Equity Indexed Annuities Were Designed
to Rob from the Banker not
Raid from your Broker.
The equity indexed annuity is so commonly pitched and portrayed
by insurance agents as an equally capable athlete to your stock
portfolio that it is no wonder we have the social
phenomenon of the Ambiguous Annuity.
When consumers have been led to expect
market - like returns in their indexed annuity
and do not see them every year, they begin
to doubt the annuity products inherent worth.
Conversely, when the market takes a nose dive, they feel
significant pride that they made such a wise choice
when they did.
In fact, the annuity's perception can be so
dependent on the the mercurial mood of the
market one is inclined to acknowledge that this
misunderstood financial instrument is no stranger to indifference.... no less than
than an innocent child with a passive aggressive parent !
So if the annuity (and in this case I mean the equity indexed version) has such a bewildering reputation, what concept did it's inventors specifically have in mind back in 1994 when they were zealously juggling
test tubes filled to the brim with colorful actuarial chemicals in their laboratory?
The product designers were forced by insurance regulations
to remain within the confines of the fixed annuity's basic platform
of providing annual principal guarantee protection. If a fixed annuity
provider was going to create an innovative product or feature, it would be
forbidden to sacrifice the maxim of principal guarantees. Otherwise, the
concept would venture into the arena of a security, or more specifically, a
variable product, and thus cease to exist as a true fixed product.
On that note, variable annuities were precisely that animal and had been
around since the 50's, but it was not until the mid to late 80's they took off
intensely. A decade later, the variable insurers had become more enterprising,
developing more investment choices and more guarantees relating to death
benefits and income benefits.
On the other hand, Fixed Annuities had been initially developed to compete for bank customers. (This should be self evident insofar as both institutions offer principal guarantee protection). But fixed annuity providers competed primarily on the playing field of interest rates, tax advantages and liquidity differences. The success that variable annuity providers were having in the late 80's and well into the 90's, however, catalysed fixed annuity providers to come up with more innovative features to arrest the interest of the investing public.
And the fixed annuity did lack one thing in comparison to it's more restless cousin the variable annuity:
The ability to capitalize on the powerful equity markets.
The inventors, neverthless, had to discover a method that would not jeopardize policy principal.
The solution fixed annuity providers came up with was something that had already existed within our market economy system for some time: call options.
After meeting annual reserve requirements to guarantee
policy holders principal, insurers could pull from their
surplus and buy call options on an index, such as the S
and P 500 for a 12 month period (known as the annual
point to point crediting option) for example, and
capitalize on only the growth (flow) only, not the
recession (ebb) of the market.
Call options are market contracts written by a writer, (also known as the seller) and are not direct investments in a stock or fund. They are merely contracts, or rights, that give the holder (in this case the insurance company) the option or right to purchase a stock at a set price (known as the "strike price") for a predetermined time period. These options are literally purchased for a fee from the seller and can be exercised by the purchaser when the strike price is met. If the strike price for a stock, for example, is $80, and an insurer holds that particular call option, the insurer will exercise the right to buy that stock if the stock is "in the money", meaning when that stock price is $80 or higher. Ideally, the purchaser would have the ability to obtain a stock presumably at a lower cost than what it is currently valued at - by virtue of owning the option.
In such positive scenarios, the insurance company would earn profit and the owner of the anuity policy would see growth in their "point to point" crediting strategy.
However, if perchance the reverse was true and the stock price, in our example, was less than $80, then the insurer would simply not exercise the option, and the only loss to the insurer would be the cost they had invested in buying the option in the first place.
In this case, the indexed annuity policy owner would see no growth in their "point to point" crediting strategy, however, they would also see NO LOSS as well.
In this manner the indexed annuity remained, from a regulatory standpoint, within the confines of annual principal guarantees as obligated to do so, but remarkably now having the ability to offer some of the upside of the equity markets through the device of option contracts.
Some limitations to this 1994 "invention" included the inability of the call option to include dividends (since the call option is not an actual investment in the stock itself). In addition, insurers sometimes had to limit the returns to policy holders in their crediting strategies (option contracts) with what are called annual caps, spreads, or participation rates. (Always read your policy to know if this applies to your case). These limitations were, and are, sometimes necessary to hedge against future losses.
But in no case would an indexed annuity policy holder suffer loss (based on the claims paying ability of this insurer, of course).
So, in conclusion, the index annuity was invented to capture some of the markets growth, and ideally, this would be superior to what a fixed CD, from a banker could provide, for example.
So, the answer to whose customer the indexed annuity
provider is trying to steal - the banker or the broker, is this:
Because the indexed annuity still guarantees principal, just
as the bank does. As such, the indexed annuity is going after
the same customer.
The indexed annuity provider is merely offering the potential to get higher than bank-like returns through the indexing strategies offered in their policies (made available through option contracts purchased by the insurer itself).
The index annuity provider cannot compete on a level playing ground with Wall Street as insurance companies have safeguards imposed upon them through state regulations to maintain reserve requirements for policy holder principal amounts. In addition, they cannot "capture" dividends, and in some cases, must limit the returns to policy holders.
Q) So why do insurance agents discuss so often the indexed annuity as if it is a stock that can never go down ?
A) Lack of industry regulation. (See my article "A Sleazy Industry, but a Soft Landing for All" in the Go! Section of this site.)
To policy holders, the safety of the indexed annuity industry is quite admirable. This writer is unaware of any indexed annuity insurers who have left policy holders actually "holding the bag" through insolvency or malfesance.
But the "sales side" of the industry is an entirely different story.
Although there is enforcable regulation on what an agent can,
or cannot say, to an annuity prospect at a point of meeting, there is obviously
no regulator at the actual point of sale. If a prospect is preferential to hearing
the growth potential of the indexed annuity, an agent is sorely tempted to
overstate such opportunities. Often the fact that indexed annuities do not
contain the dividends of the market, is not mentioned. And the limitations that are
placed on the annuity's growth with caps or spreads or participation rates
(sometimes 1 of of these 3) should also be verbalizedby the agent, but sometimes isn't.
Of course, annuity agents receive a commission (not unlike real estate agents or loan officers or shoe salesman), so this aspect of the business can tend to foster the improper dissemination of information as well.
Neverthless, despite the shenanigans of some sloppy agents out there, typically policy holders receive fair value for their buying decisions in terms of guarantees, potential index credits and peace of mind.