NASD – Ruling By Intimidation   7/05
On 25 May Mary Schapiro, NASD Vice Chairman, gave a speech at their spring conference in Chicago. Her theme was the opportunities and risks to be faced by the securities industry in the future. One of the risks she spoke of was failure to analyze the status of new products under federal securities law; she then spoke about index annuities.

She began that portion of her talk with the misstatement that “some equity indexed annuities are not registered as securities”. The fact is there are over 130 separately filed index annuities, only three are registered as securities, the remainder are filed as fixed annuities. She then says the legal distinction between a security and insurance product is not always clear, and asks rhetorically, “What if the equity-indexed annuity is, in fact, a security?” She raised the bogeyman that firms may be liable because their representatives are selling away unless their index annuity business is being supervised by the broker/dealer.

I am delighted to address Ms. Schapiro’s concern. The answer is no, an index annuity is not a security.

The SEC was asked to rule on this question almost a decade ago [Concept Release No. 33-7438: File No. S7-22-97] and they did not deem index annuities to be securities instead of fixed annuities. Therefore, an insurance agent selling a fixed index annuity is not “selling away” from a broker/dealer they are affiliated with. However, representatives must always inform their broker/dealer of any outside business activities, including offering insurance products, so that the B/D may state any objections and exercise appropriate supervision.

Once again, NASD is attempting to intimidate producers from selling index annuities by putting pressure on their B/D, even though the SEC when asked by NASD to say index annuities were securities demurred. Under current guidelines and regulations index annuities are fixed annuities and not securities, and all the intimidation in the world won’t change that.

Obfuscation  7/05
Index annuity crediting methods are often presented as enabling the consumer to participate in increases of the underlying equity index. To be accurate; however, with an index annuity the consumer is participating in the crediting method of the annuity, and not the index. To wit, 100% participation in an index annuity crediting method often bears little relationship to realizing 100% of the index performance. One crediting method may be used instead of another to give the illusion of earning higher potential returns, and it is this “smoke & mirrors” effect that may result in one annuity being purchased instead of another even though the potential returns of the former are no better, and may be even worse, than the later.

No one method is inherently better or worse than another method. An Oldsmobile, Plymouth or Studebaker will all get you from point A to point B although each one rides and handles a little differently during the journey. There are no bad methods, only perhaps, a bad understanding of how a particular method really performs.

The method that most closely mimics that of the actual index is Annual Point to Point multiplied by a participation rate. How does it work?

If the index goes up 10% measured from the start of the contract year to the end, and the participation rate is 55%, the annuity would credit 5.5% interest. If the index went up 20% the annuity would credit 11% interest. That’s it – no caps, no spreads, no averaging. However, only two carriers offer annuities using this crediting method.

Why don’t more carriers offer this simple method? Based on my talks with producers it is because most producers say it is difficult to sell 55% participation. If that is so, let’s get an idea of the potential participation that is being sold.

I calculated the annualized return for ten-year periods ending during the 1980s (71-81, 72-82...80-90) and 1990s (81-91...90-00) by applying a 55% participation rate to calendar years wherein the S&P 500 rose and crediting a 0% return in calendar years that fell. I then added up the ten 10-year period returns, divided the total by ten, and came up with average annualized returns for the ‘80s and ‘90s.

I then worked backwards using the average returns produced by the 55% participation rate for each decade and determined what caps, rates or spreads were needed by the different crediting method to reach the same identical returns.

If you applied a 55% participation rate annual reset method to the S&P 500 the annualized return for ten-year periods ending in the 1980s averaged 6.38%; the average for ten-year periods ending in the 1990s was 7.83%. The chart shows what other crediting methods needed to be to equal these returns.

What Does This Mean?
Whether you apply a 55% annual point-to-point or 94% daily average method to index movements in the 1980s you get the same overall return, and when you apply a 55% annual point-to-point or a 3.42% Monthly Cap method to the ‘90s you get the same return for that decade.

It also means that if your monthly average method had a cap of less than 13.5% or your monthiversary method kept a rate of less than 123% – looking at both the ‘80s and ‘90s – your effective participation rate is less than 55%. In fact, you would be hard pressed to find an annuity that would have given you as much as 55% effective participation in these two decades when you plug in today’s current rates.

At today’s rates and under most back-testing “what ifs” index annuities would deliver 40% to 60% of index performance. If consumers get roughly half of the index return is that bad?

Consumers Need Realistic Expectations
If we take today’s index annuities I would speculate that in a half-ways decent stock market, or when long-term interest rates push participation up a bit, that could mean long-term index annuity returns in the 5% and 6% range, which would place them roughly 2% higher than CD rates in a similar kind of interest rate environment, and that 2% more than the bank pays should be acceptable, based on the consumers I’ve talked with.

What if consumers are being lead to expect “stock market like” returns from their index annuity? Then most of those doing the leading should pray for a really rocky market period, because if the future confounds the past and the stock market soars, the only high many index annuities might see are new lawsuits filed.

The preponderance of the statistic forecasts and analysis I’ve conducted (guessing via computer) show index annuities performing like fixed annuities, which is what they were designed to do, and not like equity investments.

