdrawn from the EIA each year without a penalty, the amount of the surrender charge and when it disappears, and that withdrawals from the EIA are best undertaken at particular points during each contract year.

2) That investments in an EIA are not meant for funds that are likely to be utilized by the client to address short-term financial needs.

3) That the dollar value of the annuity shown on the client’s statement is not the “market value” of the annuity as it relates to the client, but rather the “surrender value” (unless these are separately stated and appropriately marked on each statement).

4) That the amount of the credit provided to the client during any period for index returns during each period does not include dividends which would have been received by an index fund tied to that index and which would otherwise have been be reinvested in that index; how the dividend rates for the index have fluctuated over time; the current dividend rate for the index; and if in the future dividend payout rates are higher due to changes in U.S. federal income tax policy, or due to other factors (such as shareholder demand for payment of dividends, versus retention thereof), the percentage of index total returns the client receives could be significantly impaired by the fact of the exclusion of dividends.

5) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by a cap on the index returns; that this cap limits the amount of interest credited to the client’s annuity contract; the current cap and the cap in recent years; whether the insurance company has lowered the cap since the inception of the annuity contract (for any purchaser thereof) and when; and that the insurance company reserves the right to lower such caps, which would negatively affect the client’s returns;

6) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by the participation rate; the current level of the participation rate; the past levels of the participation rate; and that the insurance company reserves the right to lower the participation rate, which would negatively affect the client’s returns.

7) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by is further limited by market value adjustments, which should be able to be described with particularity, and that such market value adjustments may negatively affect the client’s returns;

8) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by is further limited by the imposition (annually) of “administrative charges,” whether the insurance company reserves the right to increase the administrative charges; whether such administrative returns are capped; the current level and historical level of the administrative charges, and that such administrative charges negatively impact the client’s returns;

9) That the funds placed with the insurance company are part of the insurer’s general account and subject to the general claims of the insurance company’s creditors; unlike a mutual fund or variable annuity sub-account your annuity funds are not segregated and therefore the client’s funds are not protected in the event of insolvency of the insurance company; the financial strength ratings of the insurance company including its Comdex score; whether any state guaranty funds exist to safeguard investors and the extent of such guarantees; whether such state guaranty funds would apply should the client’s state of residence be changed; and the fact that state guaranty funds exist at this discretion of the states’ legislatures.

10) The default rate, over the past 10, 20, 30, 40 and 50 years or more, of insurance companies, based upon their initial financial strength rating;

11) That various legislative (tax) and regulatory (fiduciary rule-making by DOL and SEC) proposals exist which, if they were to be enacted, could adversely affect the commercial viability of many life insurance and annuity products, which in turn could significantly impair the ability of many insurance companies to meet their obligations to their present insurance policy holders and annuity contract owners;

12) That for nonqualified EIAs any withdrawals from the annuity of gains within the annuity will be taxed at the client’s ordinary income tax rates, that gains are distributed prior to the return of principal (unless annuitization occurs); that the client will not receive the more favorable long-term capital gain treatment that would have been available through a tax-efficient or tax-managed stock mutual fund; and that no stepped-up basis exists upon the death of the annuitant (and the consequences of same, to heirs);

13) That for EIAs held in IRA accounts, tax deferral is already provided by the IRA account possessed, and hence is not a benefit of this annuity contract; similarly, for EIAs held in Roth IRA accounts, tax-free growth of principal is a feature of the account and not of the annuity contract.

14) That (hypothetical) returns shown for the past 10 years, or 25 years (or some other range, as required by some state laws/regulations) reflect interest rates over that time span. There is no assurance that fixed income yields will be the same in the years ahead. If fixed income yields are lower, the amount of interest available within an equity indexed annuity product to purchase options on indexes would be less, which would likely lower future returns.

One might opine, from reading the foregoing list of facts that a purchasing client should understand, that many clients might be unable to achieve such an understanding of these relatively complex products. In that case, a fiduciary adviser who possess a conflict of interest in connection with the proposed sale would be unable to proceed with its sale, given the requirement of not just disclosure, but also of client understanding. A client who does not understand the product, and the ramifications of the (often multiple) conflicts of interest present in connection with the sale of an EIA, is therefore unable to provide "informed" consent. (Even then, the proposed transaction must remain substantively fair to the client.)

