At the dawn of 2015, forecasters predict a warming trend for annuities, but warn of a chance of a sudden and deep freeze.
The sun has been shining on annuities for the past few years, in fact. Not all products, of course. But consumers are going for some, such as fixed index annuities (FIAs), like Italian ice on a blistering afternoon.
FIAs have been breaking records most quarters since the Great Recession, enticing with their alluring upside potential/downside protection message. Will that trend continue? Or will a front of faux FIAs from the financial realm darken the sky?
Or will the whole system of FIAs become so complex that it bogs down and blows away? Will FIAs then be replaced by a current of hybrid systems that steal their thunder?
Oppressively humid weather metaphors aside, these are some pretty darn good days for annuities. More Americans are accepting them, particularly as consumers see their retirement prospects wither. People have only a few dependable ways to take control of their financial destiny. Stocks might be meteoric, but meteors occasionally crash. Just about anything established by an employer, such as a pension, can be taken away. The same thing can be said of a government program subject to the whims of politicians.
And who knows when bonds will become a substantially better deal than stashing cash in a coffee can?
The federal government is recognizing the value of annuities. The latest evidence of that would be the qualified longevity annuity contracts (QLACs) that were approved last summer. They would allow people to postpone taking required minimum distributions past age 70½ by putting an annuity into a retirement plan, such as a 401(k).
Even financial services folks, who have long curled a lip toward fixed annuities, are fashioning FIA-looking variable annuities. Heck, some are dropping all pretense and are actually selling fixed index annuities!
What’s next? Will we see Ken Fisher running through the hills, flinging daisies and yelling, “I love annuities! LOVE THEM! And you should too!”
Maybe not. But it is true that annuities are a more accepted member of the financial family, and not just sitting at the kids’ table anymore.
The Fixed Index Rise
Persistently low interest rates will continue to drag down sales of fixed traditional and multiyear guaranteed annuities, said Sheryl Moore, CEO and president of Moore Market Intelligence, an annuity analyst. But the low rates haven’t slowed FIAs any.
“Because people say, ‘Look, I do want safety. I don’t feel comfortable losing money. But I still want to be able to beat out the one-quarter of 1 percent I can get at the bank,’” she said, adding that accumulation is getting more attention. “I think that we’re going to continue to see a focus on accumulation sales, and not just income sales, because for a long time caps were so low that everybody had to sell index annuities based on the income story. No one was out there pitching 2 percent caps. But we have seen more and more of a focus on accumulation over the past few years.”
In fact, that pursuit of accumulation has pushed innovation with features such as uncapped potential and exotic indexes. Insurers are operating in a narrow lane of opportunity between low interest rates and tighter regulation.
“We’re going to continue to see product innovation on supplemental benefits like riders because there’s not a lot of innovation left for us to do within the annuity products because we’re limited to a 10-year cap and often limited to a 10 percent penalty in the first year,” Moore said. “That has the unintended effect of limiting premium bonuses and commissions and caps and all sorts of things.”
That means more innovation through riders, such as guaranteed lifetime withdrawal benefit (GLWB) and death benefit. “And even types of riders that people wouldn’t imagine, such as ‘We’ll give you a higher bonus if you buy this rider or we’ll give you a greater annuitization value if you buy that rider,’” Moore said. “That’s really where the focus of product innovation is going to be, because it is still a challenging pricing environment.”
Moore expects that guaranteed minimum accumulation benefits (GMABs) will be among the next wave of features.
“Because rates are so poor on index annuities, people are saying, ‘If I can guarantee to my client that no matter what, they’ll earn at least X percent on the annuity over the life of the contract, that would be really helpful to me,’” Moore said, putting it in the context of another growing distribution trend. “That’s a feature that’s especially popular in bank and broker/dealer distributions. We’ll see more features that cater to the bank and broker/dealer distributions, like return of premium features, bail-out provisions and things that typically have not been very popular with index annuities because there is a cost to providing those benefits.”
Moore described a scenario where a bailout provision would be used: “Let’s say the index annuity has a cap of 5 percent when it’s sold. The bailout provision might say that if the insurance company ever reduces the cap once you own the annuity to less than – let’s say 4 percent – then you can cash-surrender the annuity without paying any penalties. It’s kind of a ‘trust me’ factor.”
