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Advantage Compendium - An Index Annuity Resource |
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The top 5 companies from the previous quarter increased sales $179.7 million in the first quarter – an amount equal to the combined first quarter sales of the 24 smallest sellers, and accounted for 72% of sales. Total sales for the ten largest sellers represented 87% of all sales. Insurance agents continue to represent 19 out of every 20 index annuities sold. Banks and broker/dealers continue to avoid the market, although that will change this year. In the first quarter products with a surrender period of more than ten years had 69% of the market. Index annuities with surrender periods of ten years or longer represented 86% of first quarter sales. There were more sales of annuities with surrender periods of fifteen years or longer than all annuities with surrender periods of less than ten years combined. The index annuity commission received by the agent averaged 10.34% of premium. Index annuities with agent commissions of 9% or more represent 80% of index sales. Average weighted commission paid by carriers ranged from 1.57% to 14.27% of premium. Annual reset structures and crediting structures using averaging continue to dominate the market. Products using some degree of averaging rose to 86% of sales from 83% of sales; annual reset designs represent over 90% of total sales. The Advantage Equity Index Sales & Market Report will continue to gather index data on a quarterly basis; the report for the second quarter of 2002 will be available in August 2002.
ING SmartDesign Index Annuity Will Open New
Markets 6/02 Top Insurance agents sell fixed index annuities. Although anecdotal evidence suggests that a majority of these insurance agents are securities registered, the index annuities are sold as fixed annuities, distinct from the registered offerings of the broker/dealer. The Advantage Equity Index Sales & Market Report shows that less than one percent of the index annuity sales flow through securities firms. Fixed index annuities qualify as fixed insurance products because they meet the SEC safe harbor requirements. Fixed index annuities are fixed annuities and not securities. But there is nothing to preclude a fixed annuity from being redesigned and registered as a security if desired. Index annuity sales were $6.5 billion last year; my prediction is that sales will be over $9 billion in 2002. And yet, only 7% of the agents selling annuities are selling index annuities. Two of the reasons why index annuity sales don’t have broader penetration is that many agents will only sell financial products through their broker/dealer, or are simply more comfortable selling registered products. These agents aren’t selling index annuities. And although half a dozen variable annuity providers are now offering some type of index-annuity-like premium protection feature that doesn’t require the owner to die to realize a protection-from-market-loss benefit, these are not index annuities. The special packaging of features and benefits contained within an index annuity has not been readily available in a registered product until now. The ING SmartDesign Multi-Rate Index Annuity [800-238-6254] is a single premium deferred modified guaranteed annuity issued by Golden American Life Insurance Company and distributed by Directed Services, Inc., member NASD . The product offers a term end point crediting method with 5, 7, or 10 year terms, annual reset options using monthly averaging with the same terms, fixed rate options, and minimum guaranteed values. It is a security – the SmartDesign is sold through registered representatives and is sold by prospectus. It is an index annuity – the Smart Design offers term end point designs with minimum guaranteed values or annual reset designs that lock in interest earnings annually. It fills a void – the SmartDesign will attract a portion of the 93% of agents out there that aren’t selling index annuities and could dominate an index annuity distribution channel. I segment traditional fixed annuities as Fixed Rate Annuities and equity-linked index annuities as Fixed Index Annuities. The SmartDesign index annuity is a Registered Index Annuity and as such will be included in my quarterly sales survey. Marrion’s Mathematical Marvels 6/02 Top Effective Rate ER = [1 + (i/n)]n -1 Say that you are comparing a fixed rate annuity to a certificate of deposit. The fixed rate annuity has a nominal rate of 6.1% compounded annually, and the certificate of deposit has a nominal rate of 6%, compounded monthly. Because the fixed annuity has only one compounding period the fixed annuity’s nominal and effective rate are the same — 6.1%. However, because the CD compounds monthly there are twelve compounding periods. The CD’s effective rate is 6.17% computed as follows [1+(.06/12) ]12 – 1 = 1.00512 – 1 = .0617. Rate of Return Say that Investment A returned 30% in 3 years, Investment B returned 60% in 6 years, and Investment C returned 90% in 9 years. If you divide each investment’s total return by the number of years in the period, the answer for every investment is 10%. But, the actual annual rate of return for Investment A is 9.13%, the rate of return for Investment B is 8.15%, and the rate of return for Investment C is 7.18%. The formula to calculate the honest rate of return for an investment without irregular cash flows is this: i = (FV/PV)(1/n) - 1 If the Present Value is $10,000, the Future
Value is $15,000, and the number of periods is 5.
