Indexed Annuities: My Paranoia Of Product Extinction - search results

Buy annuities now! They are better than they have ever been, and they may not be here forever, at least in their current form. I don’t say that to be a “sales guy” trying to create urgency. I say that because there are memories that are tattooed into my brain that has been one of the most profound learning lessons of my career. I will share them with you below.

In my other article in this month’s edition entitled “GLWB Now, Or Accumulate then Choose a GLWB or SPIA?” I ended the article with the #1 reason I will usually choose purchasing a Guaranteed Lifetime Withdrawal Benefit (GLWB) Annuity now versus accumulating until retirement then choosing an income focused annuity (GLWB or SPIA). Although the math that I laid out in that article by itself should be enough, the “math” is not my #1 reason. What is that #1 reason? Because I am paranoid. Let me explain.

Once upon a time, I was a VP at one of the major variable annuity companies back when variable annuities were the dominant product line in the annuity space. At this time, fixed and indexed annuities industry wide production didn’t hold a candle to VA production. This was prior to the financial crisis that started in 2007. Those traditional variable annuities were largely sold with GLWB riders, and they were good! It was the variable annuity companies that pioneered these riders along with the earlier riders that were Guaranteed Minimum Death Benefit Riders (GMDBs) and Guaranteed Minimum Income Benefit Riders (GMIBs).

GLWBs were a great invention because they guaranteed a certain level of income, regardless of how the VA subaccounts performed. GLWBs were different than their predecessor—GMIBs—in that the GLWBs did not require annuitization. Hence, the difference between a GMIB and a GLWB was generally that the GMIB required annuitization and GLWBs were merely withdrawals that continued even after the account value went to $0. No annuitization required. GLWBs were such a great invention that the indexed annuity world copied the GLWB design around 2005 or 2006.

At the time (around 2006, 2007) our top Variable Annuity GLWB had seven percent compounded roll up rates and payout factors of five percent at age 65. These products sold like hotcakes. Variable Annuity wholesalers across the country were now driving around in Maserati’s, Bentleys, etc.

Then 2008 came and the market started to drop significantly from its previous highs in 2007. The quarterly results/losses of VA carriers started to generate horrible headlines that shed doubt about the future of major VA carriers. That is when the Brokerage firms that distributed these products started to invite carrier product actuaries to conference calls! Crazy thought huh? These actuaries’ jobs were to put these broker dealers and their reps at ease about if these VA companies can actually continue to afford to have such great withdrawal benefits. Afterall, if you have a variable annuity contract that has lost 30 to 50 percent of the “account value” but the carrier is guaranteeing income on a value that grows by seven percent, there will be strain on the carriers that guarantee that ultimate income. Furthermore, as interest rates dropped, the “present value” of the carriers’ future liability became huge! Hence, the capital drain from these VA products was a huge weight on the shoulders of these VA companies.

So, in 2008 and 2009 is when we all got to learn more about carrier hedging, dynamic hedging, futures contracts, put options, delta, theta, Vega, gamma, rho, etc. than we ever wanted to because actuaries were constantly doing calls with distributors. My carrier was saying something like they had hedged to the 99.999 percent, which meant that unless a .001 percent scenario happens in the stocks, futures, bond market, then they will be just fine. This was a consistent line from most VA carriers in the industry, not just mine. Well, .001 percent happened…

It was around early 2009, coming off the Lehman Bankruptcy, the market being down 57 percent, and interest rates plummeting, that the executives of these carriers started to come out and say, “Disregard everything we said previously. It is time to simplify and de risk our products.” The “de risk” buzzword basically meant that the lofty GLWB riders were going the way of the dinosaur. Well, by 2010 many of the products that were loved by distributors and reps were effectively extinct in the VA space.

