A while back, I posted something on LinkedIn about how to assist consumers that desperately need help get qualified for Medicaid. As you know, Medicaid can pay for long term care (nursing home care primarily), if a consumer is deemed financially incapable. It is not a replacement for long term care insurance, but it can help consumers that did not prepare. And now those consumers are in a time of distress and need. Afterall, this is what we do as an industry—help folks in their time of need. After posting these Medicaid planning tips that leveraged “Medicaid Compliant Annuities,” there were several positive responses from agents who wanted to learn more.

However, as with any social media post that gets thousands of views, there were a few negative posts—although a tiny percentage of total responses. I would divide these negatives into four different camps:

1. An attorney: All the attorney had to say was that all financial professionals should hire an attorney if they choose to help clients with this, and it’s ridiculous that I should even comment on Medicaid because I am not an attorney. Basically, only attorneys are smart enough to cover this topic.
2. Fee-Only Advisor: This guy had nothing to say other than annuities are bad and include a lot of “fees,” which was ironic to me. (By the way, single premium immediate annuities for Medicaid purposes generally have no fees!)
3. The life insurance guy that downplayed Medicaid: Because if everybody owned life insurance with a chronic illness rider, the client would never be in that position in the first place. (PS. I am a “life insurance guy” myself but disagreed with him bashing the client in hindsight.)
4. My Favorite: The guy that must’ve viewed my post as taking away from his long term care insurance sale. This guy wanted to criticize me because I called it “Medicaid planning,” like the rest of the world—including the CFP Board! (He didn’t realize that I am a significant fan of long term care insurance.) He took the opportunity to plug his designation course for all that were viewing. LOL. Consumers are destitute because of long term care expenses, and we are quibbling over terminology?

My social media post—believe—is an unfortunate microcosm of what can take place in this wonderful industry. All four individuals above viewed that scenario of helping clients who previously failed to plan as taking from their paychecks. I am sure they would not admit that, but that is where the negativity came from. Any proposed solution that was outside of how they got paid in their own world is a bad solution. To the Chevy guy, there is not a Ford on Earth worth anything and vice-versa. This mindset does our collective industry no good. It is OK to be cheerleaders for products and strategies that are different from what we offer and still make great money! There is about $30 trillion in financial assets that Americans own currently. There is enough to go around.

In politics, if you listen to the commentary from our “leaders” on both sides of the aisle, there is never anything that the other side does that is any good. If one party comes out and says, “We cured cancer,” the other party will discuss how that “horrible development” will put a strain on pharmaceutical sales and the industry will collapse. Therefore, those politicians stand on the platform of negativity, as if that will help their party’s cause. What about the “Party” of the American People? Why not just view it all as one party—The American People Party?

I like the social media example above because of the amount of irony. I use attorneys every single week. I am pro attorney. I am also an “investment advisor” that charges fees on securities assets. I am a part of that “party.” As many of you know, I love life insurance and I especially love the chronic illness riders. What about long term care? If everybody in America owned an LTCI product, consumers would be in better shape. I am pro LTCI.

My point is not about how bad social media, or our industry, is, my point is about how we as professionals need to think beyond our immediate paycheck because the “partisanship” in financial services does nothing good for our business as a whole. For instance, is there anybody in our business that thinks Ken Fischer has done anything good for our industry and the reputation of financial professionals? This is the guy who says he would die and go to hell before selling an annuity. Where is he today as the stock market is down over 20 percent and the bond market down 15 percent? Do you think he has turned a few consumers away from our business because of his messaging? Absolutely. I am sure there are consumers that have not saved much in retirement dollars—whether in annuities or with Ken Fischer—because of Ken Fischer’s messaging.

There was actually a fifth camp in my social media post. It was one gentleman that effectively said that he was previously interested in the medicaid planning topic but not so much anymore because of the “partisanship” and confusion. I agreed with him!

Just as important to me is the power of one’s word. When people realize that you are a “partisan” that cheerleads only about your product/strategy, then all of your words ring hollow from there. This is why nobody believes what politicians say, especially when they are speaking about the other party.

