[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.”
Michael Kitces, The Myth Of “Free” No-Expense Fixed Or EquityIndexed Annuities – Interest Rate Spread Is Still A Cost! (March 18,
2015).
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 equity‐indexed 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.
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 http://www.marketwatch.com/story/the-seamy-side-of-annuity-sales-2015-12-22.) 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:
- Feb. 24-25, 2016: FPA of Oregon and S.W. Washington Midwinter Conference 2016, where Ron will discuss: "The DOL's Transformational Conflict of Interest Rule"
- Feb. 26, 2016: FPA of Puget Sound's 2016 Annual Symposium, where Ron will discuss: "Reducing Your Risks in the New Fiduciary Era"
Follow Ron on Twitter: @140ltd
Public comments to this blog are welcome, provided that no advertising occurs and that decorum is maintained. To reach Professor Rhoades directly, please e-mail him at: Ron.Rhoades@WKU.edu. Thank you.
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