SuperCharged Fixed Annuities 6/02 Top You can find fixed rate annuities that guarantee to pay 6% interest for eight, nine or ten years. The fixed annuity interest rate is almost a percent higher than ten year U.S. Treasury bonds, and beats certificate of deposit yields by a strong margin, but what if you want more? You could put your money into equity mutual funds or variable annuity equity sub-accounts, but stocks can go down. You could buy higher yielding bond mutual funds, but bond funds don’t react favorably if interest rates go up and can be just as risky as stocks. You could put all your money into a fixed index annuity offering the potential for a higher index-linked yield, but in a poor market you might only receive the minimum guaranteed return. Or, you could SuperCharge your fixed annuity by placing part of your money in a fixed rate annuity and the balance in a fixed index annuity. A supercharged fixed annuity gives you a higher minimum return than the index annuity, and the potential for more interest than you’d receive from the fixed rate annuity. SuperCharged Fixed Annuity #1 Let’s suppose we could find a fixed rate annuity that guaranteed a 6% yield for nine years. And we had a fixed index annuity with a 3% minimum return that participated in 100% of the first 84% of index growth over the term and 50% of any additional growth. We decide to put three quarters of our money in the fixed annuity and one quarter in the index annuity. The worst that could happen is we’d earn an overall annual return of 5.25%. We calculate the worst-case return by multiplying the fixed rate, and the fixed index minimum guaranteed return, by the respective percentages of the money allocated, and then add the sums together. In other words, we multiply the fixed rate of 6.00% by 75% and get 4.50%, and we multiply the index minimum return of 3.00% by 25% and get 0.75%. We then add the fixed portion of 4.50% to the index portion of 0.75%, and discover that lowest overall return we could possibly earn is 5.25%. We know that even if the index crashed, our annuity combination will still produce at least 5.25% a year, but what kind of total return might we earn? If you plug in the current supercharged index annuity model into 9 year index periods over the last 30 years, you get a chart of hypothetical annual returns that looks like this.
As we already determined, the worst return for any nine year period is 5.25% and that’s what you would have earned in four terms, but in 19 out of 23 periods you would have earned more with the SuperCharged Fixed Annuity than if you’d only bought the fixed rate annuity. In this example our risk is that we’ll earn 5.25% instead of the safe 6.00% fixed rate return, but if the stock market cooperates we could earn 6.50%, 7.00%, 7.50% or even more. What is the ideal balance of fixed rate and fixed index components? It depends on the minimum risk-free rate you’re willing to accept. If you place more money in the fixed index side you increase the potential for higher interest. If you place more money in the fixed rate side you maximize your minimum return. In addition, the minimum guaranteed return of the fixed index annuity would also affect your final returns. SuperCharged Fixed Annuity #2 To try to increase the potential return let’s put two thirds of our money in the 6.00% fixed rate annuity and one third in the index annuity. The index annuity selected participates in 85% of index growth over the nine year term and averages the final year’s closing values, and to maximize index participation the index annuity’s annualized guaranteed return is cut from 3.00% to 1.80%. The lowest overall return from this new model is calculated as follows: the fixed 6.00% rate is multiplied by two thirds producing a sum of 4.00%; the index annuity 1.80% minimum return is multiplied by one third producing a sum of 0.60%. The 4.00% fixed portion is added to the 0.60% index portion producing a worst-case return of 4.60%. We’ve decided to be more aggressive, by increasing our index annuity portion of the model from a quarter to a third, and accept the possibility of a lower minimum return – 4.60% instead of 5.25%. If we plug in our new supercharged index annuity model into 9 year index periods over the last 30 years, our new chart of hypothetical annual returns looks like this.
The chart shows we still have four periods that are at or near the minimum return, and two periods around the fixed rate return, but in 17 of the 23 periods the SuperCharged annuity returns are significantly higher – over 9% a year in one term, and the average SuperCharged annuity return is almost a percent higher than the fixed rate return. The SuperCharged Fixed Annuity offers the potential for enhanced returns with the certainty of knowing the worst-case outcome. The annuity buyer predetermines the lowest acceptable minimum return and positions premium dollars accordingly. The SuperCharged Fixed Annuity is an alternative to the volatility of bonds and bond funds and is positioned as the safe element in a portfolio. It is a simple concept providing a high level of return stability. Note to Client: I tried to warn you
7/02 I know it’s a long time ago, but perhaps you remember me telling you over and over again in 1999 to take some money off the table. I told you to put the money in a vehicle that protected principal from market risk. Ideally, you would have used a fixed index annuity that offered both protection and potential. I would have been delighted if you placed the money in a fixed rate annuity or bonds. I would have been happy even if you put the money in a passbook saving account, or under a mattress, as long as it was protected from market risk.