When you are a “partisan” in financial services, your recommendations will be scrutinized heavily and your constructive criticisms will be discounted. And when your words become hollow to your prospects and/or clients you will not achieve full potential. Because of this, I do believe in transparency and calling out bad actors and bad strategies. For those close to me, you know that is my style. When my 15-year-old asks me how I thought he did in his basketball game, he knows what he is going to get whether good or bad. But, he is all ears and takes my feedback seriously. He doesn’t even ask my wife (his mother) how he did because she will invariably tell him “Great Honey!” every single time because she is such a positive and wonderful human being. In short, honesty is important but just because some person or some strategy was not in the same “Party” as you does not make them a “bad actor” or their options “bad strategy.” Our words need to mean something.

I listened to a podcast a while back where Neil deGrasse Tyson—an astrophysicist—was talking. He was discussing the deepest part of Earth’s surface and also the highest part of Earth’s surface. He stated that the Mariana Trench in the Pacific Ocean is the deepest—being over 30,000 feet deep. That is about six miles deep! Additionally, the tallest point on Earth is Mt. Everest at around 30,000 feet high. Almost six miles high! These are huge peaks and valleys to us small Earthlings. However, if you were a giant that was holding planet earth that was now about the size of a cue ball, you wouldn’t even feel that valley or that peak. In other words, in relative terms, the Earth is as smooth as a cue ball when you think “big enough.” This makes sense because twelve miles of difference between the deepest part and the tallest part is nothing compared to the overall size of the planet which is almost 8,000 miles in diameter!

Now I am not saying that our industry is as perfect as the surface of a cue ball. What I am saying is that I think it is important that we “think big picture” when it comes to our industry. Are there peaks and valleys when it comes to some products and some strategies? Absolutely. However, by more consumers being involved in our industry, those consumers and the world will be a better place. Partisanship does not help that cause.

A few weeks ago I was preparing an indexed annuity illustration for one of our agents who had a client that wanted guaranteed lifetime income. So, I was running one of my favorite indexed annuities with the GLWB rider. As I looked at the printout, I came across something that I hadn’t seen in years. It was a “step up!” It had been such a long time since I’ve seen one of these, at least on this type of a GLWB rider, that I was confused until I realized what was happening and why it was happening: The 11.5 percent S&P 500 “cap” was outpacing the GLWB rollup rate. Now that is not something you saw when caps were at five percent!

Over the last few weeks I have also had a few questions from agents asking me, “Can you explain what is happening in this illustration?” So, I felt the topic to be worthy of a column along with a few other random thoughts on GLWBs.

A couple decades ago I was with a very large company that was a leader in the variable annuity space. At the time, the hot item with variable annuities was “guaranteed lifetime withdrawal benefits”(GLWBs), and its predecessor, “guaranteed minimum income benefits” (GMIBs). These were very popular because, on the back end of the dotcom crash, consumers were looking for guarantees to protect them from the turmoil they had just experienced. The GLWBs separated themselves from the GMIBs in that the GLWBs did not require annuitization, just “withdrawals.” Hence, with the GLWBs, the company did not require the client to lose control of their account value by locking it into a perpetual income stream.

At that time our hot VA product story was that the client had a “benefit base” that was guaranteed to grow by seven percent every year, regardless of what the actual account value did on that variable annuity. Even if the account value lost 50 percent, again, the client had that baseline guarantee that they can eventually take income based off of. Furthermore, the variable annuity world marketed an additional benefit, and that benefit was “step-ups.” The notion of a step-up was that if, at the end of the year, the actual account value is higher than the benefit base—meaning that the account value increased by more than what the seven percent rollup percentages had done—the client’s new benefit base would “step up” to what that account value was in that year. And then the ongoing seven percent roll up percentages would generally apply to that higher value. Later on came quarterly step-ups, monthly step-ups, and then daily step-ups. Then the economy crashed in 2009, interest rates plummeted, and these robust variable annuity benefits “stepped down”…but I digress.

