Financial Advisors Should Be Cautious of "Super Sized" Annuities
In 2004 Morgan Spurlock released a shocking documentary called Super Size Me on the health risks of eating fast food. Although a bit extreme, Spurlock’s documentary followed him for an entire month as he only consumed fast food for breakfast, lunch, and dinner. The results? He gained weight of course! What other outcome would a person with reasonable intelligence expect? He also showed other long-term health problems and spent 14 months dropping the weight that took him only 30 days to gain. The fast food industry quickly felt the film’s impact as the health risks could no longer be ignored.
While the health risks associated with eating fried, fatty salty food had been known for some time, it took an over the top demonstration to receive national attention and action. Soon fingers pointed towards the fast food providers. Patrons made ridiculous claims such as, “You made me fat!” Last time I checked, we still live in a capitalist and free society. Companies manufacture products the market desires, and consumers buy those products. Otherwise, the company goes out of business. It’s just that simple. Don’t like a product or a manufacturer? Stop buying the products, or find an alternative.
Want Fries with Your Annuity?
Today we are experiencing the aftermath of a similar indulgences in the annuity industry. Products that looked mouthwatering a few years ago are now leaving a bitter aftertaste. Companies that offered flavorful incentives — like big bonuses — now don’t look as appetizing as it may take the consumer years to drop the weight associated with "super sizing" their annuity. This shouldn't be shock to anyone, but insurance companies don’t just give away free money. Big, up-front bonuses are appealing on the menu, but if you look at the nutrition facts, they often result in future performance concerns and consequences.
Like the fast food industry, the annuity industry creates products that consumers want. However, sometimes the consumer may want a products that may not be good for their long-term financial objectives. The immediate gratification of a big bonus today, may in some cases outweigh the reduced potential for interest later. But, bonus products often come with a long-term commitment. If the consumer seeks greener pastures a few years into the contract, he faces stiff penalties. Sure, penalty-free withdrawals offer some relief, however increasingly more clients seek legal council against the distributor and the product manufacturer, just like the fast food patron who sues the company for “making them fat.” It’s not the manufacturer’s fault; they built the product that the distributor promoted and the market consumed.
We’re currently seeing a trend in the annuity industry where carriers are shifting towards financially healthier choices. In the meantime the companies have to price products for a market that wants up-front account values enhancements even when it diminishes the future product’s value.
The Quality Quotient
Do some companies take advantage of opportunities to sell products that are all sizzle and no steak? Of course. And there are even those — and they know who they are — that promote artificially high index interest crediting rates today to make their products look more attractive, while long-term those high periodic declared rates are not sustainable. Often this is referred to as "buying the business," and in the end it is the consumer who picks up the bill.
However, most companies today appropriately price products from day one to offer the same value to consumers today, as well as those who purchase in the future. You can get a good feel for a company’s integrity by simply asking to see their renewal interest rate history. If a manufacturer won’t show a renewal rate history on all products, run the other way as fast as you can. They may have something to hide.
Quality Ingredients, Quality Products
Like most industries, the higher quality of the materials, the more expensive end product. A machine-processed, low-grade beef patty costs less than a USDA prime, hand-shaped patty, therefore the two sandwiches cost different. Just as it’s important to know what’s in your burger, it’s important to know what ingredients go into your annuity policy.
When a manufacturer creates an indexed annuity, the company first covers the guarantees, after all these are fixed annuities. So a significant amount of premium gets set aside to cover the cost of the guarantees. Second, the manufacturer creates a strategy to hedge the index gain and remaining premium goes toward this ingredient. The cost of the ingredient to hedge the index gain — the index options — directly affects how much the consumer participates in the event there is index gain. Now, if we add a premium bonus, the manufacturer has to cover that cost too. But where does the cost coming from? Does it come from the guarantees of the index annuity? Absolutely not! What about the issuers profit margin? You’re getting colder! Try looking at the options budget.
What’s In Your Budget?
To put this into perspective lets look at two appropriately priced products with the same surrender period, identical minimum guarantees, and the same riders, bells, and whistles. We will assume that the issuer’s profit margin and the selling agent’s commission is the same (two additional costs I excluded earlier for simplicity’s sake). The product without a bonus will have a larger options budget than the product with a bonus. In other words, the product without a bonus will have the potential of crediting more interest when the index is positive than bonus product because the non-bonus product has one fewer ingredient, the bonus.
Plus, buying a product today requires the insurer to manufacture a product with today’s ingredients. Whether the consumer buys a 5-, 10-, or 15-year index annuity, the company will buy virtually the same ingredients — bonds — to cover the guarantees and options to hedge the index. Does it make sense to purchase a long-term or a short-term product made with today’s ingredients? With interest rates at near all-time lows, and unstable option prices, a long-term annuity with a big bonus may leave the policyholder unsatisfied.
Who’s to Blame?
I have a hard time blaming the companies creating the products. If the distributors and consumers only marketed and purchased “financially healthy” choices the companies would eventually drop or minimize the offering of the somewhat financially un-healthy choices. But you just can’t ask for the products. In the insurance business you need to put your money where your mouth is and actually promote and sell the financially healthy choices.
With all that being said, not all premium bonus annuity products are bad. There are some situations when a bonus may make sense. When an annuity purchaser wants to overcoming a significant loss one way to quickly offset that loss is through a premium bonus. Or, when a purchaser wishes to immediately maximize earnings to create an enhanced death benefit, a bonus product with full account value at death may be just what the doctor ordered. A bonus can be beneficial as long as you and your client realize that the potential for additional interest in years to come will be reduced as a result of the bonus.
As an advocate for healthier choices, we suggest you partner with companies offering different products to fit your varying financial needs. Don’t fall for products that may taste good today, but will leave you felling ill in the future.