Could index annuities generate “stock market like” returns if we had a repeat of the ‘90s? Yes, but long-term bond rates would need to significantly increase and those increases would need to translate into higher renewal participation on issued contracts.

Alternatively, a couple of currently offered term end point crediting method products that do not lock in index gains until the end of the surrender period (to be specific, ING MarketSmart and Jackson National Life Elite 90), could offer 75% or more of actual index gain in a ‘90s scenario if there was even a modest increase in long-term bond rates. The flipside is term end point methods also perform like the index in down times, so a ‘70s market scenario would mean returns for these products near the minimum guarantee.

The Reality
Regardless of what you think you see, annual and biennial reset index annuities are currently priced to return around half of what the index does over the longer term – producers today are usually selling around a “50% participation rate” but many do not realize it. The good news is index annuities can still be very competitive against CDs and other fixed annuities even at current rates if the index cooperates.

Return measurement reflects the end of the year value for the S&P 500 Index. The results obtained should not be taken as a representation of actual returns for any product or period. Neither Standard & Poor’s nor Advantage Compendium market, sell or endorse any index product.

Sounds of Summer  7/05 
There is a neighbor on my block I’ve named Leaf Blower Man. Almost every day he is out in his yard blowing leaves around with an electric leaf blower. I’ve watched him spend fifteen minutes blowing two – yes two – leaves from his stoop to the curb. At this moment he is on his roof with his leaf blower blasting eighteen leafs or so to the ground, which he will then blow from the ground to the curb. The only time he is not out there with his leaf blower is after it snows (come to think of it, last winter he did try to use it to blow the evening’s flurries off his driveway). Personally, I do not care if a man has an intimate relationship with his leaf blower (did I mention there are no trees in his yard), or any other power tool for that matter, but leaf blowers make a whining high-pitched racket that comes directly through the walls of my house and shatters my calm.

When I am driving my senses are often assaulted by the sound of some nearby young person in a car with earthquake mode bass amplifiers blaring. Now we all remember the university study proving an inverse relationship between penis size and amplifier size and these young men are simply trying to overcompensate for their inadequacies, but although I feel sorry for them the noise they make is quite disturbing. Unfortunately, my city council voted down my request for capital punishment for exaggerated bass.

Airport noise deserves an entire book. The loudest public address system I have ever heard ignored is the one in the Newark airport – it leads me to wonder whether they think New Yorkers are deaf? The most monotonous is the one in Las Vegas that repeats a list of no-no’s every six minutes – of which two on the list would be impossible to commit if you made it through security. And of course, most departure areas have TVs blaring out occasional news where you always find one to two people actually watching and all the rest trying to ignore. I can see why one traveler invented a remote control whose sole purpose is to turn off any television in the world.

Cell phone abuse could fill a library, but I’ll give one example. One of the Dallas airport clubs has a cell phone free zone with signs posted. However, every time I’ve been there a different person waltzes in every fifteen minutes or so and begins dialing. When the offender is politely told no cell phones are permitted the reaction is always defiance, as in “How dare you tell me I can’t invade your quiet and make noise!”

I am trying to adapt. I travel with earplugs, I’ve restarted my meditation exercises, and at home when I hear Leaf Blower Man I try very hard to pretend it is merely a swarm of bees making honey. But I am forced to admit there are days I wish Bell and Edison had never been born.

You can usually find Jack Marrion outside battling windmills and collecting donations for his “Bose Headphones For All” foundation.

The Devil’s In The (Lack of) Details  8/05   
I’ll begin by saying I am not a lawyer, and although I used to own a broker/dealer (B/D) with offices in several states I currently hold no licenses or registrations, nor is any of the following intended to be legal, investment or regulatory advice, but is provided solely for educational purposes. Now that I have declaimed, the intent of this article is to talk about why the question of whether or not index annuities are securities came up in the first place and what the issues are.

Why Is There Even A Question?
Based on my research I do not believe index annuities are securities. However, neither my opinion, nor the opinion of other pundits, or even the NASD matters because it is the SEC and the courts that determine security questions. As of this writing the courts (Malone v. Addison et al) have ruled index annuities are not securities and SEC has not ruled they are. The current turmoil lies with the last part of the previous sentence.

Eight years ago, the SEC asked for comments on whether or not index annuities should be securities, received many comments, and then did nothing. The closest thing to an official position I could find from the SEC was under the Investor Information part of their website. In response to the question “Are equity-indexed annuities registered with the Securities and Exchange Commission?”

The SEC answers, Equity-indexed annuities combine features of traditional insurance products (guaranteed minimum return) and traditional securities (return linked to equity markets). Depending on the mix of features, an equity-indexed annuity may or may not be a security. The typical equity-indexed annuity is not registered with the SEC.

So, although the courts have ruled index annuities are not securities, the official word from the SEC on the index annuity securities question is “although most aren’t maybe some are”.

Regulations are often written with a bit of ambiguity so the lines get colored in by future developments, and this creates a cottage industry for attorneys. The current problem really stems from an undefined part of some annuity safe harbor rules written back in the 1986.

