Shane Stamatis

Fixed indexed annuities continue to outpace their non-indexed counter parts in sales.  The question is: Why, and what is the value proposition to which senior savers gravitate?  Is the customer better off by buying a fixed indexed annuity rather than a fixed annuity?  They should be.  Yet many critics of indexed annuities remain skeptical, and much of that is from a lack of understanding of the trade-off from a fixed interest rate to an indexed interest rate.  

Annuities are spread-based products.  The insurance company accepts your premium and earns interest, subtracts a spread for its expenses, and then credits you a fixed rate or buys an option in the case of an indexed annuity.  So think of it this way: The company earns 3.5 percent, needs 1.5 percent to cover expenses, and that leaves two percent available for the policyholder.  Now the customer can either take the two percent as interest or have the company buy an option that costs two percent and the ending interest credit will be something higher or lower.

Consider the following example (Table 1) using simple interest as a way to easily compare the similar offerings.  Let’s look at a) a fixed annuity with a two percent interest rate, b) a five percent bonus indexed annuity with a three percent annual cap on the S&P 500 index, and, c) an indexed annuity with a four percent annual cap on the S&P 500 index.  All are 10-year products with identical product features except the interest crediting method.  We will assume that over the 10-year term the indexing hits the cap seven times and gets zero percent the remaining three years.

Clearly the FIA offers significantly more interest.  In fact, they offer up to 40 percent more interest.  What is the source of the increase from 20 percent to 28 percent?  Is this magic, or some marketing game that is being played?  No—it is the reward for the risk that the customer is taking.  It is a risk premium.  Indexed annuities are supposed to be safe, so why are we talking about risk?  The principal is safe and backed by investment grade bonds and similar secure investments.  Then the insurance company takes a spread from those investments (just like a bank does when determining the interest rates on their CDs) and offers the customer the choice of either a fixed rate or an indexed rate.  It is important to note that the insurance company doesn’t care whether the customer chooses fixed or indexed.  They get their spread regardless.  The customer is risking her fixed interest credit.  She could receive the fixed credit of two percent.  If she decides to do indexing, the two percent fixed rate could be at risk of earning zero percent.

The final thing to understand is that the options that back these products are commonly purchased from Wall Street investment banks (Barclays, Goldman Sachs, BNP Paribus, etc.) who price the options so that they are risk neutral.  This means that the investment banks make their spread whether the market hits (and the option returns three to four percent) or the market misses (and the option returns zero percent).  Wall Street makes the same profit whether the market goes up or down.  Wall Street is indifferent.

If the Wall Street banks make the same profit whether the indexed annuity goes up or gets zero percent, and the insurance companies make the same profit whether the indexed goes up or gets zero percent, then that leaves the customer.  The customer is taking the risk and the customer gets the reward.  The customer risks their entire two percent interest credit.  It’s similar to the old game show Let’s Make a Deal where the contestant can keep their prize or choose between door #1 and door #2.  There was something like a new car behind one of the doors and a year’s supply of bath soap behind the other.  Most contestants chose to take the risk.  Likewise, most seniors are willing to risk getting a zero percent credit for the more likely result of getting a four percent credit.

As we drill into the Let’s Make a Deal analogy of interest crediting, let’s pretend I deposit $100,000 into the indexed annuity with the two percent fixed rate and the four percent annual cap.  I could keep my current prize of the two percent fixed rate and collect $2,000 at the end of the year.  However, I like my chances of getting something greater than zero percent (74 percent probability) so I choose the indexing crediting option and wait until the end of the year.  Then 26 percent of the time I get zero dollars credited to my policy – like choosing the year’s supply of soap in Let’s Make a Deal.  That, in effect,  means my $2,000 yielded -100 percent.  I know that sounds terrible, but it’s true.  I lost all my money!  Fortunately, I only lost $2,000 and my $100,000 account is still there for me to make another deal the next year.  The good news is that nearly 74 percent of the time my $2,000 will double and I will get $4,000 credited to my policy.  I doubled my money.  I earned 100 percent on my $2,000.

Still, don’t see the risk premium in play?  If you put $2,000 in a bank certificate of deposit and earned 0.50 percent, you would have taken no risk and at the end of the year you would have $2,010.  Even if you put the money in something riskier like an S&P 500 fund you would expect your money to be worth somewhere between $1,500 and $2,500 with the long-term expectation of eight percent resulting in $2,160.  But even that is a far cry from the $0 to $4,000 range that options offer.

Indexing works precisely because it offers a desirable mix between the safety of principle and risk of interest credit.  The customer gets the reward because the customer is the one taking the risk.  The customer should expect indexing to outpace fixed by 30 to 40 percent.  That means if they have a fixed account of two percent then they should expect the indexing over the 10 year term to be 2.6 percent to 2.8 percent.  There are crediting methods more risky than an annual cap on the S&P 500.  These methods should carry a greater reward and thus your customer should expect a higher effective rate over the life of the contract.

In our illustration-driven world combined with the recent 10-year run, I have seen annuities marketed as earning six percent or higher interest rates.  Those companies and the agents representing them run a different kind of risk–disappointment.  If our 40 percent risk premium holds true, then in order to expect an interest credit of six percent it would require a fixed rate (option budget) of 4.3 percent.  It would be difficult to convince me that such an annuity could be priced in today’s economic conditions.  That doesn’t mean it couldn’t happen in one year, but over a ten-year period is another matter.  Agents who are committed to having a successful practice are going to succeed if their customer’s expectations are close to reality.  Those are the same agents who understand what they are selling.