We all know that GLWBs on indexed annuities came from the variable annuity world. The first GLWB was put on an indexed annuity chassis around the year 2006, after the variable annuity business had been running with the concept of GLWBs and GMIBs for years. This made sense to the indexed annuity market because the VA business had used these riders with huge success. The VA business was a good business to copy because the VA business at the time was about six times the size of the indexed annuity business. 2006 VA sales were $160 billion and indexed annuity sales were around $25 billion.

Over the last two decades these riders have evolved like everything else. I now discuss that there are two different categories of GLWBs in general: a) Performance-Based (the newer breed); and, b) Guaranteed Rollup Riders (the traditional breed).

The performance-based riders generally have minimal (sometimes none) “rollup rates.” These riders largely rely on the account value to increase in order to have the benefit base (and eventual income) increase. An example of one of these GLWBs may be, your benefit base will increase by two times what the amount of credit/performance was in your account value.

The performance-based riders are a good option for the clients/agents that believe that the performance of the underlying index may enable the benefit base to grow faster than what a guaranteed rollup rider may be able to do. These riders effectively rely on “step-ups” like what I discussed with the variable annuities.

The other category—at least how I categorize them—is “Guaranteed Rollup Riders.” These are the traditional seven percent, 10 percent, etc., benefit base rollup rates. These GLWBs are for the clients/agents that want straight guaranteed income without any reliance on the account value. These are the riders that have been on indexed annuities since the beginning.

Generally, the “performance-based” riders will show “non-guaranteed” income that is higher than the guaranteed-rollup riders, at least based on the illustration. However, from a guaranteed income standpoint, the guaranteed rollup riders will generally show the highest guaranteed income.

With the guaranteed rollup riders, something odd is starting to happen with interest rates having spiked the way they have, and that is the potential to receive a step-up on the benefit base… If the indexed annuities in the early years had much potential for “step-ups” back then, then I certainly don’t remember it. If there was ever much potential then it only lasted until the financial crisis, when interest rates really started to plummet.

Why no step-ups? Two primary reasons:

1. Low interest rates: Because caps and par rates on these products were so low that the odds of having the accumulation value outpace the “benefit base” was almost nothing. (Caveat: There are some “volatility-controlled indexes” that show very high “backcasted rates” that have been able to show a step-up, but that has not been the norm.)
2. Bifurcation of objectives: Another reason that you have not seen step-ups on this flavor of GLWB is because the GLWB focused annuities are “generally” watered down from an accumulation standpoint relative to the same company’s accumulation focused annuities. If you compare the cap rates, par rates, etc., on a product that provides very good guaranteed income, you will find that the tradeoff is “usually” the lack of accumulation performance. (Note: There are exceptions to this rule in that there are products that have the same cap as their “accumulation focused” counterpart. Hence, the product I used in the first paragraph.)

With interest rates having increased the way that they have, and by choosing a product that also has great accumulation potential, there may be opportunities to show the consumer the potential for an occasional step-up on their indexed annuity. But be cautious of rosy illustrations.

One last point on income focused products that also have great caps, par rates, etc. Even without a “step-up,” a great income focused annuity represents less of an “opportunity cost” to the client—versus a purely accumulation product—when that income focused annuity also has great accumulation potential.

Get out your financial calculators, spectacles, and your pocket protectors because we are going to have some fun with this column. We are going to create a product. Of course I am being somewhat facetious because there’s much more that goes into “creating a product” than just the numbers, such as: Non-forfeiture requirements, state filing, illustration parameters, surrender charges, MVAs, utilization rates, etc. I do not pretend to be an actuary, but I am about as “actuarial” as a sales guy can be. My wife tells me that’s like being the tallest elf.

Regardless, this elf is going to show you the not-so-basics of creating an indexed annuity with a “cap” based on today’s (October 7, 2022) interest rates and options prices. The purpose of this is to not make everybody into actuaries but rather to enable you to easily answer many questions about these products by having a deep understanding of how they are created.

