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:
- There is a difference between stating what has truly happened and setting the expectation that it will happen in the future.
- 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.
- 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.
- 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!