The Fixed Annuity Market, Analyzed
June 3, 2020 by Sheryl J. Moore
It is hard to believe how very dramatically things have changed in our world in just a short three months. At this time in February, I was doing a keynote for a group of insurance company executives who focus their sales primarily on annuity products. We had some good food, did some networking, and exchanged collective angst about the challenges of marketing “attractive” annuities. It was a mostly uneventful trip until the last day, when businesses began closing and flights began canceling because of something called Novel Coronavirus, or COVID-19.
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That was my last memory of things being “normal.”
Since that day I haven’t been able to color my hair, I am in desperate need of a pedicure, and my latest tattoo remains incomplete. I am unnaturally excited to have exchanges with the people in the drive-thru at my bank and I am suddenly quick to volunteer to run and get a loaf of bread (At last! A chance to escape!). This is definitely one for the history books.
But COVID-19 has affected the insurance business in a way that will go down in history as well. Insurance companies are suspending products, reducing rates, and de-risking their attractive product features. Premium bonuses have plummeted, rider payouts have dropped, and some have even reduced commissions. This virus has forced insurance companies to conduct business virtually, offering their salespeople the opportunity to meet with clients via computer or tablet. Applications are being submitted electronically, which is something insurance companies have talked about doing for two decades. I read recently that this virtual way of conducting business results in salespeople meeting with 30 percent more prospects daily, so it isn’t all bad.
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Regulation
On the regulatory front, the biggest news may be “Best Interest Regulation.” While the Department of Labor’s attempt at a fiduciary rule was thwarted, the Securities and Exchange Commission plans to roll-out “Reg BI” in June. For those salespeople saying, “It doesn’t concern me, as I’m not securities licensed,” individual states such as Massachusetts, Nevada, and New York have all issued their own best interest regs. My home state, Iowa, just became the most recent state to adopt the most recent iteration of the National Association of Insurance Commissioners’ Suitability in Annuity Transactions model regulation, which is built upon a best interest framework. In short, it’s coming.
In other regulatory news, many are cheering the passing of the SECURE Act. This legislation gives annuities within 401(k)s a green light by easing the fiduciary burdens associated with choosing plan providers selecting an annuity provider. (Note there were many groans too, as SECURE also marks the end to stretching an IRA over one’s life expectancy for most.) Those excited for the impending boon to annuity sales should temper their bliss; there is a ton of administration that insurance companies need to establish before this law will translate to a marked increase in annuity sales. Compounding the matter is the fact that insurers need to find a way to get in front of plan sponsors. Yet something everyone in the annuity business can appreciate is that this legislation has resulted in a slew of positive press for annuities.
And to close-out regulatory matters, indexed annuity product manufacturers are still hanging in the air, waiting to hear if they will be able to illustrate indexes that are less than ten years old. More on that later, as we discuss “hybrid indices.” However, note that this does not affect products, just the illustrations of select indices.
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Product Development
Product development has been negatively impacted by COVID-19 in an inconceivable manner. When the market crashed, it had a chilling effect on fixed money instruments. Interest rates on “safe money” were already challenging, but today national averages are stunning:
- Banks
- Savings accounts: 0.10 percent.
- Checking accounts: 0.08 percent.
- Certificates of Deposit (CDs): 1.40 percent.
- US Treasury
- Series EE Bonds: 0.10 percent.
- Series I Bonds: 0.20 percent with an inflation component of 1.01 percent (semiannually).
- Insurance Companies
- Fixed annuities: 1.77 percent.
- Indexed annuities’ annual point-to-point caps: 3.37 percent.
Historically, we have witnessed how low interest rates negatively impact fixed annuity sales. This typically results in positive impact on sales of variable annuities. Yet, market volatility has conversely led to increased fixed annuity sales. This is why most variable annuity (VA) companies have both a VA offering and a fixed; this allows the assets to switch from one side of the house to the other during shifting market conditions.
That said, many insurance companies have developed indexed annuities over the past 25 years because, what happens when there are low interest rates market volatility? Rather than those assets shifting from one side of the house to the other, they fly out the door to companies with an indexed annuity offering.
Of interest is how we have seen a direct inverse relationship between how low CD rates are and how high indexed annuity sales are. Likewise, when market volatility is generally high, it results in a corresponding positive effect on indexed annuity sales. So, ultimately, all indicators suggest that indexed annuities will benefit from the current market environment.
To fully appreciate the challenges associated with pricing fixed annuities today, there are a few basic premises of pricing that you must understand. First, when it comes to annuity pricing, there are only 100 pennies in a dollar; it is all a matter of where you allocate your pennies. And there are three parties that must benefit from the annuity:
- The purchaser: Through a fair credited rate, or cap/participation rate/spread rate;
- The salesperson/distributor: Via a fair commission; and,
- The insurance company: Through their spread/profit.
I like to imagine a three-legged stool when it comes to this point. If a product has a relatively attractive commission, either the purchaser’s leg of the stool, or the insurance company’s leg of the stool must be shortened. Hot tip: The insurance company is always going to get their “pennies,” or the annuity won’t be available for sale.