Here is the product we—the insurance company—are going to create. This will be a 10-year indexed annuity that utilizes an annual reset S&P 500 strategy. This strategy has a “cap” that we will need to figure out based on today’s interest rates and options costs. This product will have a seven percent commission to the agent. Furthermore, we—the carrier—have shareholders that require a “return” on the company’s capital to the tune of eight percent (more on this later).

Agenda:

1. Determine how much we, the insurance company, can get in yield when we invest that client’s money.
2. Based on our IRR requirements from the shareholders, how much of a “spread” do we shave off the top of the yield that we are getting in bullet point number one above.
3. We then take what is left of the difference of number one and number two above and that determines our call option budget.
4. We take our call option budget, and we buy and also sell call options based on today’s option prices. Based on the pricing of call options, you and I will be able to identify what cap rate a person can get in today’s environment. Sounds pretty cool huh?

1: How Much Yield Do We Get?

First off, when a carrier takes a client’s $100k (example), that carrier will invest almost all of that money in the bond market. Although a lot of folks use the 10-year treasury as “the benchmark” for the yield rate, a better benchmark is the Moody’s Baa bond yield. This is because carriers generally invest more in corporate bonds than they do in Treasury bonds. Why? Because corporate bonds provide a higher yield. For instance, an index of “investment grade” corporate bonds might represent a 5.99 percent yield. This is much better than the 10-year Treasury bond that is currently yielding 3.88 percent. Thus, the reason corporates are favored over Treasuries.

Now that the insurance company knows that it can invest their money and earn approximately six percent on this money that is going into their “general account,” the carrier needs to allocate that money between the bonds and the call options. The bonds will be purchased to guarantee the money grows back to $100,000 every single year, regardless of what the S&P 500 does. This is how the carrier is able to support the policy guarantees. The call option chunk will give the indexed annuity the “link” to the stock market in the up years. Again, Bonds=Guarantees and Options=Upside.

2: The Carrier’s Cut

Before we calculate how much money goes to bonds and how much money goes to the call options, the carrier takes their cut… This is where the “carrier spread” comes in. That is, the carrier shaves a little off the top of that six percent (technically 5.99 percent in our example). That “spread” is how the carrier makes money. How much spread does the carrier require? It depends…

Our carrier has shareholders that require them to make a certain amount of money on the carrier’s capital. And make no mistake that putting a case on the books costs a carrier capital. Afterall, the carrier has to pay for the administration, paperwork, and the big one, agent commission. This is why if you have ever seen a carrier grow “too fast” they will shut off new sales.

There are various measurements on the amount of money the carrier makes off their investment, such as Return on Investment (ROI) and Internal Rate of Return (IRR).

To simplify this, let’s say that we, the carrier, pay $7,000 to put our $100,000 on the books, or seven percent. This is simplified because our agent commission is seven percent and there are technically more expenses than that but bear with me! If the carrier shareholders demanded an eight percent internal rate of return over the 10-year life of our product, what annual income would be required for the carrier to achieve that? If you put this in your financial calculator, it would require $1,043 per year to the carrier (PV=-7,000, N=10, %=8, FV=0, solve for PMT). In other words, by the carrier “investing” $7,000 of their own money, in order to get an eight percent return over the 10-year life of the product, that carrier would need 1.043 percent ($1,043) off the top of our six percent. Hence, a spread of 1.043 percent. (Note: In corporate finance you learn that if the IRR is greater than the carrier’s “cost of capital,” it is a project that is worthwhile. Hence, if a carrier borrows money at six percent and gets an IRR on that money/capital at eight percent, that is a product that has a positive “Net Present Value” and is good!)

For our example, let’s simplify the above and say that the carrier’s yield is six percent and the carrier spread that is required to keep the shareholders happy is simply one percent. No need to get crazy here with the decimals.