Now you tell me you’ve learned your lesson. You’re going to keep all your money in the bank, or in fixed rate instruments. But that’s not the answer either. You see, you’re not going to reach your goals with fixed rate instruments alone; they simply don’t pay enough. And you shouldn’t throw all your money into high risk-high reward speculations because that’s like shooting craps with dice that have sixes painted on five sides and a one on the sixth; the odds are too good that you’ll ultimately crap out. What you need to do is what you should have done years ago: Either balance the risk in your portfolio by using a combination of equity vehicles and no-market-risk fixed rate vehicles — like combining fixed rate annuities with mutual funds, or use vehicles that provide the potential for higher than fixed rate returns without market risk to principal or credited interest — like index annuities. I realize this may sound a bit like I’m saying, “I told you so”. Well, I guess I am to some extent, but what I’m really trying to do is the same thing I was trying to help you do three years ago. Protect what you have and give you the potential to have more. Market’s Been Down So Long It Looks Up To
Me 7/02 No tree grows to the sky... If this is financial Armageddon it is taking a very indirect route. In 2000 the bull market ended and the decline began. The general tone of 2001 was that the stock market had taken a hit, and some sectors were mightily damaged, but that things would get better; everyone was still optimistic. However, the decline continued and worsened. It has been over two years since previous index peaks were reached and the indices are down 30% to 70% from those highs. There are grave concerns about the profitability of companies and more visible threats to both our economy and even our way of life. Indeed, the general feeling I am sensing is a return to the negativity of the ‘70s and a belief, once again, that the stock market won’t produce wealth. Bear Markets clear away the defective structures of the old economic landscape and provide a fresh start The nay Sayers could be right. However, if this is the start of financial Armageddon it is taking a very circuitous route. The Economist says the American recovery is on track and productivity has risen. A June poll of economists predicts U.S. GDP growth of 2.9% for 2002 and 3.5% for 2003 – stronger than any European country. The same economists see very low inflation rates of 1.6% for 2002 and 2.3% for 2003. In addition, a modestly weaker dollar – down 10% against the Euro since February – has made American exports cheaper and should help reduce our trade deficit. This all bodes well for a market recovery. But the strongest reason why the next bull market is near is because almost no one thinks it will happen. ...And there’s no such thing as a
bottomless pit The millennium bear market taught us to run away whenever a CEO says that his company operates under a new paradigm in which the old economic rules don’t apply, to turn the channel when a researcher recommends a stock if the researcher’s employer just happens to competing for underwriting the company’s new offering, and to not buy into any business model that you can’t understand.
The bear market should probably have ended last year, but too many people were in denial about financial realities. The next bull market will be built on the shoulders of smarter, more realistic investors and should be around for a while. Will the next market charge be as frisky as the ‘90s bull? It’s unlikely. You usually need about a quarter century between periods of irrational exuberance for a new group of investors to arise that weren’t damaged by the subsequent prolonged bear market. So, the next decade should see a stock market delivering decent returns, but not stratospheric ones. If you want a market period where an index again doubles in less than four years, you’ll have to wait until 2027. Past Bear Market Charts 7/02
FIA Strategies For Registered Representatives 7/02 Annual Reset FIAs Instead of Bonds For the five-year period from 1997 through 2001 the average taxable bond mutual fund had an annualized return of 5.6%. Actual annual index annuity returns reported for this period ranged from 7.8% to 8.7%. A Treasury FIA Alternative to Bonds There is a viable alternative to bond mutual funds for the safe money position in a portfolio. The Allstate Treasury-Linked Annuity is a fixed annuity issued by Lincoln Benefit Life Company. The annuity provides a minimum base rate guaranteed for five years, with renewal interest rates that are linked to the 5-Year U.S. Treasury Constant Maturity Rate. On policy anniversaries changes in the 5-year Treasury rate from the date of purchase are noted. If the Treasury rate has increased, the annuity’s renewal rate will increase a like amount. If the Treasury rate has decreased, the annuity’s renewal rate will also decrease, but the rate will never be less than the initial guaranteed base rate. The Allstate Treasury-Linked Annuity could be used to balance, or hedge, the bond element in a portfolio. The Allstate Treasury-Linked Annuity has no renewal rate risk and no reinvestment risk. In summary, this annuity provides most of the benefits of bonds without the volatility. Ultimate Hedging Index annuities using term end point methodologies don’t lock in gains until the end of the multiple year term (most annuities do lock in gains if the owner dies). Because gains aren’t locked in each year the costs of offering term end point designed index annuities are less than annual reset structures, and thus index annuities with term end point designs tend to offer higher effective index participation than annual reset offerings.
What about the downside? All index annuities provide guaranteed returns promising at least a minimum amount of interest by the end of the term, even if the index tanks. But let’s address the concern that everyone is really wondering about. What if we’re only halfway through this bear market? What if the market is going to drop another 20%, 30%, 40% in the next year, and you don’t want to wait ten years just to see the market, and your investment, simply make it back to where it is today. The maximum first year surrender charge of any term end point designed annuity is 10%. If the unthinkable happens and you surrender the policy, you’ll have at least 90% of your original cash in your hand. Compare this maximum known liquidity benefit to the costs and uncertainty of buying put options.