Rule 151
In 1986 the SEC said if an annuity met three safe harbor guidelines under Rule 151 it would not be a security. The first two guidelines relate to regulatory oversight and risk, and are pretty straightforward. The third requirement is that the annuity is “not marketed primarily as an investment”. What does that mean? Nobody knows, and this uncertainty has contributed to the current predicament with index carriers saying the annuities are not being marketed as investments and therefore meet all of the safe harbors of Rule 151, and some in the security industry saying they are being marketed as investments and thus fail the third test. A contributing factor responsible for questioning the fixed nature of index annuities is one of who is supervising the producer.

Turf
Thirty years ago banks received savings and made loans, insurance agents sold insurance and the very infrequent annuity, and stockbrokers sold stocks, bonds and funds. Confusion was minimal and regulatory jurisdiction was easy. Today it is all a jumble.

Banks have a large amount of their regulatory turf specified by the Securities Exchange Act of 1934. In addition, banks have FDIC, OCC and Federal Reserve in their DC corner vigilantly protecting their part in the financial framework. Regulation of insurance companies and insurance agents was pretty much left up to the states and loosely defined; there has never been a federal level insurance department counterweight to the SEC. This left the insurance industry to deal with a patchwork of state laws and local peculiarities, and no regulatory counterpart to NASD, thus leaving hazy lines of ultimate regulatory supervision of the producer. Into this haze steps NASD.

NASD
NASD is not a federal agency. It is a self regulatory organization (SRO) authorized under the Securities Exchange Act of 1934. A self-regulatory organization is a member organization that creates and enforces rules for its members based on the federal securities laws. NASD pays certain fees and assessments to the SEC.

As stated in their 2004 Annual Financial Report, “NASD is the leading private-sector provider of financial regulatory services.” It is a tax-exempt company that collected $114.4 million in fines against its members in 2004, up from $33.3 million in 2003. NASD also received $222.8 million in transaction-based trading activity fees, as well as assessments based on member firm gross securities income. Last year was a good year for NASD with reported net income of $66.5 million. It should be noted that NASD does not currently collect fees on the sales of index annuities.

NASD has aggressively sought regulatory authority when there are hazy lines. NASD challenged state insurance departments on whether NASD should at least share jurisdiction (and regulatory revenues) on variable annuities, and NASD won. They also stepped into the void and became essentially the deciding word in regulating the sale of promissory notes, viatical agreements and brokered CDs. Now they are going after index annuities, and since SEC has not ruled NASD has authority over index annuities NASD appears to be going about this by putting pressure on their broker/dealer members.

Rule 3040
On 25 May Mary Schapiro, NASD Vice Chairman, gave a speech at their spring conference in Chicago and raised the “selling away” issue regarding index annuities. Rule 3040 says a representative must have permission from their B/D to participate in a private securities transaction. If the representative does not get permission the representative cannot sell securities away from the B/D.

What is a private securities transaction? In the past, NASD has raised the “selling away” red flag to B/Ds on investment advisory fees, short-term promissory notes and viaticals (Notice to Members 91-32, 94-44, 96-33).

While NASD decided Investment Advisers may fall on either side of “selling away” depending upon what they do and provided quite a bit of guidance on the investment adviser question, with both notes and viaticals NASD made the B/D responsible for determining whether the product offered was or was not a security.

If the B/D says a product is a security the firm assumes certain regulatory responsibilities that go with selling securities to customers, including appropriate supervision over the associated person in order to prevent violations of the securities laws. If the B/D says it isn’t a security and it later is determined it is, the B/D could be cited for “failure to supervise” and be in trouble with NASD. Five years ago NASD brought more than 100 formal disciplinary actions involving violations of NASD Rule 3040 in the marketing of promissory notes (Notice 01-79).

Does this mean a representative needs permission under Rule 3040 to sell fixed indexed annuities? A fixed index annuity filed with the state insurance department is not a security, therefore by NASD definition a producer selling state filed fixed rate or fixed index annuities is not violating Rule 3040 and not engaged in selling away, and thus no B/D permission is required.

In my last newsletter I mentioned that only three of the 130 index annuities were registered as securities. A half dozen B/Ds called me to get the names of the three registered products. I sensed they felt that as long as they might have to treat them as securities they might as well start with a security version of index annuities, which I believe is precisely the action NASD was hoping for.

Rule 3030
Even though state insurance department filed index annuities are not “private securities”, a representative must provide prompt written notice to their B/D of all outside business activities, and this would include offering fixed rate and fixed index annuities. The B/D has the right to ensure the outside business activity does not create the impression that the B/D had approved the product or service. How far can the B/D go in interfering with the reps non-B/D business? Mrs. Schapiro urges B/Ds to consider whether reps should be selling any index annuity without being fully supervised by the B/D. This could mean B/Ds requiring producers to complete the same B/D new account forms, arbitration agreements and disclosures for fixed index annuity sales; filing for approval all annuity ads, seminar scripts and mailers with the B/D’s compliance department; prohibiting any type of hypothetical illustrations and submitting insurer produced fixed annuity consumer materials to NASD District Offices for review.

