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Miscellaneous Articles that don't fit anywhere else
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Principal Risks: Bonds, Banks & Fixed Annuities (3/15)
Independent Agent FIA Sales Continue To Decline (12/14)
Innumeracy Requires Pictures (10/14)
Annual Reset Often Beats Reinvested Dividends (7/14) 
Annuities Are An Asset Flyspeck  (6/14)
Threats To The Fixed Annuity Distribution Network (2/14)

USA Retirement Funds Act (2/14)
Annuity State Premium Tax (11/13) 
Why 2014 Will Be Good For FIA Sales (10/13) 

Senior Designations (7/13) 
Cost of Living: 1962 vs 2012 (12/12) 
No Gain From Forced Literacy (12/12)
 
Agent Compensation: Adapting To Survive (11/12) 
Dear John (10/12)
 
Guaranty Funds –No FIA Has Lost Money Because A Carrier Failed (6/12)
 

How Prevalent Is Elder Abuse? No One Really Knows. (5/12)
 

CDAs,SALBs HSIAs – A Very Limited Market (4/12)
 
Guaranty Fund Myths (3/12)
 
The Most Volatile Stock Market In 40 Years (2/12)
 
Yes to EquiTrust Takeover
  (1/12)
 

Wall Street Discovers FIAs (11/11)
 
Summertime (and the livin’ ain’t easy) (6/11)
 

Not Unprecedented, But Scary Times (10/11)
 
Financial Reporters Overlook The Consumers They’ve Killed (2/11)
 

Summit Files Bankruptcy (2/11)
 

Annuity Producers – Evolution Or Extinction (12/10)
 
The (F)law of Small Numbers (11/10)
 

RBC Sells Liberty Life (11/10)
 
Marketing Company Mergers (10/10)
 

Limericks (5/09)
 
“We find that women are more likely to choose the annuity”* (5/09)
 

Senior Decision-Making Issues (5/09)
 

Annuity Financial Crunch Is Happening On Schedule (4/09)
 

The Great Depression & Index Annuities (4/09)
 

The Financial Meltdown: Causes & Corrections (12/08)
 
Is it Better To Be Saved By Luck Or Killed By Knowledge? (12/08)
 

Guaranty Associations
(10/08)
 

It’s A Time For Calming Consumers (10/08) 

Easy To Predict (04/08)
 
Can Seniors Make Wise Decisions?
  II (3/08)
 
Can Seniors Make Wise Decisions? I (8/07)
 
You are not going to die May 7, 2042 (8/07)
 

Financial Math (9/06)
 
Variable Annuity & Index Annuity Parallels (8/06)
 

Index Annuities 1996 - 2006 
(6/06)
 

lndex Noir (
4/06)
 
Alphas, Betas, Betty & Barney (3/06)
 
What’s Tax Deferral Worth? – About 15 BPs (2/06)
 
Index-Link Power (How It’s Done) (5/05)

 

Alphabetical

Agent Compensation: Adapting To Survive (11/12) 
Alphas, Betas, Betty & Barney (3/06)
 

Annuities Are An Asset Flyspeck  (6/14)
 
Annual Reset Often Beats Reinvested Dividends (7/14)
Annuity Financial Crunch Is Happening On Schedule (4/09)
 
Annuity Producers – Evolution Or Extinction (12/10)
  

Annuity State Premium Tax (11/13)
Can Seniors Make Wise Decisions? I (8/07)
 
Can Seniors Make Wise Decisions?
  II (3/08)
 

CDAs,SALBs HSIAs – A Very Limited Market (4/12)
 
Cost of Living: 1962 vs 2012 (12/12)
 

Dear John (10/12)
 
Easy To Predict (04/08)
 

Financial Math (9/06)
 

The Financial Meltdown: Causes & Corrections (12/08)
 
Financial Reporters Overlook The Consumers They’ve Killed (2/11)
 
Independent Agent FIA Sales Continue To Decline (12/14) 
The (F)law of Small Numbers (11/10)
  

The Great Depression & Index Annuities (4/09)
 

Guaranty Associations
(10/08)
 

Guaranty Fund Myths (3/12)
 
Guaranty Finds – No FIA Has Lost Money Because A Carrier Failed (6/12)
 

How Prevalent Is Elder Abuse? No One Really Knows. (5/12)
 

Index Annuities 1996 - 2006 
(6/06)
 

Index-Link Power (How It’s Done) (5/05)
  

lndex Noir (
4/06)
  
Innumeracy Requires Pictures (10/14)
Is it Better To Be Saved By Luck Or Killed By Knowledge? (12/08)
 

It’s A Time For Calming Consumers (10/08) 

Limericks (5/09)
 
Marketing Company Mergers (10/10)
 

The Most Volatile Stock Market In 40 Years (2/12)
 

No Gain From Forced Literacy (12/12)
 
Not Unprecedented, But Scary Times (10/11)
 
Principal Risks: Bonds, Banks & Fixed Annuities (3/15) 
RBC Sells Liberty Life (11/10)
 