3. Calculating the Call Option Budget

After the carrier takes its one percent off the top, we have five percent to play with for our client and their $100,000. This is where we need to divide the money between the bonds and the call options. The bonds need to guarantee $100,000 at the end of every year to—again—support the policy guarantees. So, what dollar amount needs to go into the bonds—earning five percent—so that those bonds in the general account grow back to $100,000 at the end of the year? Hint: The correct answer is not $95,000! The correct answer is $95,238. Thus, if you add five percent to $95,238, you will get $100,000. So, if the insurance carrier is investing $95,238 in bonds, what are they doing with the other $4,762? Call options. We have arrived at our call option budget.

Review:
What have we done so far? So far, we have designed the commission level on the product at seven percent. We also calculated how much the carrier needs in spread to make the shareholders happy, and we have also arrived at our call option budget of 4.76 percent that will soon determine the cap. (Note: All of these calculations revolve around the interest rate of six percent—technically 5.99 percent. This is why indexed annuity pricing has gotten better over the past year.)

4. Buying and Selling Call Options to Arrive at Our “Cap”

So, we have $4,762 to buy call options that link our client’s $100,000 to the S&P500. That is a call option budget of 4.76 percent of our $100,000. So, the first thing we want to do is look at the prices of call options on the S&P 500 (SPX). We want this call option to give us all of the upside of the S&P 500 between now and 12 months from now, because our product is an “annual reset.” (Note: My discussion is going to be largely about percentages. The exact dollar amounts to link the client’s $100,000 would be just a function of buying multiples of what we are talking about below. The exact dollar amounts are not important. The call option budget percentages are important.)

Table 1 represents five rows—out of hundreds of rows—that represent today’s (10/8/22) option prices for an S&P 500 option that expires approximately one year from now. Because we want this option to give us growth on our client’s money from where the market is today (3,639), we need to find the “strike price” that is close to that number. In other words, we want to buy an “at the money” call option. So, we need to see what options sellers are “asking” for these options. It appears that we can buy an option for $432.10 on a S&P 500 value of 3,625. This call option represents a whopping 11.92 percent (432.10 divided by 3,625) of the “Notional Value” that is linked to the market! We have a problem here because our options budget is only 4.76 percent.

No fear, there is a solution here. That solution is that we can buy this option but then immediately sell another option that will give us back approximately 7.16 percent. This will ensure that our net options cost is only 4.76 percent. In other words, by us buying an option for 11.92 percent and selling one for 7.16 percent, our total net cost will be our options budget of 4.76 percent (11.92 percent-7.16 percent=4.76 percent).

So above, let’s buy the “at the money” option for 11.92 percent of the “notional value.”

Selling a Call Option
As you can see in the options pricing tables, the higher the “strike price” on call options, the cheaper they are. It is because the “strike price” represents the point in time where the option purchaser actually starts making money. Hence, “in the money.” So, if we are selling a call option, we want to go as far down the “strike price” as we can. This is because when the market increases to that number, that is the point that we will be giving the upside to somebody else! Ideally, we would just purchase the option that we already did above and not have to sell a call option. However, we don’t have the large call option budget to do that, therefore we must sacrifice some upside. So, let’s go down the list and see what we need to sell. We need to produce about $259.55 (7.16 percent of 3,625) so that we net out to our 4.76 percent budget.

We found something close! We can sell an option for $257.20 at a strike price of 3,950. What does this mean?

• We netted out to a cost of $174.90 (Paid $432.10—Sold $257.20). This represents something very close to our call option budget—4.82 percent (174.90 divided by 3,625)
• We just created a product with an approximate “cap” of nine percent. This is because we are participating in the upside of the market starting at 3,625 and handing off the upside “participation” in the market once it crosses over 3,950. 3,950 is approximately nine percent (8.97 percent technically) higher than 3,625.

What we have just done is created an indexed annuity that:

1. Guarantees the client’s money will never be lost. This is because the carrier has the bonds that grow back the money to $100,000 every year, assuming rates stay the same.
2. Gives the shareholders their IRR, assuming rates stay the same.
3. Gives the carrier a 4.76 percent call option budget to buy the call options after they expire every year, assuming rates stay the same.
4. Gives the carrier upside potential of nine percent that they can pass through to the client in the form of a “cap.”
5. Pays the agent a seven percent commission.