Compensation Practices: Trips, Economic Incentives.

As I have stated in past articles in this "Who Moved My Cheese?" series of articles, fees and costs matter. The higher the fees and costs, the lower the return for investors, on average, for the same products.

The usually-high commissions paid on sales of equity-indexed annuities quickly result in "unreasonable compensation" for larger amounts. For example, a 10% commission on a $50,000 EIA contract, resulting in a $5,000 commission, would likely be considered "unreasonable compensation" in most instances, given the presence of alternative (non-EIA) investment products that pay far lower commissions (such as fixed annuities) and given the time involved in providing service to the client. (As I have stated previously, the receipt of compensation should be timed to the delivery of services; products should not be sold for an up-front commission for an understanding that advice will be provided over several years.)

Allianz Life Insurance Company of North America, which appears to dominate the EIA marketplace with about a 25% market share (in 2014), provides a 6.5% commission on first-year premium contributions to annuities for purchasers age 75 or less on two of its products (as of Jan. 15, 2016). Other EIA products, from other insurers, were available for 3% to 10% commissions, from one insurance broker's listing of available products (as of Jan. 15, 2016). Such EIA products had surrender charges imposed (generally, on a declining scale year-over-year, from 9% to 20% initial year surrender fees), with the surrender period lasting from 5 to 16 years. There exists is substantial economic incentive for an insurance agent to recommend a higher-commission (and higher-surrender fee, generally) EIA over a lower-commission EIA.

Others have observed surrender fees as high as 25%. See, e.g. Lazaro, Christine and Edwards, Benjamin P., The Fragmented Regulation of Investment Advice: A Call for Harmonization (March 3, 2015). Michigan Business and Entrepreneurial Law Review, Vol. 4, No. 1, 2015, at page 129.

Unfortunately, rebating of commissions back to the client remains illegal under state law in every state except California and under certain conditions in Florida. Even in those states, if an insurance agent rebates a commission and he insurance carrier finds out about it, the insurance agent can pretty much count on losing his contract with that carrier.

Many insurance brokers or carriers continue to offer agents trips to industry conferences, such as those held in the Bahamas or near Disney World, if a certain amount of annuity sales are achieved (usually with a particular product or insurer). (See, e.g., Allan S. Roth, The seamy side of annuity sales, MarketWatch, Dec. 22, 2015, available at The receipt of such additional compensation should be prohibited under a fiduciary standard, as an avoidable conflict of interest.

Again, I am hopeful that far better EIA products will be offered in the future. And that state laws against rebating of commissions might be repealed, over time, in reaction to the fiduciary standard's requirement of reasonable compensation, and the need for fiduciaries to agree with the client to such a reasonable amount prior to the making of specific product recommendations.

But, for now, it does not appear than any equity indexed annuity product out there would likely meet the due diligence required of a fiduciary advisor, in this author's view.

NEXT POST: Part 9 of "'Who Moved My Cheese': The Future of Financial Advice."

Ron A. Rhoades, JD, CFP® is the Program Director for the Financial Planning Program and an Asst. Professor of Finance at Western Kentucky University, at its beautiful main campus in Bowling Green, KY. He is a CFP certificant, a regional board member of NAPFA, a consultant to the Garrett Planning Network, and a member of the Steering Group for The Committee for the Fiduciary Standard. Ron previously served as Reporter for the Financial Planning Standards of Conduct Task Force and Fiduciary Task Force. An estate planning and tax attorney (Florida), and a fee-only investment adviser, Ron provides instruction to highly motivated students at Western Kentucky University in courses such as the Personal Financial Planning Capstone, Applied Investments, Estate Planning, and Retirement Planning. He has previously taught courses (at another college) in Insurance and Risk Management, Advanced Investments, Employee Benefits Planning, Business Law I and II, and Money & Banking.

This blog represents Ron's personal views and is not necessarily indicative of the views of any institution, organization or firm with whom he may be associated.

Ron is scheduled to provide two presentations in early 2016 on the DOL's rules and the general impact of the fiduciary standard on the financial services industry:
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