Looking For Protection

Transcription

1 Financial Advisor Website and Magazine Looking For Protection Financial Advisor Magazine 2011 Issue FA NEWS MARCH Index annuities promise to deliver a guaranteed return, but their costs and complexity are two serious trade-offs. By Alan Lavine Should index annuities be part of your safety-minded client s portfolio? These annuities pay a rate of interest based on a percentage of the gain or loss in a market index, such as the S&P 500, but they also offer downside principal protection. Often, there also is a guaranteed floor of about 1%. Apparently, cautious people, who typically invest in CDs, fixed annuities and bonds, are investing in this product at a fast clip. Index annuities set a new record high in the third quarter of 2010, with sales totaling nearly $9 billion, up 16% over the third quarter of 2009, according to LIMRA, Windsor, Conn. The attraction: Unlike variable annuities, they generally have no market risk, and they stand to pay higher returns than fixed annuities. Sales of index annuities were estimated by LIMRA to hit $33 billion by year-end 2010, up from $29 billion in Forty-one percent of fixed annuities sold in 2010 were deferred annuities linked to the market. And 91% of all index annuities were sold by independent broker-dealers, according to Beacon Research, Evanston, Ill. Over the past five years ending in November 2010, the average index annuity credited a 3.9% annualized interest rate. By contrast, one-year CDs yielded 2.8% annually and five-year CDs yielded 3.8%, reports Advantage Compendium, St. Louis. By contrast, the S&P 500 index grew at just a 0.65% annual rate. It is not surprising that sales of index annuities had a record quarter, says Joseph

2 Montminy, assistant vice president for LIMRA s annuity research. This is the ideal market for index annuities because there is lots of volatility in the equity markets coupled with low credited rates and declining interest rate spreads on traditional fixed annuities. Judith Alexander, analyst with Beacon Research, says guaranteed lifetime withdrawal benefits and premium bonuses are driving demand for the product. The main emphasis continued to be what was guaranteed, including premium and income account bonuses, income account roll-up rates, and guaranteed minimum interest rates above 0%, she says. Insurance company equity index annuity portfolios are made up of target maturity investment-grade bonds and equity index options, says Dr. Geoffrey VanderPal, chief investment officer of Skyline Capital Management, Austin, Texas. The majority of policyholder money is invested in bonds. A discounted amount of the present value of the bond portfolios is put into a customized equity index option for the majority of the period. As the bonds mature in the underlying portfolio, the matured bond value provides the principal protection, and the minimum guaranteed contract return is based upon the portion of the dividend generated, he adds. Today, most index annuities pay policyholders a minimum guaranteed floating yearly rate based on Treasurys that is 1% to 3% on 87.5% of the premium paid into the contract, says Jack Marrion, president of Advantage Compendium. Due to low interest rates, that guaranteed floor has declined to about 1% from as high as 2% to 3% of the total premium several years ago. Of course, there is no free lunch with index annuities. Investors, who may only earn a participation rate of, say, 60% to 70% of the upside performance of an index, give away the upside of stocks in a bull market. There might be an interest rate cap, limiting how high a client s interest rate can go. Or there may be a margin, spread or administrative fee subtracted from the index. Sometimes, the percentages, caps or margins can change during the contract term. The annuity return also excludes the reinvestment of dividends. Like other annuity products, this type of annuity comes with back-end surrender charges that can be over more than ten years. In addition, most state guaranty associations cover up to $100,000 of a fixed annuity in the event the insurance company goes belly-up.

