Dear Mr. Denlea,
At the National Association for Fixed Annuities (NAFA), we recognize that the California indexed annuity case referenced in your blog article may signal an opportunity for your firm. However, if a client contacts you as a result and you start to do some research, you will find that your understanding of indexed annuities is surprisingly flawed.
Consider the following:
You said, “The premium paid for an indexed annuity is put in an index fund. The returns are then based on the performance of the entire index. While stocks in one category may increase, stocks in another may decrease, so an investor should always be prepared to take a loss when investing in an indexed annuity.”
While you are correct that the premium paid for an indexed annuity is invested by the carrier, often in a mix of bonds and stock market index options, you are wrong in stating that the decrease in stocks will lead to a loss in the value of the indexed annuity. In fact, the value of the annuity never decreases because stocks do. The insurance company bears ALL of the portfolio’s market risk. If, for example, the S&P 500 index were to fall in value, even crash, the owner of an indexed annuity loses nothing. At worst, an indexed annuity can credit no interest, but a loss in the market index cannot cause a loss of value in an indexed annuity.
You said, “Insurance agents like to sell indexed annuities because the commissions they receive from insurers are high.”
AnnuitySpecs publishes a quarterly industry sales survey on indexed annuities. Their most recent report indicated that the average sales commission paid on an indexed annuity is 6.3%. Considering that the average surrender period on an indexed annuity is 10 years, the average agent commission is about 0.63% per year that the client’s money is in the annuity, which is below the typical 1% per year asset fees taken on other financial products.
You said, “In the California case, one elderly investor paid $14,000, or an 8% commission. If the money had been withdrawn within the first year of ownership, there would have been a penalty equal to 12.5% of the principal.”
Actually, in the California case, the purchaser paid no commission at all – the issuing insurance carrier paid the agent’s commission. Commission expenses are built into the annuity’s benefits and limitations, similar to many other services and products that people routinely purchase like life insurance and cars.
One of those limitations is the surrender charge and its major purpose is to impose a time commitment agreed to and made by the annuitant that allows the insurance carrier to safely invest in the combination of long-term investment vehicles that are necessary to create the attractive blend of safety features and interest-crediting potential that indexed annuities offer.
Annuity owners who break the time commitment cost the carrier money since it needs to unwind those long-term investments prematurely and potentially at a loss. Carriers could recoup those losses by charging fees across their entire customer base, but instead they do what is much more equitable – they charge those customers who break their time commitment a surrender charge, thus they effectively reward those customers who abide by their time commitment.
Ironically, if you would like to put your retirement savings into a financial product where your money has no market risk, then you may find that a fixed indexed annuity could be attractive. In fact, it is interesting that you didn’t point out that in the California case the $175,000 premium was paid to an insurance company and that the company returned the entire premium without penalty plus the interest earned between the time of purchase and when it was returned to the buyer.
To find out more about how indexed annuities really work, I encourage you to visit www.fixedannuityfacts.org.
Pamela M. Heinrich, Esq.
The National Association for Fixed Annuities