The bailout option would prevent carriers from doing a bait-and-switch on terms – especially important for banks and wire houses. “Those distributors don’t want to do business with carriers that don’t have integrity when it comes to the renewal rate on those contracts,” Moore said. “Because they pay less commission to the salesperson, they can get some of those features where the banker broker/dealer says, ‘This really helps me to feel comfortable doing business with this carrier and also gives me a marketing message to the client to say, “We’re not your typical indexed annuity. We have something that you can count on in terms of your rates going forward on this annuity once you’ve purchased it.”’”
LIMRA also noted that benefit riders have become a bigger deal among independent insurance distributors. Guaranteed living benefit (GLB) riders are now expected, said Joseph Montminy, assistant vice president, LIMRA Secure Retirement Institute Annuity Research.
“We’re seeing eight out of 10 index sales have a GLB available, and when it’s available, seven out of 10 times it’s accepted,” Montminy said. “They’re helping to resonate with consumers who say, ‘I do want the ability to control my money but get that income at a later point in time.’ And with that money, we’re seeing a shift. Ten years ago, probably six out of 10 index annuities came from nonqualified money. Fast-forward to this year, six out of 10 index sales now use IRA or qualified money to fund that purchase.”
New Channels Tune In
LIMRA also noticed that the bank and broker/dealer channels are taking an interest in the index world.
“Folks who may not have historically offered them are now starting to look at some of these index products,” Montminy said. “Wells Fargo went as far as to demand simpler features, shorter surrender charges, lower surrender charge amounts and lower comp.”
Banks have grabbed greater market share since the recession. In 2008, banks had 4 percent of the market. In 2013, they sold 13 percent. As of the third quarter of 2014, banks’ share had risen to 15 percent. But broker/dealers had an even more rapid ascent, growing from 5 percent of the market in 2013 to 14 percent as of the third quarter of last year. Career agents have hovered around 5 percent of the market since 2007.
Independent agents dropped from 86 percent of the market in 2011 to 65 percent as of the third quarter of 2014. Montminy is quick to point out that although the new channels grew, sales increased overall.
“Those independent agents are not losing dollar value sales,” Montminy said. “They’re still seeing their dollar value sales grow in the independent agent channel. It just happens that the banks and the independent broker/dealers are seeing their dollar value grow faster, which is why they’re capturing market share.”
In fact, Montminy said even though 2013 was a breakout year for FIAs, sales look to leap 25 percent higher in 2014 to about $48 billion. LIMRA is projecting another 10 to 15 percent gain this year.
But Kim O’Brien, CEO and president of National Association for Fixed Annuities (NAFA), sees a far bigger number.
“I think we’re not too far away, maybe three or four years, from a $100 billion year,” O’Brien said. (Montminy said that although he was impressed with O’Brien’s attitude and agreed with the upward direction, he didn’t foresee that large a leap in the next few years.)
O’Brien is basing her projection on decades in the financial world and a dozen years at NAFA.
“Twelve years ago, it was 10 percent of the marketplace,” O’Brien said of FIA market share. “Now one out of every two fixed annuities is an index.”
She has also noted the market share increase in other channels, but she said independent marketing organizations (IMOs) are probably not too nervous about the incursion. In fact, IMOs might be a key reason for that trend.
“It’s amazing how many of the independent marketing organizations have relationships with B/Ds and banks,” said O’Brien, who counts about 80 IMOs as NAFA members. “We think that’s because the banks and the B/Ds don’t really have the product or the back-office knowledge, so that growth is being driven by that relationship.”
NAFA board member and past chairman Bob Phillips sees it as even bigger than a convenient relationship. It’s a change he has seen first-hand from his perspective as the president of Alternative Brokerage.
“We’re a wholesaler, mostly life and annuities on the fixed side,” said Phillips, whose career has included stints at Legg Mason and Principal. “We’re like many of the traditional insurance agents. But there’s been talk about a sea change just in the past five years. There’s a big evolution of IMOs, or there needs to be, toward the registered rep market and the bank markets.”
He is keeping an eye on wire houses: “The rumor was, back in 2009, that one of the major wire houses was developing their own index product. Then the rates continued to shrink and they didn’t launch it. I think if rates come back, we’re going to see wire houses have their own products, which will blast open the broker/dealer market for index. Whenever one of the wire houses has their own, then most of the national broker/dealers and regional broker/dealers are going to compete for those dollars.”
David Callanan, a co-founder of Advisors Excel, the nation’s largest IMO, is not exactly talking about a partnership with broker/dealers, but he is not too worried about their presence in the marketplace either.