Is the “whether or not” question driven by concern for the consumer or the securities industry’s desire for more revenue?

One point is clear. If a producer has not notified their B/D – in writing – of every outside activity they use to make a dollar they could be hanged. Even if the producer’s index annuity business is clean and disclosed to the B/D, the producer could be fined and suspended for not mentioning that he operates a lemonade stand on weekends if NASD wants to make an example of him.

And Then There’s The Lost Revenue
The reasons given for registering index annuities sound well intentioned. The proponents of registration say consumers may be confused about how an index annuity works – though I fail to see how registration would lessen the confusion. They talk about the need for disclosure – though almost every carrier requires quite comprehensive disclosures to be signed at time of purchase. And they complain about long surrender periods – although I cannot even comprehend what this has to do with the securities question.

Frankly, I find all of this recent concern rather suspect. The final and possibly primary reason why the question of whether or not index annuities are securities is now being raised relates to revenues the securities industry feels they are losing.

Index annuities have been around for ten years. During the millennium bear market when customers of NASD member firms lost billions of dollars, index annuity owners didn’t lose a dime of principal or credited interest due to the bear market. And yet, not one voice was raised back then about the dangers of non-securities registered index annuities. It wasn’t until 2004 when index annuity sales rose over $23 billion – more than doubling in two years – that the securities industry began squawking that index annuities should be registered. Let’s face it, $23 billion placed in funds or variable annuities could mean a billion dollars in commissions to B/Ds and several million dollars to NASD in new fees.

What Will Happen?
There are many possible outcomes. The SEC could rule that certain types of index annuities are securities, or that certain types of marketing cross the “marketed as investment” line and need to be curtailed. SEC could rewrite the safe harbor guidelines that insurers would need to meet to avoid having products called securities. SEC could say that current index annuities are not securities. Or SEC could do nothing. If nothing is done NASD can continue their policy of intimidating B/Ds into treating a non-security product as a security.

If no SEC decision is made the 60% of index annuity producers that I estimate are associated with a B/D will need to wait and see what their B/D does and how they’ll be affected. Our last survey showed a small percentage of producers have already given up their securities registration to avoid the hassles, perhaps a non-decision would induce more producers to drop their securities affiliation and join the 40% of index annuity providers that are unaffected by NASD because they only sell fixed products.

Mother Was Right  8/05
My mother raised me to be polite and considerate of others. I still catch myself saying “Yes, Sir, please” when the retirement aged grocery bagger asks me if I prefer paper instead of plastic, and I can’t stop myself from holding the door open when a stranger is following me out the door of the store. But about ten years ago I made a conscious effort to be rude.

I was tired of saying “please” and “thank you” to clerks that said neither. I was annoyed by the deafening silence that greeted me whenever I held the door open for a lady. And in general I was put out that while I kept my TV volume low in my hotel room, tried to be pleasant even when I was curtly ill served by service employees, and was considerate of others, that my entreaties of civility were met by uncivil war. And so for the last ten years I have worked on becoming a real jerk

I trained myself to never say thank you unless the other person did first. I was peremptorily curt with service employees and desk clerks. If someone called me as a wrong number I loudly hung up on them before they could do it to me. And, I succeeded in my mission.

But I found the rudeness was hurting me much more than it was affecting others. You see, ill-bred inconsiderate beings aren’t even aware of their own rudeness, and unfortunately I knew better. Every time I was rude – even when it was retaliatory rudeness – I felt worse than before. And I felt exceptionally bad when I was rude to someone that still practiced courtesy and good manners, so I’m trying to change back.

I will work on saying “please” and “thank you” even when the response is “no problem” or “whatever” or silence. I will hold doors open for people even if only the wind murmurs appreciation. And I will do my very best to meet bad manners with good and rudeness with politeness (even after twenty minutes on hold). I know I will have lapses, but I owe it to my mother’s memory to attempt to make people’s passage through this world a little more pleasant.

Record 2nd Quarter Index Annuity Sales  9/05
The Advantage Index Sales & Market Report shows second quarter 2005 index annuity sales were a record $7426 million compared with sales of $6427 million for the previous quarter. 

The top ten carriers for the second quarter:

Second quarter sales were up 15.6% when compared with first quarter sales; up 40.5% compared with the same period one year ago. AmerUs Group had a commanding 57% of the index life market with second quarter premium of $24,184,512. 

NASD Face Slap 9/05  
NASD Notice to Members 05-50 released in August is designed to provide guidance to member firms on supervising unregistered (“unregistered” is the NASD spin word for state insurance department regulated) index annuities.

NASD does not have authority to say index annuities must be treated as securities and so this suggestion is not a mandate. Indeed they state, “NASD is not taking a position on whether a particular EIA is a security, nor are we attempting to describe the circumstances in which an EIA would be deemed a security.” However, Notice 05-50 is a slap in the face to every state insurance commissioner, and the SEC, and a blatant attempt to grab regulatory turf.

Who Is and Is Not Affected?
If a producer sells index annuities and is not affiliated with an NASD broker/dealer – if the producer does not have series 6 or 7 registration or it is inactive because it is not “hanging” with a B/D – the notice has no effect.

