Satisfaction, regardless of the product or service involved, occurs when experience is parallel to expectation.
Said a different way, would a consumer who expects a 2-3 percent rate of return and experiences a 2-3 percent rate of return have a higher level of satisfaction than a consumer who expects a 5-6 percent rate of return but experiences only a 4 percent rate of return?
What if both scenarios involve the same product?
These questions are hard to answer. They examine the validity of a financial product through the behavioral lens of a consumer’s experiences instead of using pure math. Sometimes the way something makes us feel is more important to us than how much it costs.
The conclusion is this: A fixed indexed annuity (FIA) with a bonus and lower crediting potential is not inferior to an FIA without a bonus and higher crediting potential. In my opinion, the notion that FIAs with higher caps (maximum amount of interest possible in any one term) are superior will lead to decreased consumer satisfaction as this altered focus on index credits will lessen the likely equivalence between experience and expectation.
This conundrum of mine started last summer when what I call a dinner-ruiner brought a screeching halt to my nice, quiet dinner.
A dinner-ruiner is one of those people who decides that the moment you’re not actively chewing your food is the perfect time to volley question after question your way like the last hurrah of a Fourth of July fireworks show.
My last run-in with a dinner-ruiner occurred during summer 2016, shortly after the Department of Labor finalized its fiduciary rule. Typically, a dinner-ruiner jumps in at the awkward moment between the salad and main course or between the main course and dessert.
My dinner-ruiner seized the after-salad opportunity.
He put his hand on my knee, leaned in closely to the right side of my face and said in a quiet voice, “What do you think about this fiduciary rule? I think it’s a good thing. It’s going to make us all focus on finding the best products.”
I said, “Well, Mr. Dinner-Ruiner, what makes the best product?”
With his hand still on my flipping knee, he said, “I just think it’s all about the caps — don’t you agree?”
In a single big breath I replied: “Are you kidding me? Not at all! Our industry is moving toward higher caps while at the same time advocating shorter surrender periods. Shorter surrender periods will reduce the profitability of the insurer, which of course will lower the caps. So what do we gain? More liquidity for full withdrawals on a product/asset class for which increased liquidity undermines its very purpose — income. I mean, shorter surrender periods will likely just lead to some advisors laddering annuities again, and then every five years or so, writing a new contract and thus new commissions. Who will that help? No one — so this concept of lower comp is really just smoke and mirrors. And caps aren’t guaranteed, so what happens when the cap changes, when it’s reduced? Yeah, it’s clearly all about the caps — something you can’t control or predict. Good luck with that.”
Without any facts, he told me I’m wrong and someday when I’ve been doing this long enough, I’ll see.
That conversation led me to wonder whether I could prove mathematically that, in the end, an annuity with an upfront bonus and lower crediting potential wouldn’t be materially different from an annuity with higher crediting rates and no bonus.
And if this is true, then this new focus on crediting rates would therefore likely decrease consumer satisfaction since the promise of materially greater wealth is not likely to be fulfilled.
There’s no easy way to compare FIAs with and without bonuses. Here’s what I did.
I used the annuity spreadsheet comparison calculator from two large independent marketing organizations (IMOs).
I compared indexed annuities that had surrender schedules of 10 years or longer. Why not look at annuities with shorter surrender periods? Because they often eliminate bonuses. As a result, the consumer pays for the shorter surrender period through the reduction of interest crediting potential. Therefore, it’s inappropriate to consider shorter-surrender annuities when making this comparison.
I narrowed the search to FIAs that had an income benefit rider available (no preference was made to cost). They also had to have an S&P 500 annual point to point with a cap index crediting strategy available.
In doing so, I split each IMO’s FIA offerings in separate piles. Each IMO’s offerings were split into two groups: FIAs with a 4 percent or greater bonus and FIAs without a bonus.
For each category, I eliminated all the FIAs below the group median. Although those FIAs may have some unique features, this argument is about crediting and bonuses, so the lowest bonuses and lowest-cap FIAs are gone.
From what’s left of each group, I took the average from each IMO. For bonus annuities, that meant the average bonus and cap. More simply, for non-bonus annuities, it was just the average cap. Then for the calculations, I took the average of the two IMOs’ offerings.
My thought was that by taking the initial median rather than the average of each IMO group, I would simulate the selection process many advisors go through. (They seek higher bonuses or higher caps.) Taking the average of the higher side of the median, it should then diminish the influence of any outlying products potentially superficially inflated by an insurer temporarily trying to elevate sales while intending to recapture this cost through the gradual reduction of renewal rates.