“I have had the question from a lot of our advisors: ‘What happens if Morgan Stanley, or whoever, creates a fee-based product? That’s going to be terrible!’” Callanan said. “And I say a fee-based product is probably going to have a three-year surrender charge. Maybe two, one. Maybe even none. I don’t understand how they’re going to do that effectively. It’s not a variable annuity. The power of this thing is the fact that the insurance company can invest a little longer and does have protections based on surrender charges, so they can get a little more yield and that yield goes back and benefits the client.”
But that does not mean Callanan wants financial folks to fail in the indexed space. In fact, he hopes they do well.
“It just adds more validity to the product,” Callanan said of fixed index annuities. “It’s been around now for 20 years, but the more penetration you get in banks and wire houses, the better. That’s because I’m convinced that an advisor can provide a better service-based platform for a lot of consumers than those places can. But, for goodness’ sake, if we get to the point where Morgan Stanley and Goldman Sachs are presenting these things every day, it becomes more commonplace.”
Callanan welcomes the wider recognition of FIAs, which he sees as part of an overall plan for client financial health. He likes them as simple as possible and dedicated to some gain but a lot of preservation.
So, he is not a big fan of one of the newest trends in FIAs.
Exotic Indexes and Uncapped Potential Debut
For the past few years, carriers have been offering annuities that link to indexes other than the typical Standard & Poor’s 500. Now, some companies are combining indexes to create new ones.
Moore, of Moore Market Intelligence, expects to see more hybrid indexes, partly because this helps companies offer another new feature.
“Hybrid indexes on these products are the way that people get to an uncapped crediting method,” Moore said. “So, instead of the S&P 500, it might be an index that includes the S&P 500 as well as other indexes, and they make up an index out of several others. And often it’ll have a cash component and do rebalancing and what have you.”
The new feature is being promoted pretty heavily, mostly in response to low interest rates, Moore said. The 10-year Treasury note has been hanging around above 2 percent for much of last year and does not look like it will rise anytime soon. That is a problem because it’s the primary measure for pricing fixed annuities.
“It makes it very challenging to offer attractive caps and participation rates,” Moore said of the bond’s low rates. “When caps and participation rates are so low, insurance companies and marketing groups are looking for better ways to make their product look more attractive. And, in reality, using different indexes or different crediting methods doesn’t necessarily make the product better – it just makes it more marketable.”
The marketing message is that rather than the 3½ percent cap you would typically have on an S&P index, you can have a new index without a cap. But how can a company offer an index without a cap?
“What they might do is take the S&P 500 but blend it with some nonperformers in terms of indexes,” Moore said. “So, bond indexes tend to be much more conservative in performance. Cash also. And then there are some indexes that are very new and have no history that you can add too. It essentially waters it down in terms of performance.”
A cap is the most typical of the three ways to limit interest in an FIA. The other two, participation rates and spreads, are sometimes perceived as an improvement over caps because a cap is a hard limit. No matter what the index does, you’ll never get more than the cap.
But a participation rate and a spread would actually allow a client to get more than the cap if the options seller didn’t price his options correctly, Moore said. Options are typically what a carrier buys to cover the index portion of the FIA. Generally, though, the options seller will make sure his risk is relative regardless of the index or the crediting method.
“He might say, ‘Well, you know, if you really want the ability to say your product doesn’t have a hard limit on the maximum potential for gains, you could use a participation rate because if the S&P 500 goes up 20 percent and if you’re using a cap at 3 percent, you’re never going to get more than 3 percent,’” Moore said. “‘But let’s say your participation rate is 50 percent and the S&P 500 goes up 20 percent. Well, then you’d actually get 10 percent index interest.’ But he’s been selling options way longer than indexed annuities have ever existed. So he’s pretty good in his pricing since he’s the one who’s on the line for it.”
In the end, Moore said, regardless of the index or the credit method, they are going to perform about the same over a long period of time.
“Index annuities are a really great product,” she said, “but in an effort to make one company’s product look better than another’s, it seems like we get a lot of this ‘innovation’ for the sake of marketing, which really complicates the sale.”
Moore also gets worried about some of the new indexes and how they are marketed. She described what she thought was a head-scratcher in a company’s marketing piece describing a new index.