If a producer is securities registered and sells index annuities though their broker/dealer, and the broker/dealer already takes supervisory responsibility for the index annuity sale, life will not really change because the B/D is essentially doing what the Notice prescribes.

However, if the producer is the one out of every two producers that sell index annuities as a “Rule 3030 outside business activity” and is affiliated with a B/D, their future course of selling index annuities is in the hands of their B/D. Notice 05-50 suggests a couple of ways for a B/D to handle index annuity sales: 

The first suggestion seems to say that a B/D should make the final determination on the fixed annuities sold by an affiliated rep, even if those fixed annuities are not sold through the B/D, but the sale won’t have to physically be sent to the B/D. The second suggestion is more exacting.

“Encouraged” seems like such a nice word. However, it’s like being on the NASD boat in the middle of the ocean and being encouraged to row – the alternative being thrown overboard to drown. The second suggestion essentially tells B/D to treat all index annuities as securities.

Since the index annuity language in 50-05 are not mandates, but simply “suggestions” and “encouragement”, a broker/dealer could technically ignore much of it.However, NASD also adds these words “a firm might incorrectly treat the EIA transaction as an outside business activity under Rule 3030 rather than a private securities transaction under Rule 3040 and thereby fail to supervise sales of the product as required by NASD rules.”

 NASD is standing over B/Ds holding an ax raised to strike telling B/Ds they of course may treat fixed index annuities as fixed annuities (because legally that’s what they are). However, if the law ever changes and SEC says even ONE of these index annuity products you didn’t supervise is really a security – even though 232 were not found to be securities – we will chop off your head for failure to supervise. I don’t blame B/Ds for being cautious in this matter.

What this mean for B/D affiliated producers?
At the very least it means an expanded interpretation of NASD Rule 3030. For many years reps have needed to inform their B/Ds – in writing – of any outside business activity. In the past it has been acceptable practice to simply inform the B/D you also sell fixed annuities as an outside business activity without going into specifics. The Notice ramps this up by almost saying you need to give your B/D a list of each and every index annuity product you sell and get approval on individual products.

The arrogance of NASD in expanding the definition of Rule 3030 is beyond belief. What they are saying is the B/D has the authority to approve the day-to-day activities in each and every non-security business a rep has. Most of the Notice, and especially this part, is a slap in the face by the NASD to the insurance commissioners because what NASD is saying is if an insurance agent also has a series 6 or 7 that the agent’s non-securities insurance activities are subject to NASD jurisdiction.

The B/D is on the hot seat. If the B/D does nothing, and the index annuity is later found to be a security, NASD will gut the B/D for failure to supervise. If the money for a non-security index annuity comes from a security then the B/D has to determine if the sale of the security was suitable. As of this writing I have heard from seven broker/dealers that are now requiring all index annuity sales to be transacted through the B/D, two B/Ds that are creating approved index annuity lists, and others that have not yet decided what to do.

Why Is The NASD Doing This?
The Notice says, “NASD is concerned about the manner in which associated persons are marketing and selling unregistered EIAs, and the absence of adequate supervision of these sales practices” Again, another slap in the face by the NASD to all state insurance departments by implying they cannot supervise what they regulate.

NASD sounds like they’re trying to protect the public good. Does NASD offer any proof that consumers are being harmed by index annuities not being regulated as securities? No.

My company did research earlier this year examining the entire NAIC database on consumer complaints. I found that in 2004 nationwide, there were 895 closed consumer complaints against traditional fixed rate annuities, 181 against the top 25 variable annuities and 38 against the entire world of index annuities – this works out to ONE index annuity customer complaint for every $614 million of index annuities sold.

There does not appear to be grounds that the fixed nature of index annuities is hurting consumers. So, might there be another reason for why NASD wants to control index annuities? I’ll leave that for the reader to decide, but I will mention NASD does not currently collect fees on the sales of index annuities.

In the original draft of the notice the NASD was more forceful in stating index annuities were securities. The final notice is more timid. It appears someone reminded NASD that SEC had not abdicated and named NASD the new king.

The notice does not strengthen the contention that index annuities are, in general, securities. The arguments used by NASD are identical to the ones used in 1997. However, it places greater pressure on the SEC to reexamine the question.

What Can The Producer Do?
If the producer is affiliated with a B/D he will need to find out how his B/D will react to Notice 05-50. The least onerous approach might be to help the B/D put together a list of acceptable index annuities.

The industry group NAFA is fighting against security regulation of fixed annuities. Their web site is www.nafa.us and they are the only industry group I have heard from that is working to keep index annuities as fixed products.

Producers should contact their state insurance commissioners and ask what is being done to counteract this infringement by the NASD on their jurisdiction.

Don’t give the hangman the rope. If any marketing material or ads in the least way imply that index annuities are investments instead of long term savings instrument, they should be thrown away and not used.

But don’t jump off any cliffs. I’ve already had producers tell me they will give up their security license rather than put up with all of this. However, if NASD loses, then the gesture of giving up a securities license may be an overreaction.

