Fixed Annuities Rise Again

May 2008

PRODUCT INSIGHT; Pg. 38 Vol. 16 No. 5

1324 words

Fixed Annuities Rise Again; Falling interest rates on CDs have finally given new life to these languishing contracts.

Dave Lindorff

For the past few years, fixed annuities weren't even on Kristy Kemnic's radar. But about three months ago, the Michigan-based bank rep started getting bombarded with requests for the interest-bearing contracts from her clients. "With the spread growing between short and long rates," she says, "fixed annuities now look attractive to conservative investors who have been keeping their money in CDs and money market funds."

Higher interest payments, a volatile stock market and the ability to defer taxes are all bringing fixed annuities (FAs) back into style. "Starting last December, every bank I've talked to says fixed annuities have been going through the roof," says Ken Kehrer, principal at the Princeton, N.J.-based consultancy Kehrer-LIMRA. Because the interest rate offered by annuities reflects what insurance companies can earn from investing in five- to 10-year bonds, as the spread grows between those bond rates and short-term interest rates, annuities look better and better compared with CDs. But sales have fallen off.

Fixed annuities had been languishing. At one point, 40% of FA sales came via banks, says Kehrer. Today, that percentage has dropped to the high twenties. "For 18 months, we had this lingering flat yield-curve environment, which was not good for annuities," says Lynn Forde, director of the retail retirement group at Wachovia Bank.

In a flat yield-curve environment, conservative investors could get the same or better rates on short-term CDs without having to pay annuity fees or lock up their money for years. "But since the start of the year, that curve has been steepening, which is good for annuities," says Forde. By early March, she says it was easy to find FAs offering three-year guarantees of more than 5% per year, and guarantees of 3% per year for the balance of time on five- to seven-year annuities. By comparison, a one-year CD at Wachovia was offering only 2% at the time, and longer-term CDs weren't much better.

RUNNING SCARED

Some equity investors are fleeing the market for the safety of FAs. "Sixty percent of the money we're seeing flow into fixed annuities is new," says Forde. "It's mostly people who are getting out of equities because of the volatility, and 40% is people who are moving out of CDs. It's been five or six years since we've seen an environment like this." Michael Jorgensen, assistant director of retirement and investor services at Principal Financial Group, says sales rose almost 90% from 2006 to 2007, and have jumped significantly each month since December. "People are running scared now about the stock market, and are looking for safer investments," he says.

FAs also offer tax-deferral benefits for as long as the contract lasts. Kemnic, who is senior vice president of investment and insurance services at Byron Bank in Byron Center, Mich., says two of her typical fixed-annuity clients are a couple, both aged 62, in the 28% tax bracket. "They had three CDs earning 5.2% that they had rolled over three times," she says. "When they looked at their 1099s and the taxes they'd had to pay, the idea of a fixed annuity, which defers the income, suddenly looked good."

Kemnic took a $75,000 CD that was coming due and put it in a six-year fixed annuity guaranteeing 4.55%. "They pay no taxes on the gain until the end of the six years," at which time they should be retired and in a lower tax bracket, she says.

TEASER RATES

FAs are often marketed with teaser rates that range from 7% to 11% for the first year only and then drop to as low, or less than, 3%. "A lot of banks will offer these one-year, bonus-rate products to their clients, but we don't," says Forde. She prefers annuities that feature higher regular rates every year. Wachovia uses straight FAs from AIG and Transamerica, that mature in five, six or seven years.

One favorite is an AIG FA that offers a guaranteed 5% per year for three years, with a minimum of 3% for the remaining two, three or four years. As with most FAs, this one has a surrender charge for early cash-out, which drops from 7% in each of the first two years to 6%, 4% and finally 2% in the remaining years. Clients pay the commission-in this case 3%-up front.

The drop-off in rate belies the notion that rates on FAs are locked in. "Fixed annuities are really generally not fixed," says Kehrer. "They start off with a higher guaranteed rate for a year or for several years, and then most of them drop to a lower market-based rate, which can vary. So really they should be called 'adjustable annuities.' Banks need to take great care to explain to clients that the rates will change, and they need to make them sign statements to that effect." In addition, national regulations limit the sale of FAs to people under age 90. Wachovia won't sell an FA to anyone over 80 for suitability reasons. "You don't want an 81-year-old buying a five-year surrender product," says Forde. "It doesn't make sense."

Ivana Lotoshynski, an advisor at a New York Community Bank branch in Roseland, N.J., says she finds some FA bonus-rate offers compelling. "It depends on the length of the product and liquidity factors," she says. For example, Jackson National offers a five-year annuity with a first-year rate of 7.75% and a guarantee of at least 3% thereafter. "For a conservative investor in the 30% tax bracket, or even a 25% tax bracket, that 3% rate is like 4% in a CD [because of the tax deferral], and right now, you can't get that," she says. "And the first year rate of 7.7% is quite good." Plus, retiring clients may move into a lower tax bracket by the time they have to pay taxes on the annuity gains.

Arthur Hornak, program manager for Sun National Bank, in Freehold, N.J., tells advisors to shop around for their clients. "The rate offerings change from week to week," he says. "In the first week of March, AIG had a good special of almost 5% for six years, while American National had one locking in a 4.9% rate for six years." Commissions vary too. "That AIG product carries twice as high a commission as the American National product, which is a much better deal for the client," he says. Current rate offers can be tracked at a website called www.annuityrate.com, he says.

FAs now offer some more flexible features, such as a guaranteed return of principal in the first year if you want to get out and a penalty-free cash-out for a medical crisis. Principal Financial, for example, offers "senior-friendly" annuities, which guarantee that investors won't lose their principal if they cash out early. "You'll pay a surrender charge, but priority goes to assuring that you get your principal back first," says Jorgensen. The issuer will waive some or all of the surrender charge to return the full amount of principal.

Principal Financial's products offer free waivers of any surrender charge if the investor becomes disabled or has to enter a nursing home for more than 90 days. Its FAs also carry a free feature allowing withdrawal of up to 10% a year at no penalty. Surrender charges decline over three years-7% in the first year, 6% in year two, 5% in year three and then zero, with commissions of 3% to 6%.

Many banks are sticking with such senior-friendly plans that protect them from the bad publicity should a client suffer a medical crisis and lose a substantial sum trying to access their funds.

About 80% of Sun National's FAs carry nursing home, terminal illness and disability riders, which are either free or shave some 25 basis points off the interest rate. Hornak focuses on products from AIG, American National, Jackson National and New York Life, all of which have high credit ratings.

Given the volatility of the stock market, the likelihood of an even steeper yield curve and the intense competition among issuers, it's likely that fixed-annuity sales will gain ground in coming months.

Dave Lindorff is a freelance writer living in the Philadelphia area.

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May 1, 2008