“When you turn to the third or fourth page, it has this chart where it lists some different years and some different values. And it says, ‘Hypothetical Historical Performance.’ And it has an asterisk next to it, and it leads to a footnote that says, ‘Although this index was just created July 24, 2014, had it existed in the past, here is an example of how it may have performed.’ ”
She called the carrier and said, “You are releasing this piece that is going to tell your distributors it’s OK to be communicating to a client that they can get 24 percent, 36 percent gains, because here is this marketing piece that makes it look like that’s what people in the past have earned with it, even though this index was just created three weeks ago. And they said, ‘Well, you think that’s a problem?’”
The communication, not necessarily the index, is a problem at NAFA, said O’Brien, the association’s CEO, and Phillips, a board member.
“It’s dangerous unless we self-police,” Phillips said, casting an eye toward federal officials considering an expansion of fiduciary responsibility. “Everybody realizes that the regulatory environment is only going to increase. It has; it will. We don’t know what the Department of Labor is going to do or the Securities and Exchange Commission on fiduciary responsibility.”
Callanan said he would prefer that companies focus more on the income rather than on creative indexes.
“You could talk about inflation-adjusted income or any kind of enhancement to start your income at one level and have the ability every couple of years to increase that based on something,” Callanan said. “I think you’re going to see more and more of that in this space, and I really believe it’s what is important because it’s what the consumer needs.”
But Callanan conceded that there will probably be at least another year of exotic indexes and capping strategies: “Maybe I’m predicting more what might happen in ’16 and ’17, but typically when everybody starts talking about something, that’s when the ride’s over.”
In Comes the Income: QLACs, DIAs and SPIAs
The Qualified Longevity Annuity Contracts (QLACs) that the federal government created last summer allow people to buy a deferred income annuity (DIA) with qualified money inside a retirement plan. The DIA would pay later in life, when that contract holder reaches age 80, most likely. A key benefit is that it would reduce the required minimum distribution (RMD) that people would otherwise have to start taking at 70½. In November 2014, AIG’s American General was the first large company to offer a QLAC.
Montminy of LIMRA said he’s heard quite a bit of excitement about QLACs.
“It’s exciting because it does provide you the opportunity to have money that can go beyond the RMDs, but I think it’s going to be more of a niche kind of market,” Montminy said. “We’ve heard some people say it’s going to be a game changer. Actually I don’t think it’s going to be a game changer, but I do see it helping to grow sales.”
Moore of Moore Market Intelligence said QLACs are probably going to be of most interest to career agents. She suspects the first purveyors of the products will be companies like MetLife, Guardian, New York Life and Northwestern Mutual.
One of the encouraging aspects is that it would promote the idea of DIAs at a time when low interest rates have dampened enthusiasm for those products and single premium immediate annuities (SPIAs).
“We’re very optimistic about SPIAs and DIAs overall,” Montminy said. “We see those as being something that will grow as more consumers need to create their own pension plan. Once rates start to increase, I think those sales will grow. Our forecasts right now are we see those sales almost doubling by 2018, and that can be conservative.”
The average contract size for SPIAs in 2013 was $124,000. And it was $137,000 for DIAs, Montminy said.
O’Brien of NAFA said she is optimistic about DIAs, which at $2 billion a year are where FIAs were when they first started in 1995.
“The biggest growth area for the DIA is probably more in the public sector and the institutional market, because of the decisions the Treasury has made on the 401(k) target funds and also the recent QLAC decision,” O’Brien said in describing ways that the DIA is being allowed in qualified plans. “I think those are going to be very strong propellers of growth for the DIA.”
NAFA is also trying to get the Treasury to allow FIAs with GLWBs as QLACs along with DIAs. “The main difference between the two is the access to cash value,” O’Brien said. “There are good reasons for both.”
A Clearing Sky
O’Brien said she sees a sunny future for DIAs with the government’s interest. She also expects FIAs will thrive as even more broker/dealers open the door to sales. O’Brien suspects that the Treasury’s exiting of quantitative easing will help lead to improvements in non-indexed fixed products.
Callanan of Advisors Excel also sees vast opportunity in the baby boomer generation, famously crossing the 65-year line at 10,000 a day. He thinks those retirees are looking not looking for bells and whistles, but for solid, trustworthy planning.
“I know there are advisors out there who are dying for the next, juicier thing that gives a better return so they can go pitch it,” Callanan said. “But I don’t believe that’s what the successful guys need. If you’re a great financial planner and offer your clients great benefits, I’m convinced that the struggle of competition won’t be the problem.
“We function in the world of abundance,” Callanan said. “There are so many consumers out there who have a need. And I think that’s why the industry has been growing the past few years. I just think the opportunity is very, very large, and we’re just starting to tap into what it can really be.”