A Reporter’s Guide To Fixed Annuities 8/02 It seems like whenever some reporters or financial writers attempt to talk about fixed annuities – whether fixed rate or fixed index – they get it really screwed up. They’ll often write about fixed annuity fees – although fixed annuities don’t have fees. Or they’ll say that the consumer is locked into an unchanging income stream – which is not the case. Or they’ll try to balance the story by asking stockbrokers and securities analysts what they think of fixed annuities – which is somewhat akin to asking a Boston Red Sox fan what he thinks the New York Yankees chances are this year. I was somewhat confused about these reporters and their sometimes negative approach to fixed annuities, so I asked a financial writer I know for his perspective. My friend explained it was possible that these writers, instead of taking the time to thoroughly investigate and learn about fixed annuities, were trying to force this new fixed annuity information to meet the preconceived conclusions they’d already developed from other areas. Some reporters have done real research on fixed annuities and simply decided they like other alternatives better than fixed annuities. I thank them for their dedication and appreciate their analysis. For the others, in an attempt to increase general knowledge of the fourth estate I have prepared a little piece, designed for reporters, on what fixed annuities are and how they work. Fixed Annuities Don’t Have Fees The insurance company doesn’t deduct a management fee and share a net return with the customer. Instead, just like the bank, the insurer pays a fixed return, and this may be stated as a fixed rate or as fixed participation in an index. Might some banks have lower operating costs or higher revenues than another and thus offer a higher rate? Yes, and an insurer could spend less on office supplies than another insurer and thereby ultimately be able to pay a higher rate on fixed annuities. But I don’t know how you translate all of this into fees? Do some annuities have fees? Yes. These are called variable annuities and they work a lot like mutual funds. Fixed Annuities Are Not Variable Annuities ►Variable annuity principal is subject to market risk. Fixed annuity principal is not subject to market risk. ►Variable annuity returns may be lost due to market risk. Fixed annuity credited interest cannot be lost due to market risk. ►Variable annuities have mortality charges and management fees. Fixed annuities do not charge mortality and management fees. ►Variable annuities do not pay minimum interest rates. Fixed annuities do credit minimum guaranteed interest rates. 99% Of Annuities Are Not Annuitized A fixed annuity is an accumulation vehicle. It should be compared on that basis with other savings instruments. Unlike other instruments fixed annuities provide the option of a guaranteed income, but it is a choice not a mandate. A Maturity Date Is Not Life Without Parole Fixed Annuities Are Not Subject To Capital Gain Taxes Savings vehicles are subject to ordinary income tax, not capital gain tax. One wouldn’t tell someone that they shouldn’t open a bank savings account or buy a CD or purchase Savings Bonds because the earnings were taxed at a higher rate than if they invested in a growth fund. Fixed annuities aren’t a capital investment; they are interest paying savings instruments. Fixed Annuities Are Almost Always Appropriate For
Seniors But let’s compare fixed annuities to other savings vehicles. A fixed annuity – whether it is a fixed rate or fixed index – offers the potential for higher interest than you might receive from a bank or savings bonds. ●Neither principal nor credited interest is subject to market risk. ●Although fixed annuities aren’t federally insured, their track record of principal protection and safety is extraordinary. And unlike bank accounts or taxable bonds fixed annuity owners decide when to take the interest and pay the tax – not the IRS. If seniors want an instrument that is very safe, may pay higher interest than other savings vehicles, and gives them control over their taxes, then fixed annuities are appropriate. Fixed Annuities Pay Fixed Annuity Returns Fixed annuities aim for savings instrument-like returns while providing savings instrument-like protection of principal. Once again, variable annuities and mutual funds are investments; certificates of deposit and fixed annuities are savings instruments. Reporters should keep any comparisons valid and consistent. Fixed Annuities Aren’t Perfect In Short Index Annuity Sales Set Yet Another
Record—Up 74% From One Year Ago 9/02
The index annuity commission received by the agent averaged 10.34% of premium. Index annuities with agent commissions of 9% or more represent 80% of index sales. Average weighted commission paid by carriers ranged from 1.57% to 14.27% of premium. Annual reset structures continue to dominate the market. However, sales of products using averaging dipped as more consumers opted for annual point-to-point designs. Annual reset designs represent over 90% of total sales. Insurance agents continue to represent 19 out of every 20 index annuities sold. Banks and broker/dealers continue to avoid the market, although that is changing. Complete information on sales and current products is available in the Advantage Index Product Sales Report. The report for the third quarter of 2002 will be available in November 2002. Natural Laws 9/02
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Do Higher Fees Mean Higher Returns? A few years ago I analyzed the most recent five year results of growth mutual funds. The funds were than ranked according to annual expenses and five year performance. What I discovered was the quartile of funds with the highest annual expenses returned 4% more each year than the quartile of funds with the lowest annual expenses. If you want specifics, the highest expense funds averaged 19.6% a year for this period while the lowest expense funds averaged 15.6%. I did the same study a year later for the next five year period and the highest expense funds once again beat the lowest expense funds, but by a narrower margin. Does all this mean we now have a new natural law – that higher fees mean higher returns? No, it merely means in these two real world examples the low fees generalization stated as fact was wrong, and may not be an indisputable natural law at all. In a perfect world lower fees would mean higher returns, but the world ain’t perfect and other factors come into play. In the index annuity world one bromide in particular is often expressed as an unconditional fact, “index annuities don’t include reinvested dividends so their returns will be worse than stock mutual funds”. I’m not going to take the easy road and dismiss this statement by simply repeating another statement I’ve often read that says that most stock mutual funds under perform the indexes the annuities use, and the fund’s lower returns could more than offset the reinvested dividends received, because I don’t have actual performance data handy. What I will examine are other factors affecting comparative returns. If you look at the last 50 calendar years (1951-2001) the average annual return of the S&P 500 was 9.5%. If you include dividends the