Annuities Have Only Become Complex
Due to the Low Interest Rate
Do you have any food allergies ?
You know, those strange physical reactions you have
to certain food-stuffs that others don't think twice about
It is something you cannot overcome because
it is in your nature ; there is nothing you can do about it.
You were born with it and you will probably die with it and
the sooner you obey its command, the better !
Life Insurance companies offering fixed annuities also have a
genetic predisposition as well. They are entirely, uncontrovertibly sensitive to the phenomenon of current interest rates.
Why would this be the case ?
Insurers are restricted, within limits, from speculating in the stock market with risky investments because State laws regulate their investment choices and reserve requirements. As such, the guarantees that insurers provide to policyholders (and those guarantees cannot be changed once a policy is issued) actually restrict an insurers own portfolio investment choices heavily to the realm of fixed income securities such as bonds, both corporate and treasury, which are heavily interest - rate sensitive devices. The low interest bearing bonds backing up much of an insurers portfolio must earn a superior return for the insurance company than what that company guarantees on its annuity contracts in order for the company to be profitable.
In light of the current squeeze on insurance company profits due to these extremely low interest rates, insurers in the last 5 years (since 2008) have lowered the minimum guarantees offered in new fixed annuity and indexed annuity policies. Whereas prior to 2007, interest rate minimums for the majority of new fixed deferred annuity issues was 3.00% annually, in 2014 that minimum floor is around 1% annually, and in some cases even 0% !! (These are minimum contractual guarantees - not potential crediting rates which can be much, much higher).
The result of this reduction measure allows insurers to lower their reserve requirements and thus increase operating efficiencies.
Since it impossible to compel annuity prospects to purchase annuities on the merit of high fixed interest rates that do not exist, Insurers have thus been forced to become more creative.
And after putting their creative caps on, insurers discovered a bonanza in the effective marketing of a solution to the well promulgated demographic trend of increasing life expectancies and stock market uncertainties. (Collectively known as the "longevity risk" phenomenon).
Insurers are selling the "longevity risk" concept en masse. Theior solution is that longevity risk (fear of running out of money) can be mitigated by guaranteeing to oneself a lifetime income from an annuity that provides a lifetime income rider feature. The lifetime income rider is an annual payment made by a policy owner (the cost is anywhere from .40% to 1.25%) that enables the insurer to guarantee a lifetime payment at a certain point in time of the owners choosing.
To understand the longevity risk proposition, insurers are simply betting that you will not live much beyond your life expectancy, and you are betting that you will. In most cases, the illustration at the point of sale should inform the policy owner what he or she can expect at a certain point in time so that the policy owner can mathematcically determine if the income rider makes sense.
It is the advertising, messaging, and the sales practice of this
income rider feature, however, that has permeated the insurance
industry's marketing for the last 5 years - and at the same time
confused the public to no small degree.
Here is a brief attempt to expose the mixed messaging:
There are 3 calculations that insurers use in determining the
lifetime payment amount that the income rider has purchased.
The first calculation is a ficitious growth rate of the clients money
tabulated at a presumed fixed rate of return, say for example, 7% for
ten years. This is an entirely fictitious calculation that does not
represent real money in any way.
The second calculation is a predetermined withdrawal rate the insurer uses to multply against the ficititious sum derived in the first calculation. So, for example, assume the policy owner is 65 and they have owned the annuity with the income rider for 7 years and they wish to take a lifetime income. The insurer simply multiplies the sum total of their fictitious 7% yielding account by the predetermined payout factor (which the company furnishes when the policy is first issued) of, say, 5.50%, and this yields the lifetime payment amount.
The third calculation mostly is used by insurance agents as a selling point. The lifetime income payment derived from the second calculation when divided by the original principal can be suggested as a "payout rate". So, for example, if the policy owner is receiving $6,500 for life on their original principal of $100,000, then the agent may suggest that the payout factor is 6.50%.
All 3 calculations have "rates" inherent in their function.
But these "rates" have nothing to do with the actual accumulation or growth of principal, although it certainly sounds like it does.
The actual growth rate of the annuity is dependent upon the indexing strategy the policy owner has chosen and this is an entirely different subject than how an income payment is derived.
Much of the so - called "complexity" of the indexed annuity really comes down to improper disclosure of those 3 calculations just mentioned. Too often consumers have been led to believe that at least one of these 3 calculations (fictitious growth rate, withdrawal rate or payout rate) are actual pure interest rates for the accumulation.
Sorry, not so much !
And that is (one more reason) why the annuity is so
ambiguous; an unregulated sales force selling an honorable
and time tested financial product leads to simple ambiguity!!
Oy Veh !