The Basics on Indexed Annuities

By Sheryl Moore
AnnuityNews.com

June 1, 2011 -- It has been more than 2,000 years since consumers were first offered the benefits of annuities. With these insurance products came guaranteed annual payments for life, regardless of how long one lived.

Historically, sales of these income annuities accounted for a small portion of all insurance sales. This changed after the economic devastation caused by the Great Depression. Individuals were looking for a pillar of stability in their search to safeguard themselves from financial ruin. Later in the 20^th century deferred annuities were introduced, offering the opportunity for tax deferral coupled with lifetime income payments at a later date. This marked the beginning of a whole new world of product development in the insurance industry.

In 1995, the first indexed deferred annuity was introduced, long after fixed deferred annuities and variable deferred annuities. The indexed annuity is a product that is just like any other fixed deferred annuity, but with a different way of crediting interest. Interest on this innovative annuity is based on the performance of an external index, such as the S&P 500. Just five years old, sales of indexed annuities (IAs) were a drop in the bucket with 40 insurance carriers contributing to the $6.5 billion of premium that came in for 2001. Skeptics postulated that the product line would not last long. Little did they realize that the appeal of the product’s higher upside potential would keep consumers interested during low interest rate environments, and the downside guarantees would be especially important (particularly for those who saw the stock market tank after the turn of the century and then again in 2008).

So where are we today? A new revolution has emerged in the world of IAs. Not only are sales burgeoning, but carriers are jumping at the chance to get into this established market, despite persisting historical-low interest rates. Highly rated and respected insurance carriers that once shunned indexed annuities as the red-headed stepchild of the insurance industry are now being forced to develop the product. Where historically such carriers’ sales seesawed between variable and fixed annuities, today these companies are seeing assets flying out their doors altogether.

Americans’ discomfort from losing money in the recent 2008 market collapse has led to declining variable annuity (VA) balances. At the same time, historically low rates on fixed annuities have resulted in lower sales for the conservative alternative to VAs. In short, the seesaw ride is over. For many, the only answer to conserving assets is to develop a product they once spurned and embrace an annuity with guarantees, principal protection and the opportunity for gains based on the market’s performance.

This same scenario has also led to nontraditional distributions to evolve. In a landscape dominated by the independent insurance agent, few alternative distributions have attempted entry. Some career companies have had modest success and lately banks have experienced noticeable increase. However, a new kid is about to hit the scene. Soon, Wall Street will join the ranks of those successfully marketing indexed annuity products. Compounding the changing market environment is the competitiveness of companies firmly established in the IA industry. Overall, there has never been more interest in indexed annuities. Companies, products and distribution are all changing at the speed of light.

At the close of 2010, sales had increased more than 400 percent over 2001 levels and reached $32.3 billion. Today, 41 carriers compete – an unremarkable increase in companies considering the giant leap in sales. More than a dozen carriers are in research and development on IAs today. All of this excitement leaves the existing carriers who once had large market shares of a smaller IA market, competing to differentiate themselves in an increasingly cutthroat landscape. Where we once had very simplistic IA offerings, we now have many, including flexible products with alternatives to annuitization, annuities with leveraged death benefits, commodities indices and even return-of-premium features. The market will only continue to intensify in terms of product design.

With so much happening in the IA market, let’s go over some of the basics of indexed annuities that differentiate them from traditional fixed annuities. There are several types of rates that can affect an indexed annuity, depending on the carrier and what their pricing lever is.

Fixed Strategy Rate – the company-declared rate on the fixed strategy (if any), which would be comparable to traditional fixed annuity rates. Fixed strategy rates on IAs today range from 1 percent – 3 percent.

Guaranteed Rate – the underlying minimum guaranteed interest to be credited on the policy. On a traditional fixed annuity, these minimum guarantees are usually expressed as a guaranteed floor that typically runs 1 percent – 2 percent annually. All indexed annuities have a guaranteed floor of no less than zero percent each year. However, they also offer a secondary guarantee in the event the index does not perform or that the purchaser cash surrenders the contract. This secondary guarantee, known as a minimum guaranteed surrender value credits a rate of 1 percent – 3 percent (based on the five-year constant maturity treasury rate’s performance) on a portion of the premiums paid. Although the National Association of Insurance Commissioners’ standard non-forfeiture laws dictate that the rate can never be credited on less than 87.5 percent of the premiums paid on the contract, it may be credited on as much as 100 percent of the premiums paid (note that the greater the guarantee on any annuity, the lower the potential for gains).

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Index – the underlying external benchmark upon which the crediting of excess interest is based. Nineteen of the 41 carriers in the market today offer an alternative index to the S&P 500 on their product strategies. Indices offered via IA strategies include Barclay’s bond index, DJIA, Euro Stoxx 50, FTSE 100, Gold Commodity, Hang Seng, iShares Barclay’s Capital U. S. Aggregate Bond index, iShares MSCI Hong Kong Index Fund, Lehman Brothers Aggregate Bond index, Nasdaq-100, Nikkei 225, PIMCO U.S., Russell 2000, S&P MidCap400, U.S. 10-Year Treasury Bond and the S&P 500.

Crediting Method – the formula used to determine the excess interest that is credited above the minimum guarantee. There are far fewer crediting methods identified in the IA market today (11) than there were even 10 years ago (42). Without getting too detailed on the calculations, today’s clients have the option of choosing among annual point-to-point, term end point, daily averaging, monthly averaging, monthly point-to-point, performance triggered, fixed, and some minor variations among these strategies.

Participation Rate – the percentage of positive index movement credited to the policy. (i.e. If the S&P 500 increased 10 percent, and the IA had an annual participation rate of 60 percent, the policy would receive interest credited of 6 percent on the policy anniversary). Participation rates on IAs today range from 10 percent to 140 percent.

Cap Rate – the maximum interest rate that will be credited to the policy for the year or period, or the maximum index growth upon which interest will be calculated. (i.e. If the S&P 500 increased 10 percent, and the IA had an annual participation rate of 100 percent and a cap of 8 percent, the policy would receive interest credited of 8 perent on the policy anniversary.) Annual point-to-point caps on IAs today range from 1.75 percent - 10.20 percent.

Although the vast majority of licensed insurance agents do not sell these indexed annuities, many more are adding this variety of fixed annuity to their toolbox each day. Indexed annuities account for four out of every 10 fixed annuity sales, after just being introduced 16 years ago! Although IAs may be fairly immature in terms of the product life cycle, their sales have the potential to overshadow sales of fixed annuities and variable annuities, once producers are familiar with “the basics.”

Sheryl Moore is president and CEO of AnnuitySpecs.com, an indexed product resource in Des Moines. She has more than a decade of experience working with indexed products, and provides competitive intelligence, market research, product development, consulting services and insight to select financial services companies. She may be reached at sheryl.moore@annuityspecs.com.

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