When it comes to fixed annuities, it is helpful to understand another basic principle of annuity pricing. When a purchaser deposits $100,000 into a 10-year fixed annuity, the insurance company turns around and purchases 10-year bonds. Let’s assume the bonds are crediting the insurance company with 4.00 percent interest. The insurance company will credit less than this amount to the fixed annuity purchaser, and the difference is then used to pay expenses, distributor/agent commissions, and earn a profit/spread.
Given all of this, and to help put things into perspective, the 10-year treasury bond is not at 4.00 percent; it isn’t even at 1.00 percent. (Yahoo! Finance has some great historical graphs to show how this has plummeted). So, to say that insurance companies are trying to make lemonade out of lemons is a gross understatement.
To aid in your understanding of indexed annuity pricing, the basic principle of pricing fixed annuities, above, is slightly modified. Instead of placing 100 percent of the purchaser’s annuity payment into bonds, the insurance company only puts 97 percent of the amount into bonds. The remaining three percent is used to purchase options, which provide the indexed-linked interest. Here, I remind you that the 3.00 percent of the annuity purchaser’s premium is only able to purchase options that afford an average 3.37 percent annual point-to-point cap today. This leads me to our discussion of the biggest trend in the indexed annuity market.
Market Trends
We know that the excess interest credited to indexed annuities hinges on three things: The rates (caps/pars/spreads), the indexing method (annual point-to-point, monthly averaging, etc.), and the index. Let’s talk about that last item, specifically, as it has changed dramatically in the past eight years. When I started my market research firm 15 years ago, there were six indices upon which you could base indexed interest on these annuities: The DJIA, NASDAQ-100, Russell 2000, S&P 400, the S&P 500, and a now-defunct bond index.
Today, there are an astounding 116 different indices upon which to earn indexed interest on indexed annuities.
Enter the hybrid index. Hybrid indices are those that consist of one or more indices, and usually have a cash or bond component as well. Some hybrid indices are volatility controlled. Some are proprietary, so that they are marketed exclusively by a single company. Typically, the hybrid index is developed around the same date that the annuity is conceived (where, by contrast, the newest index prior to the emergence of these indices was more than 20 years old). These indices are almost universally controlled via a participation rate or spread, so as to give the ability to market that they offer “uncapped” potential to the annuity purchaser. They are usually illustrated favorably. Their “sexiness” is derived from the impression that they have an “unlimited potential for gains.”
By the way…not true.
Anyhow, why the boom in indices? In short, historically low rates. The indexed annuity product manufacturers seem to innovate best under pressure. Never underestimate how creative an insurance company can be until you put them in periods of pricing duress. The first time pricing indexed annuities became challenging, after their initial introduction, companies began using spreads instead of caps to limit indexed interest. The next period of unattractive rates gave birth to new crediting methods. So, instead of just offering point-to-point calculations, we began to see monthly and daily averaging methods. Now that financial institutions have embraced the products, “innovating” through indexing methods is no longer possible; these firms are strict on which indexing methods they allow. And so, new hybrid indices are how insurance companies are “innovating” to find a way to market something that would otherwise look relatively unpalatable.
And because everyone is focusing on the fantastic potential for gains, not many are talking about guaranteed income that cannot be outlived. Guaranteed Lifetime Withdrawal Benefit (GLWB) elections have fallen to an all-time low of 35.2 percent. Still, those companies telling the “income story” have started innovating in their own manner. Guaranteed roll ups have largely gone by the wayside, and have been replaced by GLWBs that use indexed gains for the Benefit Base value, offer stacking features, or boast “increasing income.” The Long Term Care (LTC)-kicker feature is still popular, offering purchasers twice the amount of income than typical if they qualify by needing assistance with two out of six Activities of Daily Living (ADLs).
The historical low rates have also resulted in restricted liquidity for all annuities. Gone are the days when 10 percent penalty-free withdrawals came standard! Most fixed and indexed annuities today offer five percent penalty-frees, and some even go so far as to offer seven percent (gasp!).
Sales
Coronavirus may be stinging us all, but it has had an interesting effect on sales. Specifically, indexed annuity sales are down 4.3 percent from last quarter and 7.4 percent from this time last year. Surprisingly, fixed annuity sales are up. One-year fixed rate annuity sales are up 0.5 percent over last quarter, but still down 27.1 percent from the same period a year prior. Similarly, multi-year guaranteed rate annuity sales are up 9.1 percent from last quarter, but down 32.5 percent from this time last year.
The good news in all of this is that sales will hit record levels once everything levels-out, the 10-year treasury rebounds, and everything returns to “normal.” Those familiar with annuities have a history of purchasing fixed products when they experience the losses of the market. And as people increasingly hear the word “annuity,” realizing that these products can address their top fear of running out of money in retirement, it sets the stage for a boon in your business. Until then, the annuity industry will do what it always does—adjust and keep providing the guaranteed lifetime income that Americans so desperately need.