The final court on this issue is SEC, not NASD, and it is up to fixed index annuity producers and providers to prove their case.

What’s Wrong With Index Annuities?  10/05
I have written dozens of articles on what is right about annuities, let's look on the other side of the coin.

Tax Status – Annuity interest is tax-deferred, not tax-free. Interest is subject to an additional 10% penalty if withdrawn before age 59½. Interest received is always taxed at ordinary income rates, regardless of holding period. There is no step up in account value basis at death.

The effect of these truths to a large extent depend upon the comparison made.

Pure tax-free municipal bond interest often, but not always, tends to be less than the net after-tax deferral yield of a fixed annuity. Municipal bond interest, unlike tax-deferred interest, is included in calculating Social Security benefit taxation.

Whether the 10% “under age 59½” penalty is a killer depends upon the respective yields. If both Annuity A and Non-Annuity B have a 5% rate, and the owner is under age 59½ and withdrawing the interest, the annuity is giving up ½ of a percent and netting 4 ½%. But what if Annuity A has a 5% rate and Non-Annuity B has a 4¼% rate? Annuity A then wins this heat.

Tax-deferred ordinary income versus capital gains tax treatment is seldom simple. How tax efficient is the taxable choice? Will the Alternative Minimum Tax come into play? Will the ordinary tax rate be higher or lower when tax-deferred interest is received? Depending upon the assumptions used either side can be made to win.

Usually if you are the beneficiary of an annuity your tax basis is the cost of the original owner; if you receive stocks due to a death your tax basis is the fair market value at date of death. The annuity loses this tax battle on an appreciated asset.

No Federal Insurance On Accounts – Fixed annuities are only backed by company assets, and as a last recourse, state guaranty associations funded by carrier assessments.

Although some attempt to win this argument by bashing FDIC, you will almost never convince a consumer that a non-federally insured place is safer than a federally insured one. A fixed annuity is not safer than FDIC because by definition federal insurance trumps state guarantees.

The point is not that CDs are unsafe it is that fixed annuities are also safe. It should be noted that no index annuity owner has ever lost money because the insurer failed.

Liquidity – Index annuity surrender penalties can be as long as 18 years and may result in a consumer getting back as little as 75 cents on the dollar if annuity is cashed in 11 days after purchase. Some annuities cannot be cashed in and must be annuitized.

You can argue that longer surrender periods help the carrier invest for the longer term and thus generate higher yields from which to work with. You can mention that the owner intends to annuitize the contract, so it does not matter that the full account value will never be received if the policy is cashed in. You can even mention the high surrender charges are a good thing because they impose discipline on the annuity buyer. You can mention all of this, as long as you can persuade a jury that your primary motivation in promoting the 12 year or longer double-digit surrender penalty product instead of the 5 to 7 year surrender period product was not due to the 9% to 13% commission earned.

Penalties Last Longer Than Guarantees – A typical index annuity may reset some aspect of interest crediting before surrender penalties end, and even policies that have minimum renewal rate factors have them usually set so low the policy would be uncompetitive at the minimum.

Over 90% of index annuities involve a “trust me” factor whereby some aspect of the crediting structure may change before you can withdraw your accumulated value without penalty. I believe annuities need this flexibility to cope with changing financial conditions, but that doesn’t obscure the fact that this flexibility is unilateral.

Opaque Cost Structure – Sales commissions, policy costs and profitability factors are hidden, and crediting method structures are often opaque, making it impossible for a consumer to truly compare the merits of one annually declared rate annuity with another.

True.

No Stock Market Returns – Because index annuities do not include reinvested dividends and typically participate in only a portion of index gains they will not perform like the stock market.

Index annuities don’t perform like the stock market; sometimes they do better (but that is not the message I want to send). The main point is index annuities are not supposed to compete with the stock market. They should never be presented as “stock market returns without losses” because they are not designed to do so. Index annuities might produce 40% to 50% – with an outlier at 70% – of the index return in a strong bull market period (improved participation might result if bond rates soared and option prices remained low). In a rocky market period they might produce 100% to 200% of a stock index return. However, both comparisons are misleading. Index annuities are designed to compete with other fixed annuities.

Presumption Of Prophecy 10/05
I believe a lack of future knowledge is why all investment planning for tomorrow is always a matter of guessing, gambling and superstition, even though it is disguised as science by the use of computer models and financial formulas. Millions of people construct retirement plans purporting to say what a mix of assets will return over the next ten, twenty or forty years. The problem with all of this forecasting is it always attempts to extrapolate the past into the future and except in the broadest terms the financial past doesn’t repeat.

Boom and Bust
I can prove that the average market return for the 1990s should have been 9.8%. It’s simply a matter of looking at the stock market returns of the previous century, calculating averages and standard deviations, doing a few dozen linear regressions, and ta-da! In fact John Bogle, founder of Vanguard, wrote an article as the decade began saying “during the 1990s stocks will have their work cut out for themselves to exceed returns in the 8% to 12% range.”¹ Based on my models I can state with 98% certainty there is no way the 1990s could produce an annualized return of over 14%! However, the real stock market return for the previous decade was not 9.8% it was 17.8%.