annual return is close to 12%. On the surface it looks like the unconditional statement is correct. Even if an index annuity had 100% index participation it appears that funds with reinvested dividends would still win. But even no-load mutual funds have management fees and other expenses, which range from as little as 0.12% for index funds to over 2.0% for some managed funds. In addition, asset sales within the fund’s portfolio (portfolio turnover) can generate taxable income resulting in taxes paid resulting in a reduced return for the investor. The SEC said that anywhere from a few basis points to as much as 5.6% of a stock mutual fund’s return is lost to taxes and the average stock fund loses 2.5% of its return due to taxes. The "No Negative Year" Feature Of Annual Reset Index Annuities More Than Offset Reinvested Dividend Gains. So maybe the reality is if you factor in expenses and taxes the net average long-term stock fund return would have been around, maybe 8% to 9%, with a high of 11.2% to 11.5% for an index fund (or for a low-expense, tax-efficient managed fund). Index annuities with term end point structures have recently offered participation rates of 100% to 105%, and they do not charge management fees and they are 100% tax-efficient. So in theory, term end point index annuities might have delivered average returns in this macro example of 9.5% to 10.0% beating many stock mutual funds and disproving the unconditional fact, at least as it relates to saying all stock mutual funds win. Index annuities with annual reset crediting methods offer a unique feature; they treat years of negative returns as years of zero interest. If you plug in reinvested dividends the average annualized S&P 500 index return is around 12.0%. But if you omit the dividends and swap years with index losses for zeros, the average annualized index return jumps from 9.5% to 12.6%. This means that an annual reset structured annuity with net effective index participation of 55% would have beat many stock funds and 90% net participation would have beat index funds. Now, unlike annuities with term end point structures, in the real world index annuities with annual reset crediting methods have not yet provided periods of 90% net index participation, but almost all have repeatedly been over 55% effective participation. ...Your mutual fund earned
an additional 2% in reinvested dividends on that 10% market gain? If you want to go even further to defrock the “mutual funds with reinvested dividends will always do better” criers, consider that the degree to which index annuities participate in the index is largely determined by the interest rate environment and option prices. Today, and throughout most of the relatively brief history of index annuities, index option prices have been above their historic average and interest rates have been below those of the preceding quarter century. If you haul out your index annuity interest crediting formula, and plug in some of the interest rates and option prices from the past, your model will throw out participation rates of 200%, 300% and 400%. ...Your mutual fund earned an additional 2% in reinvested dividends on that 10% market gain? ...Fine, we just credited 30% interest to the index annuity on that 10% market gain without the dividends! The point of all this is not to say you should replace your mutual funds with index annuities. Index annuities aren’t designed to be replacements for index and managed funds because these are investments and index annuities are saving vehicles. And the point is not that index annuities will someday offer 200% participation rates (you’d have too many actuaries passing out from hyperventilation if that happens). The point is index annuities shouldn’t simply be dismissed with the generalization “index annuities don’t include reinvested dividends so their return will be bad” because it’s not always true and may not even be important depending on your goals. There will be times when index annuities do better than index funds and managed investments (the last two years come to mind), and some index annuities could conceivably beat some stock funds much of the time. In fact, because of their risk-adverse design the returns from index annuities just might be a lot closer to managed stock and index funds over the long haul than one would think. But the role of index annuities is to provide the potential for a higher return than other savings vehicles that offer the same principal protection from market risk. Index annuities are viable solutions for many financial situations and are not easily dismissed or generalized.
The mutual fund portion of the IRA market increased dramatically because the tremendous rise in the stock market grew assets at a record pace and consumers placed more of their retirement assets in funds to catch the wave of rising values. The ‘90s were the decade of unlimited profits and possibilities. For all mutual fund accounts, including both qualified and nonqualified, the Investment Company Institute reported that during the first quarter of 2002 a net $10.2 billion flowed into stock mutual funds and $2.9 billion net flowed into bond funds; an additional $6.9 billion went into money market funds. It wasn’t as pleasant in the second quarter. While net bond fund purchases increased $30.6 billion, most of the money for these purchases came from the $67.2 billion redeemed from money market funds, and people also redeemed $200 million more stock mutual funds than they purchased, although the pattern of redemptions wasn’t evenly distributed (people added a total of $17.8 billion during April and May and then took out $18.0 billion in June). The mild stock fund redemptions of the second quarter looked like a trickle when compared with the flood of cash withdrawn from stock mutual funds in the beginning of the third quarter. In the second quarter retail saving account and time deposits (certificates of deposit) increased $70 billion. In addition, both fixed rate and fixed index annuities enjoyed an exceptionally strong quarter. My hypothesis is that much of the money leaving mutual funds is either waiting on the sidelines or is being placed in vehicles that protect principal from market risk. I would further guess that this general movement towards protection is also occurring in the IRA market. The last bull market produced a fundamental shift in people’s thinking. Consumers now believe that equities will produce higher returns than fixed rate instruments, and the millennium bear market hasn’t altered this shift in attitude, but consumer thinking has been modified by the prolonged down cycle. Consumers won’t be going back to the bank, but neither will consumers jump up and open their IRAs and psyches to the unrestrained risk of stocks and stock funds. Instead, fixed index annuities offering the potential for higher returns while protecting principal, and variable annuities with enhanced principal protection features and options, will capture a significant piece of the mutual fund share of the IRA market in the years to come. The ‘90s were the decade of profits and possibilities. However, the millennium bear market will cause the decade of ‘00s to be one of protection and potential – a perfect environment for index annuities.