Although my calculations are my own calculations and not specific to a carrier, the product I just explained with those caps, commission rates, etc, really does exist today. So, those calculations are not pie in the sky.

Technically, one of my favorite products is the same as what I laid out here, except the A-rated carrier just announced a cap increase to 10.5 percent for premiums over $100k! How can they do that? Numerous ways. Maybe the carrier is demanding less spread for themselves. Or maybe the carrier is able to get investments at higher yields than my six percent. Both of these would mean more call option budget.

I am fully cognizant that this was a three-coffee article for you to read, but I promise you, if you are serious about indexed products, this article will help you in the future when it comes to answering questions about “How do the carriers do it?.”

My dad, who was the wittiest and toughest person I ever knew, owned a construction business (underground utilities and concrete) for 40-years. As somebody who “dug ditches” since his early teens all the way up to his death, he had a way with words that I usually don’t repeat but I will here. He once told me jokingly, “How do you know when the deal was negotiated fairly for both sides? When both sides of the agreement feel that they have been screwed.” Now, that’s not something that you learn in business school, nor do I condone that method of thinking. He tended to say things for the effect.

Rather, I prefer the thought of both sides feeling that they received a fair deal. That is how you make for happy business partners and a sustainable and reputable business. I do believe that when agents partner with other agents and “split commissions” that there is a structure that—based on my experience—does exactly that. It makes both sides feel the deal is fair.

Oftentimes a “junior agent” might seek to partner with a veteran agent. The reasons for this partnership are obvious. If the junior agent cannot get the sale without the help of a veteran agent, it would be silly to not utilize a veteran (assuming one is available) even if it means that the junior agent would get less than 100 percent of the total compensation. As they say, 100 percent of $0 is zero compensation. By the way, if you are a junior agent and don’t have access to a “veteran agent,” partner with an IMO that will help you with the sale. In many cases—as with my IMO—there would generally not be a commission split unless I am hopping on an airplane.

A second scenario might be the inverse of the above. This is where a veteran agent will seek to partner with a junior agent. Why would a “rainmaker” want to partner with somebody junior? For the veteran agent to free up time to do what he/she does best—rainmaking. Thus the veteran agent may seek to offload some of the time-consuming legwork to a junior agent.

A third example may have nothing to do with junior versus veteran. It may be a scenario where an insurance agent is partnering with a CPA or an attorney. Many times the CPA has a captive audience and they just need an “insurance expert” to do the case design and also close the case for them.

These three scenarios are great business scenarios and very smart! They allow each individual to do what they do best while not trying to do a task that neither person is optimal at, while at the same time the junior advisor (or the CPA/Attorney) is learning from the veteran agent. The three scenarios are efficiency at its finest and what makes our industry’s compensation flexibility such a great thing. However, you must know what a fair “split” arrangement looks like so that neither party feels ripped-off.

So, what is a fair split arrangement? This is the main topic of this article.

The Million Dollar Round Table (MDRT) was the first—that I know of—to really prescribe a breakdown of what commission splits should look like. These commission split percentages that they recommended were generally based on the types of services that each agent would provide. The below breakdown is very similar to what the MDRT first came up with except for some slight verbiage changes that we applied. This is merely a guide, but I believe a very good guide.

• 20 percent—Prospect Delivery: This is where the agent has brought the client to the table, whether through past relationships, a referral, or marketing activities.
• 20 percent—Data Collection and Delivery: This is where the agent collects all the data needed for the sale (health information, financial information, fact finding) and also delivers material to the client that is needed prior to the sale.
• 20 percent—Case Design: This is where the agent designs the strategy, which includes: running illustrations, modeling scenarios, seeking the right prices, organizing the end plan that is to be presented, etc.
• 20 percent—Closing The Deal: This is where the veteran agent comes in many times to “make it rain.” This is where the final presentation/conversation occurs with the clients. This is the inflection point—the case/plan either gets implemented here or dies here!
• 20 percent—Ongoing Service: This is the delivery of the policy, annual reviews, continuous updates for the clients, etc.

