Media misunderstanding can lead to misinformation and confusion

Articles on the topic of annuities often mix discussions of fixed and variable products without any indication as to which statements apply to which products. For instance, it common to begin discussing fixed annuities and then throw in a comment regarding high surrender charges and high fees—fixed annuities typically do not incorporate fees of any kind. Surrender charges are generally the only potentially direct charges to the customer. As mentioned, they can be partially or completely avoided in many circumstances.

References to long periods of time before the contract matures also result from the complete misunderstanding of what a maturity date really is. The maturity date is typically the LAST date by which the client must take receipt of the proceeds, not the first date on which they may do so without surrender penalties.

References to “complicated products” and confusing language are also generally highly overstated. The various state regulations require that insurance contracts be “readable”. And they manage this requirement by applying Flesch scoring methods to the contract language—these scores may, for instance, require that the contract be “readable” by someone with a 10th grade education.

Further, in an effort to make sure that the client has understood what has been sold to them, most companies now require disclosure statements that detail the specific component of the product.

There is much negative press regarding information being deliberately hidden or misrepresented to a client. This is untrue. An insurance policy (of any type) is a unilateral contract—which means it is drafted in whole by one party and accepted or rejected by the other in total. There is no negotiation involved. These types of contracts are always construed by the courts against the drafting company. Thus, there is nothing to be gained by the carrier using confusing or ambiguous language.

Advertising materials are also covered by state regulations. If a product is mentioned by name, surrender charges must be included in the advertisement.

Details of surrender charges are always included on the “spec” page prominently positioned at the front of the contract.

And if all else fails, the client always has a free look period in which to change his mind.

Surrender charges and commissions on FIAs

A commonly misunderstood connection between surrender charges and commissions is the belief that fixed index annuities pay higher-than-usual commissions. Currently the average commission on FIAs is about 7.2%.

Common misstatements regarding “high commissions” imply that they are used as inducement to sell very elderly people annuities that are inappropriate for them. The fact of the matter is that commissions are commonly reduced, generally by as much as 50%, for annuities sold to older individuals. This is very dissimilar to MFs or other market risk products that do not waive surrender charges or guarantee certain minimum positive returns in the event of death, nursing home confinement, terminal illness, RMDs, creation of a lifetime stream of income, etc. I am unaware of any other financial instrument that reduces surrender charges (or contingent deferred sales charges) due to age.

Commissions for FIAs were higher in the early years of the products than they are today. As the products have gained in popularity, surrender charge periods and commissions have been significantly reduced and are now quite similar to the duration and commissions for other fixed and variable annuities.

A no-surrender charge product with a typical 1% annual asset fee as opposed to say a 7-year surrender charge product with a 7% street level commission will actually have a higher cost to the client and will thus reduce the potential return to the client, not increase it. This is as true of mutual funds and other vehicles as it is true of fixed and variable annuities. An asset based trail must recover an increasing cost over time from the spreads and since the spreads cannot be increased (in most cases), they start out higher at the outset than spreads on products with traditional stacked front end commissions and contingent deferred sales charges. Just as a typical “A” share mutual fund will actually cost a client less if the asset is held for a longer duration than a “B” share mutual fund will, so will a stacked front end commission on the annuity cost less than the asset based trail over the same duration.

Surrender charges—why are they necessary?

Costs associated with developing, administering and marketing annuities, especially at the outset and during the early years exceed the “spread” or differential on what the carrier earns versus what it pays out or credits in returns.

Assets and liabilities must be effectively matched…thus long-term (generally higher yielding) assets cannot be used to back a low or no-surrender charge product (which would be a short-term liability). The longer the surrender charge period, the further the carrier can go out on the yield curve to invest premium dollars. In a normal yield curve environment, this results in a higher net investment return for company to work with.

If the purchaser holds the annuity for the longer term, the insurance company recovers their costs and profits from the annual spread. If the client, however, elects to terminate the contract early, the surrender charges are used to offset their un-recovered costs. Thus, earlier terminators are not being subsidized by those client who hold their contracts to the end of the surrender charge term.

The company could price a product to recover all of its costs early, but this would result in lower benefits for all clients, not just to those who elect to surrender early. Thus, surrender charges protect the returns of the clients to stay and impose those costs on the persons who would otherwise not bear their fair share of these expenses.