3 So it s best to diversify your clients equity index annuities with a number of carriers. An investment in an equity-index annuity is tax-deferred. At maturity, the policyholder can cash out and pay income taxes on earnings, or opt to receive periodic payments for life. Withdrawing from any type of tax-deferred annuity before age 59½ means a policyholder could face a 10% IRS fine. David Maurice, a partner in the financial planning firm Carrier and Maurice, Johnson City, Tenn., does not recommend index annuities because of surrender charges, complexity and the fact that ordinary income tax is charged on the earnings. It is hard for investors to compare index annuities and estimate their expected returns due to complex formulas used to calculate returns. We think [index annuities] are flawed by design, Maurice says. I can get better returns with less risk by diversifying clients in a wide range of assets classes over the long term. Jerry Miccolis, financial planner with Brinton Eaton, Madison, N.J., agrees. He diversifies client investments based on their future cash flow needs, life expectancy and legacy needs. He puts conservative clients who need every penny to live on over their lifetimes into diversified portfolios of individual bonds and stocks. He protects all of his clients against severe stock market losses by investing in a structured note developed by Deutsche Bank, called EMERALD. This note generates modest growth in normal markets and sudden and lasting appreciation in times of excessive market turmoil. Pure asset allocation is the best way to get safety plus return, Miccolis says. We rebalance portfolios and use a protective structured note that is less costly than using put options. Others use index annuities sparingly. We do recommend them for the right people, Graydon Coghlan, a San Diego-based financial planner, says. I agree with other financial planners about the disadvantages of index annuities. But we are here to help individuals that don t want to take the risk and put money in the stock market. Evor Vattuone, financial planner with Aspire Capital Management, Walnut Creek, Calif., says he might use index annuities, but very rarely and only for a particular type of client. We use them when our planning objectives call for a specific fixed income stream and a survivorship risk that can be addressed and guaranteed by the insurance contract and can t be obtained in the open market. VanderPal, of Skyline Capital, says index annuities are an appropriate investment. He was co-author of a 2010 study published by the Wharton Financial Institutions Center

4 that found equity index annuity returns were competitive with stock and bond portfolios. Their designs limited downside returns and provided modest returns on the upside. For example, in the five years that included the stock market meltdown from 1998 to 2003, the average equity index annuity grew at a 5.5% annual rate. By contrast, the S&P 500 registered an annual negative return of -0.4%. In the up market from 2002 to 2007, the S&P 500 grew at an annual rate of 13.37%. Meanwhile equity index annuities grew at a 6.12% annual rate. Index annuities were never designed to exceed the performance of an index, but to provide a return similar to CDs and bonds and protect the downside, he says. There are a lot of people that lost a tremendous amount of money using asset allocation strategies. In answer to critics who contend that equity index annuities are illiquid due to surrender charges, VanderPal says the annuity contracts often permit policyholders to withdraw 10% of the account value per year without penalty. Plus, equity index annuities provide full surrender value upon death of the policyholder. Many also offer full surrender value for nursing home and extended hospital stays and long-term illness. Some insurers offer full surrender value for unemployment if the policyholder is less than 65 years old. If you plan to use index annuities, it s important to analyze product variables such as: The way the insurance company calculates interest. Whether it is simple interest or compounded interest affects the index annuity s return. The annuity s interest can be lowered by the cap rate and/or participation rate on the contract. VanderPal recommends avoiding the term point-to-point method of crediting interest. Point-to-point compares the change in the index at two discrete points in time, such as the beginning and end dates of the contract term. If the index declines dramatically on the last day of the term, part or all of the earlier gains can be lost. Surrendering early also can wipe out gains. The most judicious crediting method is the point-to-point with a monthly or annual reset, VanderPal says. The annual reset compares the change in the index from the beginning of the month to the end of the month or the beginning of the year to the end of the year. So your gain is always locked in. This method works best in volatile and uncertain markets.

5 The High Water Mark is another crediting option. It considers the index value at various points during the contract, usually annual anniversaries. It then takes the highest of these values and compares it to the index level at the start of the term. Advantage: This may credit you with more interest than other indexing methods and protect against declines in the index. Disadvantage: Because interest is not credited until the end of the term, you may not receive any index-linked gain if you surrender your index annuity early. Index annuities may average an index s value either daily or monthly rather than use the actual value of the index on a specified date. Averaging may reduce the amount of index-linked interest you earn.