With the above being said, a common approach would be that the veteran helps close the sale. That would mean that the veteran could easily justify getting 20 percent and the junior agent getting 80 percent. If the veteran also did case design, then he/she might ask for 40 percent.

As an IMO, I work with scores of agents per week and they often ask me how they should get compensated on cases they “split” with other agents. I have never had an agency balk at the above MDRT method.

I have never had a client balk at my indexed annuity or indexed universal life insurance conversations when I tell them that the products are designed to do better than their fixed rate peers, not the stock market. I will tell them that if fixed rates on fixed annuities today are three or four percent, then over the long run they can expect to potentially get four, five, six, or seven percent in an indexed annuity. However, these are not guarantees. If the client balks at that conversation, then it is usually because the client is not the right fit for indexed annuities. For example, if I am talking with a 25-year-old kid who is expecting double digits between now and his retirement, then he will likely scoff at four, five, six, or seven percent. But that is OK because that tells me that he is a bad fit for this product type. Conversely, if I set the expectation that these products will perform for that 25-year-old the way he wants, I would be setting myself up for annual reviews that are as pleasant as colonoscopies. (Note: I would argue that indexed annuities as a bond alternative is something that even some younger folks should think about, but I digress.)

The fact that consumers are fine with indexed annuities, without having to inflate the story, is why I am perplexed when I see in marketing material or hear in a sales pitch how “XYZ product has performed 12 percent over the last ten-years.” To be clear, I have spoken about the true past performance of my clients’ indexed annuities and think that great past performance should be cheered. In fact, I am seeing biennial statements for a few of my clients that are indicating 20 percent interest credits over the last two years. So, am I speaking out of both sides of my mouth here? What is my problem with marketing “12 percent ten-year returns on XYZ Indexed Annuity?” A few things:

1. There is a difference between stating what has truly happened and setting the expectation that it will happen in the future.
2. It can be disingenuous: Many times, those returns are not true returns. In fact, oftentimes the product has not even been in existence for 10 years. So how are they marketing that? They are marketing that because that is what the illustrations are able to show. Per illustration regulations, the illustrations are able to show “back casted” performance over the last 10 years, as if that particular index and product had been in existence.
3. The A-10 Warthog: That favorable “back casting” oftentimes is what the product was designed around. Like how the A-10 Warthog jet was designed around the giant 30 mm gatling gun, versus the gun being put into an already existing airplane, carriers oftentimes find—or create in partnership with an investment bank—indices that “back cast” beautifully and then design the product around that. As we all know by reading the Dalbar Studies, chasing history can be a losing proposition.
4. It goes against basic economics. If a carrier is able to take a call option budget equal to, say, four percent of the entire premium and turn that four percent into a 12 percent return over a year, it is unsustainable. That is a 200 percent return on our call option budget! If many of the very smart people on Wall Street believed that the carriers’ call option strategies would consistently deliver 200 percent returns, they would swarm to those call options themselves and bid the prices up so high that the ultimate return on that call option strategy would be nowhere near 200 percent. Markets may not always be “efficient,” but I can guarantee that they are efficient enough to not allow 200 percent returns for very long.

These products are beautiful products and the time is right for these products, with the bond market (AGG) being down around 10 percent ytd. and the S&P 500 also being down double digits. Although in a down year a client has the potential to lose out on a four percent interest credit with indexed annuities, I do believe in the notion of “risk premium.” That is, if the carrier were to take that four percent and buy call options with it, they should be able to get more than that four percent back, over the long run. For example, over the long run stocks have done better than bonds, because of the fact that stockholders have always been rewarded for taking on that extra risk. I view the carrier’s call option budget no differently. The carrier may not always get a 200 percent “risk premium,” but an additional one, two or three percent to pass through to the clients on top of the original four percent call option budget would be nice. Said another way, indexed annuities have outperformed their fixed rate peers over the long run, and I believe they will continue to do so. Thus, the title of this column!