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Option prices tend to rise as the stock market becomes more volatile. Volatility as measured by the VIX (CBOE Volatility Index) closed at a level of 19.25 on 27 March. On 23 July the VIX closed at 50.48, a degree of option volatility only experienced briefly during the Asian Crisis in late summer 1998 and during the crash of 1987. Although volatility levels have fallen to the 30s since July, the bottom line is that option prices are, depending on the crediting method, higher to sharply higher than they were. There are complicated hedging strategies that may help mitigate the effects of higher option prices, but the low interest rate environment is much more difficult to work around. The Advantage Composite Bond Index, composed of investment grade corporate and 10-year treasury bonds, attempts to reflect changes in the portfolio yield of an insurance company. The bond index formula comes up with similar yields to today when it looks at the months following the 1998 Asian Crisis, which also resulted in a period of declining participation rates. The last period before 1998 with interest rates as low as today was 1968.
The Advantage Index Participation Rate Indicator (IPRI) says that yield spreads should be higher than they are and caps should be lower. Most insurers held the line during the summer, but September is seeing broad reductions in index participation. The general feeling that I get from talking to insurers is that over the longer term they believe volatility will go down and interest rates will edge back up, relieving the pressure. Extrapolation 9/02
The problem with extrapolating financial data is future values are not based on scientific or mathematical laws, but on human emotion and opinions of financial value, neither of which can be predicted. Using past “knowns” to predict future investment unknowns is sometimes accurate, but flipping a coin will also produce correct answers about half of the time. Behaving Like Consumers 10/02 The implication from this for financial counselors is that they can strongly influence the return expectations of consumers, and thus influence the success of their presentation, by cueing the consumer. Here’s what I mean: If an agent begins talking about the 2% yields on CDs and then mentions the 4% fixed rate annuity yield, the consumer will be more receptive than if the agent starts right off talking about the 4% annuity rate. The 4% annuity rate offered may not even be a competitive annuity rate – other annuities might be paying 5%, or the annuity rate could be very competitive but the consumer had a mental image of 6% when you sat down. By cueing or grounding the consumer on the lower rate of another product the agent establishes a reference point for the consumer to use in making a perception of value on the product being presented. The same cueing can be done to minimize current or future complaints about performance. As an example, just before the consumer receives their 2002 index annuity statement, which shows a zero credited in the index-linked interest column, the financial counselor could talk about the one year losses of index funds, to place a no-loss return in its proper perspective. Cueing can help to reset price or return expectations in comparative situations, but it’s much less effective in resolving perceptions of cost.
The implication from the Wharton study is that an agent is wasting his time explaining to a consumer that the reason index annuity participation is 60% instead of 100% is due to the effects of higher volatility and lower interest rates, because the consumer figures the insurance company is either making even more money at the lower rate or still has a huge profit built in even if costs went up. It would be more effective if the agent compared index participation rates of several products to establish a value reference, or showed competitive returns could still hypothetically happen at the lower rate and create a value perception. Perhaps I will do a study one day to see which index annuity crediting methods consumers feel are the fairest. In the meantime, cue your customers and sell value, not how much it costs. *Consumer Perceptions of Price (Un)Fairness, Bolton, Warlop & Alba, Wharton School, University of Pennsylvania, 2002
Personally, this has never been a huge concern for me because I plan on being dead by 2030, but the crisis conclusion proved to be very popular. Politicians use the Social Security card to win votes by saying they are doing a better job than their opponents in protecting Social Security. The financial and retirement planning industry has used the Social Security crisis to scare consumers into investing more for retirement because maybe Social Security won’t be there. And the media can always count on filling a slow news day with a picture of some eighteen year old and poll results shouting that, “62% of young adults don’t believe Social Security will be around for them. Of course, these are the same young adults that think “Whazzup” and “Like” constitutes an intellectual exchange. But in spite of this consensus, there’s new data suggesting Social Security will be just fine in 2030 and beyond. Beginning in the 1950s both the American and European fertility rates started dropping below the stability or replacement rate of 2.1 children per woman. In the 1970s American fertility rates crashed. If fertility drops, and people live longer, you eventually get a decreasing population with fewer and fewer young people and more and more old people. Immigration can help slow the tide towards an aged society, but it won’t stop it. This is the statistical story from the 1980 census that prompted changes in Social Security funding, resulted in raising the retirement age, and keeps the Social Security crisis story visible. It’s a story that is coming true in much of Western Europe as pension demands consume a bigger portion of the economy. However, in the 1980s American fertility rates sharply spiked. The 2000 census revealed a United States population that was far higher than the most optimistic forecast. True, there was significant immigration in these decades, but underlying the immigration numbers was the fact that native-born American fertility rates rose and are expected to continue to rise. Why happened to American fertility? One popular theory is that women in the 1970s and early 1980s delayed having children, this would explain both the rapid drop in fertility in the 1970s – the period upon which the pessimistic Social Security forecast was made, and the very rapid fertility rise in the 1980s. What this implies is that the Social Security Crisis conclusion was based on looking at too