That was on the boom side. On the bust side I can show with better than 90% probability that the market will not go down three years in a row. A bear market, yes, but ending after a one or two year decline. However, the millennium bear market resulted in index declines ranging from 35% to 75% and losses for calendar years 2000, 2001 and 2002. Oops.

Now, if you take a broader look and extend the ‘90s through 2003 – create a 13 year decade – you get an annualized return of between 10% and 11%. Does this mean my original 10% projection was pretty much correct but it simply took a little longer to happen, or was I dead wrong, but by making enough adjustments I can make any numbers fit my preconceived conclusion? Unfortunately, I believe it is the later (which is why economics is called the dismal science). 

I’m not alone in my concern over how the past is misused. Even William Sharpe, Nobel Prize winner and creator of the Sharpe Ratio used to measure expected investment returns based on volatility recently said, “Past average experience may be a terrible predictor of future performance.”²

What I think all this means is not to take too seriously financial plans that show you will need an income of $82,000 in 2035 based on a 5.4% “safe rate” and assuming a 3.2% inflation rate requiring $1,518,519 of principal thus necessitating an annual investment of $16,075 that will naturally earn a 7% average yield all with a 97% confidence level, providing nothing unforeseen happens, the world does not change, and tax laws and investment strategies are not adjusted based on emotions and fads.

What I believe is you need to remember long, long-term financial trends while taking into account short-term realities. For example, a tax-deferred dollar of interest is usually going to be worth more than a taxable dollar of interest, so in general, choose tax deferral instead of current taxes for those future need dollars. But, if you discover your tax rate might be higher when you withdraw your tax-deferred dollars than when you put them in, adjust your plan and don’t defer your taxes.

The stock market has produced risk-adjusted returns higher than those of bonds, but periods of less than five years, and even ten years, can be problematic if you are withdrawing income from stocks. So, perhaps you could invest most of the long-term money in the stock market, but when you get within ten years of spending the money take another look at short-term realities and make necessary adjustments.

And maybe if your plan requires a 5% annual yield for income, but returns are down and you only make 4% one year, it might be better to simply tighten your belt and spend a little less rather than increasing the risk aspect of your portfolio and disrupting your plans to get that higher return. Don’t get hung on prophesized numbers, learn and apply long-term concepts, and adjust as needed.

1 Bogle, John, Investing In The 1990s, The Journal Of Portfolio Management, Spring 1991
2 Ianthe Jeanne Dugan, Sharpe Point: Risk Gauge Is Misused, The Wall Street Journal, 31 August 2005 p C1

5 Year IA Returns Top Bank Competition 11/05
You could put a little spin on the numbers and say the worst performing index annuity still beat the total return of the average stock mutual fund by over 4% and the average index annuity return was 70% higher than the average CD for the five year period ending September 2005. The reality is index annuities performed reasonably, but not exceptionally, in a difficult five year timeframe. The average index annuity total return was 24% for the 5-year period.

Average Index Annuity Return Was 70% Higher Than Average CD

Advantage Compendium Ltd completed its 5-year Index Annuity Return Summary whereby carriers were asked to send copies of actual customer statements, with the personal data blacked out, for the five year period commencing at the end of September 2000 and concluding at the end of September 2005. In all, return data from 28 products was obtained representing over 80% of active carriers.

The lowest returns were realized on term end point and high water mark structures. Since the beginning and highest index value was the same these annuities credited their minimum return. It should be noted that these structures have produced the highest returns of all index annuities in other periods. Differences in individual policy performance were more a result of product design and luck of the market rather than renewal rates or methodology.

The index annuity crediting the most interest for the period was the Midland National Life policy – a dramatic 51% – and this was realized by consumers selecting a combination of the S&P 400 MidCap, the S&P 500 and Russell 2000 Index back in 2000. Consumers choosing the bond index within their American Equity New Millennium were rewarded with a total return of 38% for the next 5 years. And the availability of a premium bonus pushed certain Allianz and Americo returns to over 35%!

A 4800% Participation Rate

One could, I guess, compute an effective participation rate for the average index annuity versus the average U.S. Stock Fund total return of .05%, but I believe it shows a participation rate of 4800% for the IA. But any comparisons between index annuities and investments are misleading because index annuities are not designed to compete against investments. Index annuities are a savings vehicle, not a security, as this last five-year period aptly shows. The fact that investors during this period incurred huge losses while fixed index annuity owners did not and earned, at a minimum, guaranteed interest, should be viewed as de facto evidence that these are not securities.

This 5-year period began during the worst bear market of the last 70 years and ended during a seesaw year that had the market losing and recapturing the same ground. Two of the five years generally produced no index-linked interest and the period closed with the S&P 500 still 15% below where it began. In addition, the early years of the timeframe witnessed some of the highest option prices ever seen and the later years saw bond rates at their lowest point in 40 years. It was an ugly environment on all fronts, and yet index annuities still managed to be competitive with CDs and other safe money places.

3rd Quarter Index Annuity Sales Slide   12/05
The Advantage Index Sales & Market Report shows third quarter 2005 index annuity sales were $6895 million compared with sales of $7426 million for the previous quarter. Third quarter sales were down 7% when compared with second quarter sales; down 2% compared with the same period one year ago.