In the end, the average bonus annuity carried an upfront bonus of 8.61 percent and an S&P 500 annual point to point with a cap of 2.89 percent. The average non-bonus annuity had an S&P 500 annual point to point with a cap of 4.91 percent.
How would you compare cap to cap? I made a spreadsheet using the S&P 500 for every 10-year period, Jan. 1 through Dec. 31, each year, starting with 1975. From here, we can compute the ending balance for every 10-year, 20-year and/or 30-year run since 1975, using the parameters outlined above.
Chart 1 above illustrates the difference in value between the non-bonus annuity and bonus annuity at 10-year, 20-year and 30-year intervals, with each annuity having an initial, one-time premium of $100,000.
(Bonus annuity account balance at 10, 20 and 30 years: $133,433, $164,849, $204,219; non-bonus annuity account balance at 10, 20 and 30 years: $140,966, $199,240, $280,585)
That knee-touching dinner-ruiner was right — right? The math is clear. Not quite.
Annuities are used for future income. Disagree? Then why do so many annuities have a lifetime income benefit rider (LIBR) attached to them?
Aha! If we defer the income for five full years and use a 6 percent rollup and a 5 percent payout, then we get an annual lifetime income amount of more than $7,000 per year ($7,267 to be exact). For now, let’s make the income on both annuities equal, even though they’re not.
As you’ll see, taking income regularly from the FIA diminishes the higher crediting advantage of the non-bonus annuity. Chart 2 below illustrates the narrowed gap.
Most interestingly, all but one of the periods resulted in the non-bonus FIA account value hitting zero at the end of the 24th or 25th policy anniversary. Meanwhile, the bonus annuity exhausted the account value mostly at the end of the 22nd policy anniversary.
Furthermore, the average account value (using every 10-year period since 1975) was higher using the bonus annuity until the end of the eighth contract year.
Since the LIBR fee is calculated as a percentage of the account value, the non-bonus annuity carries a greater fee. If we make the income the same for each type of annuity, the non-bonus annuity is
$1,902 more expensive. However, if we adjust the income amount — removing the bonus’s influence on the first year LIBR rollup — this reduces income to $6,691 per year (versus $7,267). In the end, the non-bonus fee becomes $3,445 more than the bonus annuity.
Here’s what I mean:
By the time the bonus annuity exhausts its account value, the purchaser has received $9,792 more income than the non-bonus purchaser. To all of you saying, “Yeah, but the non-bonus annuity lasts longer,” I say:
Right, which simply means the death benefit in the non-bonus annuity exists longer than in the bonus annuity. By the time this is negated, meaning when the account value is also exhausted in the non-bonus annuity (end of the 27th year), the purchaser will have paid $3,445 more in fees and received $12,672 less in income.
The bonus annuity purchaser could use the higher annual income to purchase life insurance to offset this risk. Term life insurance would even be appropriate since the lower value in the bonus annuity is not a permanent risk.
Does a higher cap guarantee a higher account value? No, interest isn’t guaranteed. And further, when you alter the focus of FIAs’ benefits from predictability and guaranteed income to accumulation and growth, then what happens when growth is stagnant? What happens when the insurer reduces the cap? Guaranteed income is guaranteed. You can accurately depict what it will be. What the account value will be in 10, 20 or 30 years from now in an FIA, regardless of cap, is much harder to predict.
One last thought: Distance magnifies errors. If you hit a golf ball toward a target five feet away, a 10-degree error left or right is hardly noticeable. But if the target is 500 feet away, that same degree of error is obscenely noticeable. When using an annuity for what you know it will at least do — not what you hope, predict or think it might do — the probability of error is removed. However, when you focus on caps, if you’re wrong on the crediting rate by just a bit, then distance — in this case, time — will magnify your error.
Earlier I asked whether a consumer who expects a 2 to 3 percent rate of return and experiences a 2 to 3 percent rate of return would have a higher level of satisfaction than a consumer who expects a 5 to 6 percent rate of return but experiences only a 4 percent rate of return?
I believe the answer is yes.
Since summer 2016, we have seen a mass exodus toward lower surrender schedules or higher crediting caps and lower compensation.
An indexed annuity, with an upfront bonus, is not inferior to an indexed annuity with no bonus and higher index crediting potential (higher caps, lower spreads).