short a period to be statistically valid and there really never was a crisis in the first place. If you look at the new data the current U.S. population of 281 million should be almost 400 million by 2030 and perhaps half a billion by 2050 with approximately the same median age as today. On the other hand Europe will be much older. So, America will have younger productive workers with lower labor costs than Europe and higher spending needs, making America even more of an economic powerhouse than it is today. Based on all of this Social Security will show a profit that could be used to offset rising senior health costs, and because American society remains relatively young the costs of health care as a proportion of our overall national spending remains low. Why isn’t news of this happy possibility being shouted from the masthead? There are too many parties that benefit from a Social Security problem to acknowledge the system may be stable. What does all this mean? Even if the “Social Security will be fine” forecast is correct, retirement planning counselors can’t lose by continuing to tell people to save for retirement. I can’t imagine someone retiring in 2030 and saying, “Darn, Social Security is still around so I now have too much money to spend!” On an individual basis it can make sense to save for a crisis potentiality. But any attempts by politicians to raise Social Security taxes or reduce benefits should be examined from all statistical angles. Interest Rates 10/02 The cause? High option prices due to market uncertainty and more importantly, very low interest rates. Interest rates are a particular concern. Rates on 5-year U.S. Treasury notes are under 3% and 10-year maturities are under 4%. Although long-term investment grade corporate bond yields are higher and junk bond yields are even more competitive (reflecting sour views of the economy), it is becoming more difficult to cover minimum interest guarantees, pay expenses, and buy options. If the economy doesn’t begin growing stronger the Fed could cut interest rates. It is possible we could see ½% money market rates, 1% CDs, and 3%-4% 10-year corporate bonds. We’ve seen similar rates before. Investment-grade corporate bonds yielded between 3% and 4% for most of the 1950s. Bond rates didn’t rise above 5% until 1966 and this increase reflected the inflationary pressures of the Vietnam War. What could a low rate environment mean for annuities? Prolonged low rate expectations could mean 1½% would be the new standard for minimum guarantees, or minimum annuity rates could float and be indexed to some benchmark. Agent commission structures would also decrease to cut costs of acquiring business and policy fees could be needed to cover the costs of small annuity accounts. It is more likely that as the economy expands interest rates will trend higher as the demand for money increases, and the stock market will also move higher as earnings grow. This probably won’t be the fireball stock market of the last decade, but rather a more sedate affair. However, a calmer market will also have lower option costs, which translates into greater index participation for index annuities. What should be done? Continue buying quality index annuities. Several of the annuities with longer term end point crediting structures still offer competitive rates, and if we’re at the bottom of the abyss they could provide a very profitable ride. If index participation drops too low in the weeks to come, place the money in the fixed account that many annuities offer and keep your powder dry until next year. Strange as it may sound, it could turn out that locking up a fixed index annuity with a 3% minimum guarantee today could be a very prudent financial move.
SmartDesign is a registered index annuity. There have been attempts by carriers to market registered versions of the index concept in previous years, but they’ve never caught on. SmartDesign is a true index annuity that just happens to be registered as a security. ING SmartDesign sales came from a broad and diverse spectrum including banks, wirehouses, planning boutiques and regional firms. They have successfully opened the door to markets that had either ignored or dismissed index annuities in the past, and although this probably wasn’t their intent, ING has made it easier for the entire index annuity industry to move up to the next level. The Allstate® Treasury-Linked Annuity is a fixed annuity issued by Lincoln Benefit Life Company. The annuity provides a minimum base rate guaranteed for five years, with additional interest based upon the performance of the 5-year U.S. Treasury Constant Maturity Rate. In summary, changes in the 5-year Treasury rate from the beginning of the five year guarantee period are noted. If the Treasury rate has increased, the annuity’s interest rate will be enhanced by the same amount in the following year. If the Treasury rate has decreased, the annuity’s renewal rate will also decrease, but the rate will never be less than the initial guaranteed base rate for the duration of the guarantee period. In all cases, both credited interest and principal are protected from market risk. The treasury-linked concept is not a new one. Annuities purporting to tie rates to treasury yields were around 15 years ago. The Allstate annuity makes my list because of some strong product features and the timing of their introduction. But Are These Index Annuities? Predicting The Past
11/02 I’ve talked to financial counselors that base the allocation of assets on the results of Monte Carlo modeling and the perceived risk tolerance and goals of the consumer. As an example, a financial counselor will input a minimum desired return and a combination of assets, and the simulation might say that 80% of the time this mix of assets would have produced the return. And the counselor might tweak the asset mix resulting in a simulation producing the desired return 90% of the time. These results accurately depict how these allocations would have performed in the past. The problem is with interpretation of the data. I’ve had financial counselors tell me that the way they present the data to the consumers is by saying things like “Allocation A gives an 80% confidence level in hitting this return and Allocation B gives a 90% confidence level, therefore we should select Allocation B”. Unfortunately, the consumer may think you’re saying there’s a 9 out of 10 chance that you’ll hit your desired return if you select Allocation B. The reality is you’re taking a 100% gamble that the past will repeat and your confidence level for any particular period is an illusion. Historical data does a wonderful job of predicting the past but a poor one at predicting the future.
