The Annuity Match Game

By Kerry Pechter

InsuranceNewsNet Magazine, July 2011

The key to selling annuities is to match the right client with the right contract at the right time. That's not necessarily easy.

When I wrote Annuities for Dummies a few years ago, I was tempted to preface the book with a funny, disarming line like, “I know what you’re thinking … ‘Annuities are for dummies.’”

I fought off that temptation. But depending on your own experience with this duck-billed platypus of the investment world—part investment, part insurance, neither fish nor fowl—you may be thinking that exact thought right now.

If so, I don’t blame you. You’re probably familiar with the distracted, faraway look that clients get if you mention annuities or “insurance contracts.” You know that annuities are “sold not bought.” You know the regulatory baggage they carry.

On the other hand, you may also know that annuity manufacturers offer very compelling compensation rates. And not least important, you undoubtedly understand that annuities have an important purpose: They can move financial risk—market risk, longevity risk or the risk of a bear market right before or after retirement—from an investor to an insurer. There’s a reason why Americans put almost $300 billion into them each year.

The key to selling annuities, I’d argue, is to match the right contract with the right client at the right time. If that sounds easy or obvious, it isn’t. No two clients have identical needs, and annuities come in at least five varieties that have little in common but the word “annuity.”

In this article, I’ll describe those five most common types of annuities and suggest the best type of person to sell each of them to and when, ideally, to sell them. In order of sales volume, they are:

Variable Annuities (with guaranteed lifetime withdrawal benefits)

Variable annuities (VAs) are portfolios of mutual funds with insurance-related benefits—tax-deferred growth, death benefits and optional “living benefits” such as a guaranteed lifetime withdrawal benefit (GLWB) or a guaranteed lifetime income benefit (GLIB). Sales of variable annuities tend to rise and fall with the equity indexes. They’re a popular way to hedge investments in equity mutual fundsYou can sell a variable annuity to almost any adult at any age but for different reasons. You might sell them to young adults to allow them to grow their mutual funds tax deferred over 30 or 40 years. Because there’s virtually no limit on the amount of after-tax money that can be contributed to VAs, they’re good for people with more savings than they can fit into other tax-deferred accounts, such as 401(k) plans or IRAs.

Moving up the age scale, you might sell a contract with living benefits (deferral bonuses and lifetime withdrawal benefits) to a 55-year-old near-retiree (1) to establish a rising floor (in contracts with “roll-ups” or deferral bonuses) under the value of a balanced portfolio that they intend to tap for retirement income and (2) to guarantee an income even if the account happens to hit zero before death. Older people buy VAs for the death benefit; it can put a floor under the amount that their beneficiaries will receive when they die.

Making sure a contract is appropriate for your client isn’t just good salesmanship—it’s the law. Under securities regulations, broker/dealers must review their reps’ VA sales to determine their “suitability.” If you exchange a client’s existing VA contract for a new one, for instance, be prepared to explain how the switch helped the client.

Indexed Annuities

The best prospects for buying indexed annuities (IAs) tend to be highly risk-averse savers who aren’t satisfied with the yields offered by investment grade bonds but who also regard equities as too dicey. If VAs are for nervous equity investors, IAs are for hungry bond investors.

Like variable annuities with living benefits, they offer a combination of upside potential and downside protection. VAs, where the investments are mainly equity funds, emphasize upside potential. IAs, which are mainly bond investments, emphasize downside protection.

Lots of IAs were sold in the early 2000s, almost exclusively by insurance producers, after the Fed cut interest rates but before the tax-cut/Iraq war/housing boom kicked in. Then came the lawsuits over the mis-selling of IAs and the Securities and Exchange Commission’s short-lived threat to classify them as securities. That storm has largely passed.

Few people truly understand how these products work. Manufacturers put about 95 percent of the premium in bonds and the rest in options on equity or commodities indices, usually the S&P 500. If the options pay off, the profits enhance the bond returns. At worst, the bonds earn enough to keep the client whole. Issuers have recently added VA-style living benefits to these products.

Fixed Deferred Annuities

These products are built for savers, not investors. They offer a promised (but not always guaranteed) rate of interest over a specific term (up to 10 years). They’re attractive when they offer an attractive rate of return, but they’re a tough sell in the prevailing interest rate environment.

The same folks who buy certificates of deposit (CDs) buy fixed annuities. When the yield curve is steep, fixed annuities tend to outperform CDs. That’s because insurers can get higher rates farther out on the curve, while CDs are limited to the short end of the curve. When the yield curve is flat, going farther out on the curve offers no advantage.

Depending on your client’s attitude toward interest rate risk, you could offer a guaranteed-rate fixed annuity, a nonguaranteed rate annuity (whose initial rate might drop after the first year) or a market-value-adjusted annuity (which offers slightly higher rates but assesses a penalty on withdrawals after a rise in prevailing interest rates).

Single-Premium Immediate Annuities

Single-premium immediate annuities (SPIAs), also called income annuities, are true annuities. The annuities discussed so far are primarily purchased as protected investments and merely offer the option to convert to an income stream.

SPIAs are purchased not as investments but as tools for turning a lump sum into the maximum possible income during retirement. They’re the only annuities that use mortality pooling to enhance the client’s retirement income.

Let me emphasize that SPIAs aren’t investments. If you frame them as investments, their “returns” will look both riskier and paltrier than mutual funds. If positioned as a personal pension or as a hedge against market volatility or outliving one’s savings, they’ll make much more sense to your client.

To sell SPIAs, turn their negatives into positives. SPIAs aren’t liquid, but they’re safe. To the extent that they have no cash value, they offer a larger payout rate. Yes, the client’s monthly income might be fixed. But inflation can be hedged by investing other assets more aggressively.

Retirees whose annual living expenses exceed their income from Social Security and pensions are likely to be receptive to buying an SPIA to cover the income gap. A client who is nervous about dying prematurely and forfeiting any unpaid premium can buy a smaller SPIA or one with 15 years of guaranteed payments.

Deferred Income Annuities

There’s no cheaper way to eliminate tail longevity risk—the risk that a person will outlive her money—than by buying a deferred income annuity (DIA). Unlike SPIAs, DIAs are typically purchased 10 to 25 years in advance of the first scheduled payment. Because of the waiting period, they can be purchased at a discount. The discount is even steeper when the payment stream is life-contingent.

Who would buy one? Couples who recognize that one of them might live beyond age 85. Or a 65-year-old with $500,000 in savings who understands that spending, say, $50,000 today for a floor income after age 85 will allow him to spend (or invest or give away) the other $450,000 during the intervening 20 years without as much worry. Granted, demand is negligible. But interest may be growing. This year, MetLife introduced a DIA. Later this year, New York Life intends to launch a DIA that people might purchase 10 years prior to the first payment.

Much, much more could be said about selling annuities. But it all amounts to this: Match the right contract with the right client at the right time.

Kerry Pechter is the editor and publisher of Retirement Income Journal (retirementincomejournal.com) and the author of Annuities for Dummies (Wiley, 2008) and other books. He is a past editor of Annuity Market News. His articles have appeared in The New York Times, The Wall Street Journal and other national publications. He has also worked in annuity marketing at Vanguard. He can be reached at [email protected].