The combination of the stock market losing over 50 percent in the financial crisis as well as interest rates dropping significantly sank many carriers. But then you had technical accounting issues that added salt to the wound, such as “deferred acquisition cost unlocking.” Billions of dollars of losses were reported by many carriers, quarter after quarter. Many VA companies were also downgraded by ratings agencies and many completely went out of the VA business. All because of this one product design.

For over a decade thereafter, I heard many advisors say, “That XYZ product that you guys sold at your old company, I should’ve sold more of that and should’ve bought more of that.” In hindsight they knew they had a good deal, but it was too late.

The irony was, around 2009, 2010, 2011, the executives of these carriers were now having their fixed/indexed annuity experts train many of the VA wholesalers on how indexed and fixed annuities work. What was once the black sheep of the carrier family of products was now the “last man standing” in many of these carriers, and the main strategic focus. The fixed/indexed annuities had better pricing dynamics and hence these products were more “derisked.”

Fast forward to today. Today, Indexed Annuities guarantee more robust GLWB payouts than the VA space ever did! The traditional VA space (not including RILAs) is about 54 percent of the indexed annuity space from an industrywide production standpoint. Accumulation focused indexed annuities are also better than they have ever been! In my 25 years I have not seen these indexed annuities as attractive as they are now. So, in my other article, I discuss how I am very much about taking advantage of these products that we have today. I will repeat, I don’t say that to be a “sales guy” trying to create urgency. I say that because there are memories tattooed into my brain that formed one of the most profound learning lessons of my career. Get them while we have them.

In closing, I want to be clear that I am not saying that carriers will eventually have to purge the wonderful indexed annuity benefits that we have today. Afterall, Indexed Annuity pricing as well as pricing on the GLWBs have completely different pricing dynamics than the VA space had. For instance, the difference between the “Accumulation Value” in an indexed annuity and the “GLWB Benefit Base Value” will not increase by say 50 percent in any one year because of a market crash. Why not? Because with indexed annuities the client cannot lose their account value. That means that the carriers “amount at risk” is not subject to as much volatility. That is right, the stability of the account value of an indexed annuity actually helps the carrier “hedge” the GWLB benefit on that same annuity.

What I am saying is, these products have never been better and that is largely because of where interest rates have been recently and where they are now. These higher rates may not last forever. Remember what I said earlier, if a carrier is guaranteeing a future income stream, lower interest rates means that their liability/capital requirements increase. If interest rates go lower, just don’t be in a position where you say, “I wish I sold more of that.” Some healthy “paranoia” is OK.

In addition to running an independent marketing organization where I help four hundred agents with their annuities, life, and long term care business, I also have a small group of high-net-worth clients I work with. Here, I help them with their retirement planning, estate planning, tax planning, and long term care planning. This is also where I work with securities and “assets under management” as an investment advisor. In doing so, I always pay close attention to where the current interest rates are as well as what I believe the secular trend will be.

Obviously, I am not alone here as there are multi-trillion-dollar money managers that analyze interest rates in order to buy bonds while yields are high, especially if they expect yields to drop in the future (to oversimplify). Why do they do this? Because of the inverse relationship between prevailing yields and the market value of the bond that you currently hold. As many of you know, if one holds a bond today that offers a high interest rate, if interest rates drop tomorrow, that bond would have likely increased in value leading to more wealth for the current bondholder. Bonds 101.

I mention all of this because, although somewhat theoretical when applied to index annuities and GLWBs (guaranteed lifetime withdrawal benefits), I want to share with you what goes on inside of my head when I think of the similar scenario of having an indexed annuity with a lifetime withdrawal benefit rider while interest rates decrease.

In the June edition I typed an article entitled Indexed Annuities: My Paranoia Of Product Extinction where I discussed that annuities with guaranteed lifetime withdrawal benefits are priced extremely generous today and agents and consumers need to take advantage of the current offerings while they exist. Sure enough, since then we have witnessed a few major players decreasing their payout factors on those guaranteed lifetime withdrawal benefits, for the exact reasons I prognosticate in the article. (Note: if one understands the actuarial mechanics behind these products, they can usually predict the moves that the carriers will make with their product pricing, certainly much better than how one can predict the stock market.)