My data might show at current rates Index Annuity X would have generated 10% or better annual returns in 33% of the periods over the last 50 years, and that Index Annuity Y would never have generated 10% or better annual returns. Does this mean that Index Annuity X has a 1 in 3 shot at producing a double digit return in the next period or that Index Annuity Y has zero chance? No, I think it means over time X should produce more periods of 10% or higher returns than Y. But I don’t know when those periods will occur nor how many of them there will be. A Monte Carlo simulation that says one assumption produces a desired result 90% of the time and the other assumption hits the mark 80% of the time merely mean the two assumptions are darn near equal, not that the desired return will be hit. Coincidence Not Causality
#3 The Holy Grail in investment planning is finding assets with inverse or negative correlation. What I mean is if Investment A rose 10% whenever Investment B fell 10% you might attempt to reduce the risk of overall loss by adding Investment A to a portfolio containing Investment B. In January 2000 the Nasdaq 100 Index was near the 3800 level. The Nasdaq 100 rose to over 4700 by early spring, took a hit in late spring 2000, and has spent the last 2½ years sliding down. By the fall of 2002 the index was off almost 80%. However, over the last 2½ years the rise in a certain Investment X has almost been the exact opposite of the fall in Nasdaq 100 values. Back in January 2000 if you’d taken half your money out of the Nasdaq 100 and put it in Investment X your total combined return for this entire period would be close to zero. Now, zero may not be great, but it beats the heck out of an 80% loss.
What is Investment X? Is it a dynamic pricing model using linear regression? Does it involve put options, call options and butterfly straddles? No, it’s Budweiser. The chart shows the daily closing price of Anheuser-Busch stock for the period, and if unlike me you had purchased the stock instead of the product your portfolio would probably be in better shape. Why did the stock perform well during the bear market? I’m sure analysts would conclude that investors drifted to the certainty of defensive consumer stocks and away from high technology companies, that during recessions investors like companies that lead their industries, and that people drink more beer and less champagne when unemployment rates go up. Or, it could merely be coincidence. Causality is what investors are really looking for in the market. Causality means if this happens then that happens. But in the market causality producing beneficial results is usually either coincidence or a fluke. My car buying does not affect the stock market, nor is October automatically a bad month for the market. There is no relationship, it’s pure coincidence. Although Anheuser-Busch stock would have offset certain risks in the last bear market, I’d be willing to bet that it won’t happen again because people are now prepared for the possibility. What’s the answer? If the past doesn’t aid us in developing diversified portfolios that avoid
or minimize market loss, then perhaps we need to use vehicles or methods that
offer greater protection from market loss and still offer the potential for
gain. This would include greater direct hedging in equity portfolios, utilizing
the death and living benefits of variable annuities, and using the protection of
principal and credited interest features of indexed annuities. Annuity Safety & FDIC
11/02 I’ve heard these same tired excuses used to try to sell against FDIC insured bank accounts for 20 years and they’ve never convinced a consumer to move money into an annuity. If economic conditions resulted in the failure of many banks and exhausted the fund, Congress would simply authorize the government to put more money into it. To suggest that a bank deposit within the FDIC limits won’t be covered if the bank fails insults the consumer’s intelligence and makes the agent look desperate. What is the consumer really asking? Although some are in love with FDIC – it took me two years to convince my folks to buy government bonds because they weren’t FDIC insured – the vast majority of consumers are really saying that they are scared to death of losing money. The only financial product that has greater protection from principal risk is cash in hand and many people will never own anything other than FDIC insured savings. However, some of those savers might be convinced to use an annuity for at least part of their money if they believe it too is safe, but the way you show the safety of an annuity is not by trash talking FDIC. The Advantage Group unequivocally states that no fixed index annuity customer has ever lost annuity principal due to failure of an insurance company. You want safety? No index annuity owner has ever lost money because the insurer failed. I didn’t say most people didn’t lose...I didn’t say almost nobody lost money...I said nobody has ever lost money in an index annuity because the carrier failed, not no how, not no where, not no one. Your response might be that the only reason my statement is true is because no carrier has failed since index annuities were introduced. Au contraire. Two carriers offering index annuities sought regulatory relief in the ‘90s, but their customers emerged with both principal and interest intact. Even if you concede my statement is correct, you may respond that the same doesn’t hold true for fixed rate annuities because in the last twenty years several insurance companies have failed, including big ones like Executive Life. I agree that several annuity carriers have failed in the last two decades, however; I can find no evidence that any annuity customer received back less than 100 cents on the dollar because of the failure. I’ll pay $250 if you can show me someone that’s lost
principal in a fixed annuity because an insurance company failed! Am I saying that every fixed annuity customer that stayed the course throughout the regulatory relief process of every busted carrier got back all of their principal? No. I’m saying that I can’t find any proof that they didn’t. So, here’s my offer. The Challenge | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