Insurance carrier makes money on the upside of the market by giving the client less than the full upside

If the financial index return is 9% and the client is credited with 80% of that (or 7.2%), the client has received all of the upside that is available. The company buys options (or hedges) to cover the exact amount that can be supported by the underlying return on investments. The company does not profit in any way from the differential between the full upside movement of the index and the percentage that is credited back to the client.

The company does not invest financial assets in the instruments making up the index. The carrier invests primarily in bonds to provide the underlying guarantees as well as other financial instruments (or hedging strategies) that provide the pre-stated portion of the index return that the client will receive.

Adjustments to the full upside are necessary because rarely would the cost of providing the underlying guarantees leave enough available to exactly match the full upside potential. How much upside can be purchased depends on the rate of return on the underlying assets (bonds), the guarantee that is being provided and volatility of market.

Short versus long-term surrender charges

As with any insurance product, an annuity must be selected to fit the particular needs of the person buying it. As with any financial product, they will be suitable for some, but not all people, and for some, but not all, of their financial assets.

Like most insurance retirement products, annuities are designed to be held for a number of years. Accordingly, annuities—whether fixed or variable—may not suitable for persons, regardless of age, who could not be expected to keep their product in force for the long term.

Early termination or withdrawals above a specified amount may be subject to surrender penalties as well as potential tax penalties.

Surrender charges are waived in many circumstances: death, terminal illness, nursing home confinement, RMDs, conversion to a stream of income, unemployment and most annuities have a specified annual free withdrawal amount such as 10% of the accumulated value. And all without the potential loss associated with market risk.

Longer surrender charge durations afford the insurance carrier to the ability to invest longer term which generally offers higher interest returns to the client. This means that those who surrender early are not being subsidized by those who stay the course.

No other financial instrument offers the ability to avoid surrender charges under so many circumstances and market risks as well.

Is there sufficient regulation to protect consumers from misleading sales practices or unsuitable sales?

To sell fixed annuities you must hold an insurance license.

Fixed annuities are heavily regulated and enforced by fifty state statutory reserve guidelines, minimum non-forfeiture laws, insurance company investment laws, GAAP reporting standards, and Actuarial Guideline 35.

The marketing and sales of fixed annuities are also highly regulated by state insurance laws, including comprehensive insurance trade practices provisions covering misleading presentations, false advertising, full disclosure, etc.

Very importantly and uniquely, all fixed annuity insurance contract must allow a “free look period” that begins when the contract is received by the customer during which he or she may cancel the contract without any penalties. The insurance company does not require any reason or rationale for the cancellation just written, documented notice of the desire to do so.

Each state requires that every licensed agent complete continuing education to ensure that they have the latest knowledge of laws, products and insurance practices.

In addition, the NAIC adopted the Consumer Protections in Annuity Transactions Model Law in 2003, covering senior citizens, and has since adopted an expansion to include consumers of every age. Over thirty states have enacted the model and six more states are set to do so. We encourage the state of California to do so.

Furthermore, the two states holding over 67% of the total premiums for indexed annuities require that those businesses domiciled in their state follow the model in ALL states in which they do business. Most importantly, insurers are voluntarily requiring their agents and brokers in all states, to follow suitability standards because it is good for the customer and good for business.

NAFA has sponsored meetings and information on this consumer protection law, and its Board of Directors voted unanimously on March 2nd to support adoption and passage of the latest model. NAFA supports such laws, which protect consumers from unethical and misleading sales practices.

Are Fixed Indexed Annuities a third type of annuity?

No—clearly they guarantee principal and returns that have been previously credited and the client is never at risk of loss to market forces, thus they are fixed annuities.

The use of a measuring stick for determining an interest credit that is outside of the insurer’s control is merely an evolution (as opposed to revolution) from the traditional methods of determining interest. It does not turn a fixed product into a security.

At no time is the client’s money invested in stocks, bonds or any other market-risk vehicle.

These are general account products with the carrier being fully liable for the interest as determined according to a pre-determined and stated-in-advance formula. Should the company have failed to hedge properly to cover the upside potential, they are still liable to pay the interest as determined by the formula.

At all times, the client is entitled to a positive minimum return as determined by state insurance regulations. Except through the application of surrender charges, the client cannot lose money. And there are many ways to avoid surrender charges.