Quite the Contrary: Investors who bought indexed annuities a year ago are sleeping much better than owners of variable annuities or mutual funds.
January 9, 2010 by Ron Panko
Source: Best’s Review (February 2009 Issue) As the stock market melted down last fall, financial advisers were busy urging clients to not panic, to be patient and to stick with their long-term investment plans.
But some advisers received thank-you notes, a good number of which probably came from clients who had purchased indexed annuities, a hybrid type of investment previously called equity indexed annuities.Bill Hettenhausen, an insurance agent from Swansea, Ill., said he received a Christmas card from a retired couple that read: “Let’s hope this recession is over soon. Thanks for protecting our little nest eggs.”And an Aviva USA agent received a letter in early October from a couple in Hendersonville, N.C. It read: “If we had our nest egg in variable annuities or in the mutual funds we had before that, we would have just experienced the worst week of our lives…Thanks for introducing us to your products.”
Why the thank-you notes? Because as stock indexes fell in value by as much as 50% last year, indexed annuities maintained their value. In fact, since they were introduced in the United States in 1995, not a single indexed annuity customer has ever lost a penny of account value due to equity market declines, said John Currier, executive vice president and chief product officer at Aviva USA. The company has been the top seller of indexed annuities since the first quarter of 2008, according to AnnuitySpecs.com, a market research firm.
Indexed annuities don’t perform like stocks or stock-index mutual funds. When stock markets go down, indexed annuities preserve principal. When stock markets go up, indexed annuities credit interest based on the performance of an outside index, such as the S&P 500. This additional interest is only a portion–and sometimes a small portion–of the stock gains. Nor are they like bank certificates of deposit or traditional fixed annuities, which usually guarantee higher interest rates than indexed annuities can.
Most of the time, the performance of indexed annuities falls somewhere between that of a stock index and a CD or a traditional fixed annuity. But when there is a dislocation in the markets, policyholders may feel the benefit of the product is special. “We sometimes joke that zero is your hero,” said Currier. “A zero-percent return in today’s environment is a big plus compared to what the average investment manager may have provided.”
A Good Time to Buy?
As Aviva’s Chief Operating Officer Chris Littlefield said, a particularly good time to have purchased an indexed annuity would have been before the financial crisis hit.
“I can’t say whether now would be a great time to invest,” Aviva’s Currier said. “But people do seem to want less risk these days, and the current market conditions have created a more significant focus on products that address needs of protection more so than in the past.” He added that product suitability for individuals depends heavily on personal circumstances.
Sheryl Moore, a market research analyst specializing in indexed annuities, said in December that the products were very attractive compared to traditional fixed instruments. Moore is president and chief executive officer of AnnuitySpecs.com and Advantage Group Associates.
Now is a good time to buy, she said, because prevailing interest rates are low and returns on indexed annuities could be very good when the stock markets rebound. For example, crediting caps on indexed annuities using annual point-to-point strategies are as high as 10%, an amount that could be credited if stocks significantly improve.
“Consumers are going to have a great opportunity to get the full amount credited up to their cap,” she said. “That’s why this is an especially good time for agents to be selling indexed products and for consumers to be buying them.”
Product writers use the vast majority of premiums paid to buy high-quality bonds to provide the guaranteed returns of indexed annuities. Standard non-forfeiture laws require insurers to guarantee an annual return of at least 1% of 87.5% of premium invested, Moore said, so principal may not be fully protected during a longer-term product’s first few years.
Most carriers offer minimum guarantees of about 3% of 87.5% of premium, she said. The remaining portion of the premium is used to buy options on one or more stock indexes. These are exercised if the index has a good year, and proceeds are paid in additional interest.
Different kinds of options are available. If the insurer caps how much interest a policyholder can earn over a given period, the option today may be less expensive, and the insurer can offer a higher rate of participation in index gains. This rate determines how much of an index’s gain will ultimately be credited to an account.
If there is no cap, the option today will likely offer a lower participation rate; but in a sharply higher market, the lower rate may pay more in interest than a contract with a cap.
Participation rates in December ranged from percentages in the mid-20s to the mid-40s, said Currier. Interest rates can also be calculated by means of a spread that’s determined by the rate earned in the option less a fixed percentage retained by the insurer. Option prices depend on the volatility of the stock market, Moore said.
Another crediting method is the monthly point-to-point with a cap, such as 2.5% or even 3%. This type of method would produce the best results when a stock index rises steadily over a full year. The monthly results are added and subtracted, and the sum of the percentage gain is credited at year end. If there is a loss over a year, the account keeps its starting value.
Currier said that, in the perfect environment, this type of crediting method could produce gains of 30% or more. “No one strategy is perfect all of the time,” he said. “The strategies have different environments in which they perform best. But what this environment has really highlighted is that just the principal protection alone is worth an awful lot in terms of prosperity and peace of mind for customers.”
According to Moore’s research, in the third quarter of 2008 nearly 74% of indexed annuities employed annual resets of contract value on the indexed crediting methods. Less than 1% of third-quarter sales were of products without an annual reset. The annual reset is one of the strongest features of an indexed annuity, she said. It means that at the end of a year of sharp stock market declines, the indexed annuity policyholder has an account value at least as great as when the year started. Yet the index level at the end of the policyholder’s year is going to be the starting point for the next year’s index performance measurement.
“I think that makes a very strong value proposition for indexed products,” she said. “It might take years for other kinds of investments to correct what happened in the index.”
Safety With Potential
Hettenhausen, who has run his one-person, independent agency for three decades, said his Christmas-card-sending clients selected indexed annuities because they offered safety as well as a chance to earn more. Both the husband, retired from the military, and the wife, retired from civil service, live comfortably. The husband works a part-time job. They each have pensions; their modest number of other assets are invested in CDs and traditional fixed annuities.
Originally, the couple had a point-to-point indexed annuity with a long term, but when it matured, they switched to two shorter-term methods. One credits point-to-point annually. The other credits every two years, based on the sum of monthly changes in the S&P 500 Index.
“I really thought the long point-to-point design was the route to go when I first got into this in 1997, but now, with what’s transpired over the last decade, I can’t imagine how anyone in the long point-to-point is not going to be looking over their shoulders, wondering whether all of their interest is going to disappear in front of them,” Hettenhausen said. Investors with long point-to-point products, for example, might be up 50% after seven years, only to see the index tank in the last three years, effectively wiping out their index gains.
The change to shorter point-to-point designs has helped. If his clients had reinvested in a long point-to-point, “they would have been less out of luck than if they had invested in the market,” Hettenhausen said.
“I can’t imagine how long people in mutual funds are going to be waiting for the market to recover,” he added. “They’re saying they’ll have to wait three or four more years, and then they’ll be able to retire, but if it happens again, what do they do? Unretire? I personally do not have money in any mutual funds, stocks or bonds. My money is either in a bank, credit union or money market fund, and most of it is held in annuities by Jackson National or Illinois Mutual.”
Hettenhausen said he likes the biannual (credited every two years) monthly reset type of plan. “If the market makes a run, that design could capture a good rate of interest for my clients, and I’ve put a lot of mine into that design,” he said.
Aviva Life and Annuity Co.
A.M. Best Company # 06199
Distribution: Independent marketing organizations, personal producing general agents
Jackson National Life Insurance Co.
A.M. Best Company # 06596
Distribution: Independent agents, brokers and banks
Illinois Mutual Life Insurance Co.
A.M. Best Company # 06542
Distribution: Independent agents, brokers and general agents
For ratings and other financial strength information visit www.ambest.com.
By Ron Panko, senior associate editor, Best’s Review: Ronald.Panko@ambest.com