Although somewhat theoretical, let’s draw a link between how bonds increase in value when rates drop and how you could “intrinsically” increase the value of a client’s retirement portfolio by putting them in annuities today with the payout factors decreasing down the road. The last few paragraphs of this article will be me giving you an example of the increased “intrinsic” wealth that your clients, who are locked into a high GLWB today, will get once the payout factors decrease as a few carriers have done.

The technical reason that bonds increase in value as interest rates increase and decrease is because of this: The market value is the cash flow that you will receive from that security discounted back to today’s date by a “discount rate.” The discount interest rate is basically just the new rate in the new environment that we are in.

Let’s use an example: Yesterday, you put $100,000 into a bond that will give you six percent ($6,000 per year) in interest on your $100,0000 investment over the next 10 years, then return your $100,000 of principal back to you at the end. Today, what is the “market value” of that bond? The answer is, it depends. If prevailing rates are still six percent today, then it does not take a financial calculator to tell you that if you discount back a future benefit of $6,000 per year, plus $100,000 at the end, then the “market value” is $100,000 today. This is assuming the discount rate/current rate is based on six percent.

However, let’s assume that interest rates decreased to 5.5 percent since “yesterday,” when you bought the bond. Now what is the market value of your bond? When you discount back that $6,000 per year income plus the $100,000 at the end by the 5.5 percent rate, $103,768.81 is the current “market value” of your bond! We are now $3,768.81 wealthier because we owned an instrument that gives us the same fixed income, even while interest rates dropped! Inflation/costs of living probably dropped as well even though you had the same $6,000 per year coming in to buy those goods and services! Of course your bond is more valuable then! (Note: Technically, the bonds increase and decrease in value based on supply and demand, but it is this bond pricing formula that is the “guiding hand” of that supply/demand.)

Now, let’s say that you are a 55-year-old couple with $100,000 and you put your money in an indexed annuity that will pay you a guaranteed lifetime payout of $15,155 per year, starting at age 65. Again, on both of your lives. Yes, this product exists right now! How long will that income stream of $15,155 come in? Statistics show that age 92 is the life expectancy of one person out of a couple. I would actually argue higher because of “adverse selection”—the notion that healthier than average people buy longevity insurance—but I digress.

When you look at the cash flow analysis, you will find that the internal rate of return on this cash flow going from age 65 to age 92 is around 6.6 percent. The internal rate of return can be defined as, “the amount of return an investment would have to return on an annual basis in order to generate that level of income.”

So, our $100,000 that we used to buy this annuity “yesterday” is going to effectively yield us 6.6 percent, based on the last person living to age 92. However, what if interest rates are such that the carrier has to drop the payouts where the new internal rate of return on new policies for the same scenario is not 6.60 percent, but rather 6.1 percent? Hence, a 50-bps decrease. What would theoretically be the market value of the future income stream on that client’s annuity? $109,646. Our annuity is now 10 percent more valuable just because interest rates decreased. By the way, what I just explained is also how market value adjustments work in increasing and decreasing rate environments.

Now, I am not suggesting that the client is techincally $9,646 richer on his/her personal balance sheet because interest rates have decreased. What I am saying is, this is a technical way to look at the value of the future stream of income they will receive. This is the lens in which the “technicians” on Wall Street view the value of fixed income assets. If there was a secondary market for GLWBs, this math is what would be utilized.

Furthermore, this is not all theoretical BS, because if you think of interest rates lowering, it is often because the costs of goods and services have subsided (lower inflation). This means that you technically can purchase more with your $15,155 payment stream than you could if rates otherwise remained the same. Hence, your annuity is more valuable.

However, for folks purchasing the annuities after rates have decreased, needless to say, they will not have a $15,155 payment stream and they will not see their “theoretical wealth” increase like those folks that got in while the getting was good!