The top ten carriers for the third quarter:

Average Fixed Premium vs. Average Index Premium
We asked companies to provide the average index annuity premium and average traditional fixed annuity premium; 84% of those surveyed responded. The average index annuity sales premium reported was $50,585; average premium ranged from $14,693 to $76,610. The average fixed annuity premium was $41,157; average premium ranged from $7,160 to $77,107.

Total index annuity sales for the first nine months of 2005 are $20.75 billion.

Commonwealth Cowboy Rides Again 12/05
Massachusetts State Secretary William Francis Galvin does not like annuities. In a March letter to his subjects this commonwealth cowboy had this to say about deferred annuities, “They are almost always not a good investment for older people”. In fact he goes on to say, “If you are over 65 years old, annuities are probably NOT for you” (his capitals, not mine).  Why not? Because they “rob [senior residents] of needed access to their money” due to surrender charges. Why the “warning”? Evidently someone told Galvin that some bank employees were telling Massachusetts’ residents they could earn 2% or 3% more interest in a fixed annuity instead of a CD last year, and didn’t suggest one of his regulated security products instead.

Galvin makes absolutely no attempt to differentiate between variable and fixed annuities and there is no attempt at balance or presenting a complete and accurate picture. One could speculate that if Galvin tried to send out this one-sided biased letter to consumers as a producer, instead of as an elected politician, that a legitimate state commissioner would have him up on charges.

What did Massachusetts Commissioner of Insurance Julianne M. Bowler have to say about this encroachment on her regulatory turf? Evidently not one word.

Galvin’s latest attack is against a Massachusetts broker/dealer that he alleges is letting associates act as unregistered investment advisors. This is a legitimate concern. No one should act as an investment advisor without proper training and registration. The problem is this legitimate concern is mixed in with a broad vitriol laden brush slurring fixed annuities, insurance companies and agents too. [This is the link: http://www.sec.state.ma.us/sct/scticc/iccidx.htm]

The one-sided comments in section F of his charges are amazing for their vehemence and slant (if you want to have some fun substitute “U.S. Savings Bond” every time the phrase “equity-indexed annuity” is used and “federal government” whenever “insurance company” is used. It makes for an interesting read).

He also charges forth trumpeting the discovery that insurance agencies and marketing companies earn an override commission from insurance companies. Is this illegal? He doesn’t say. And that annuity company folks and agents meet at conferences and talk about annuities. Is this illegal? He doesn’t say. Does the securities division have jurisdiction over fixed insurance products? He doesn’t say. He does proclaim from his pulpit that because carriers and agencies work together, that wholesalers are allowed to “infiltrate” the sales force and “were unrestrained in their ability to push equity-indexed annuities”. From reading his testament I wasn’t sure whether Galvin thought he is supposed to be Elmer Gantry or Rambo or both.

Galvin’s office is alleging there are two violations of security laws regarding “unethical or dishonest conduct or practices” and failure to supervise, but he is using the “index-annuities are evil” platform popularized by the truth challenged folks at NASD. However, are index annuities charged with any violations under state security laws? No.

What did Massachusetts Commissioner of Insurance Julianne M. Bowler have to say about this unsubstantiated attack on a product under her jurisdiction?  As of this date, not one word.

Galvin and NASD are trying the same style of deception – do a media washing of a dark load of some bad producer behavior mixed with a clean load of index annuities and hope the dark load stains through. I would hope the press would be wise enough to see past this, but so far the press is doing exactly what they are told.

The sad thing is all of this carping about annuities does nothing to solve the real problem, which is getting bad people out of the financial business. If people are acting as unregistered investment advisors there are already federal and state laws on the book that can get them. If states need to protect consumers against bad annuity producers then tell the state insurance departments to go after them. The Massachusetts insurance enforcement division settled 150 administrative actions against insurance companies and agents during the first nine months of this 2005. It is time for Commissioner Bowler to tell Galvin that she is in charge of what goes on in her ranch. Yippee Ki-yah.  

Broken Models  12/05
The current year comes to a close with NASD attempting to usurp insurance department turf with a grab for the potential booty from fixed annuity fees and fines, even though the federal court has ruled these products do not fall under their jurisdiction. It is also a year that saw a rise in lawsuits against those ethically impaired producers in the insurance world that prey upon the elderly with seeming impunity. Both are the result of regulatory flaws.

The Securities Exchange Act of 1934 largely defined the federal regulatory role relating to banks and securities, but regulation of insurance companies and insurance agents was pretty much left up to the states and loosely defined. Power abhors a void and so security regulators are steady in their attempts to gain increasing jurisdiction in this loosely defined world. Their regulation might be a good thing, because many state insurance departments are not good in getting rid of bad agents, but the security regulatory model is also broken. The broken model is why the SEC has been examining the whole security regulatory issue for over a year.

Interesting topic. I have a paper on the subject coming out that attempts to explain why it is broken, but I don’t pretend to have all the answers. I do believe the regulatory world of 2010 will look much different than today.