Senior Decision-Making Issues (5/09)
 

Senior Designations (7/13)
Summertime (and the livin’ ain’t easy) (6/11)
 
Summit Files Bankruptcy (2/11)
  

Threats To The Fixed Annuity Distribution Network (2/14)

USA Retirement Funds Act (2/14)
Variable Annuity & Index Annuity Parallels (8/06)
 

Wall Street Discovers FIAs (11/11)
 
What’s Tax Deferral Worth? – About 15 BPs (2/06)
 

“We find that women are more likely to choose the annuity”* (5/09)
 

Why 2014 Will Be Good For FIA Sales (10/13)
Yes to EquiTrust Takeover
  (1/12)
 
You are not going to die May 7, 2042 (8/07)

 

 Principal Risks: Bonds, Banks & Fixed Annuities 03/15
Default risk is the risk of loss if the issuer can't pay back the principal or interest. Interest rate risk is defined as the loss of principal value due to a rising interest rate environment. How real are these risks for bonds, bank saving tools and fixed annuities?   Default Risk The default risk on a bank instrument covered by FDIC insurance is zero. Since FDIC began over eighty years ago no depositor in an FDIC covered account has lost money when their bank failed [https://www.fdic.gov/exhibit/]. Most depositors have access to their insured money the next business day in the new bank that took over the failed bank’s deposits, or in a check written on the FDIC Deposit Insurance Fund. If the Deposit Insurance Fund runs out – as it did during the last financial crisis – FDIC may tap the unlimited resources of the Treasury.   Where there is a state insurance guaranty association, and that has been true for every state for roughly the last quarter century,   no one has lost principal (premium) in a fixed annuity up to covered state guarantee limits,  except in California, which is the only state that pays 80 cents on the dollar – all of the rest cover dollar-for-dollar up to the limit.

The primary differences between FIDC and state guaranty association is that federal trumps state when it comes to real world credit worthiness, and while there is a Deposit Insurance Fund there isn't an Annuity Guaranty Fund. If an annuity carrier fails, the states assess the remaining carriers to payoff covered annuity owners. Due to the process, it can be years before an annuityowner in a failed carrier is made whole, although the typical period has been two years.  

Historically, everyone in a failed bank or fixed annuity carrier has been made whole up to the coverage limits. The differences are how quickly the annuityowner is made whole and the size of the association coverage. Today, 42 states provide at least $250,000 of annuity cash value protection; 8 states provide $100,000. What if you are above those limits?

An extensive study1 I conducted found thirty one annuity carriers went into receivership in the last 25 years and with only five exceptions these annuityowners were paid for every penny of account value – including amounts above the guaranty limits. Since 2000 there were only seven failed annuity carriers and only one that didn't pay 100% of both guaranteed and non-guaranteed cash value. There have been 541 failed banks taken over by FDIC since 2000. Of these I can identify 35 that have completed the liquidation process. Of those, I can only verify five that returned 100% of account value above the insurance limits. The remaining failed banks paid depositors as little as 37 cents on the dollar and it took years to collect.

What about the other 506 banks? FDIC shows they are still in the liquidation process. Although 541 are a lot of banks it is important to note that the century started with other 11,000 financial institutions and there are still over 6,000, thus the overall bank failure rate was 6.4% [FDIC Savings Institution Reports].

In raw numbers it looks like there isn't a contest. Since 2000 there were 541 failed banks and 7 failed annuity carriers. Of those with money above coverage limits all but annuityowners of 1 annuity carrier got back everything, while depositors of 536 banks are still waiting. However, everyone within coverage limits of both got back 100% of their principal or premium. How do bonds compare for protection of principal?

Bond Defaults: A Standard & Poor's study looking at the period from 1970 to 2006 found the percentage of corporate bond defaults depended on the financial rating of the company, which is not a surprise. The default rate of "AAA" rated bonds was 0.6%; the default rate on "C" to "CCC" rated bonds was 69.2%. The overall default rate for investment grade bonds ("AAA" to "BBB") was 4.1%. The overall default rate for junk bonds ("BB" & below) was 42.4%.   An annuityowner in an A.M. Best “B” rated carrier ultimately has the same risk of principal loss as a “AAA” rated bond owner    Making an inexact comparison, the percentage failure rate of annuity carriers since 1985 and banks since 2000 would place them somewhere between a "BBB" and "A" bond rating on this S&P default schedule. However, failure or      receivership is not the same as default. Since banks have FDIC and fixed annuities have guaranty associations an argument could be made that, based on history, the insured/guaranteed money has the equivalent of a "AAA" rating in practice, and uncovered monies would have the equivalent of a "A-/BBB+" bond default rating.  

Cumulative Historic Default Rates2 S&P Corporate Bonds  
Ratings    Defaults This is not saying all banks and annuity carriers have the same risk of failure. A bank rated five stars by Bauer Financial and an annuity carrier rated "A++" by A.M. Best are much less likely to fail than a bank rated one star or a carrier rated "C". Of the 31 failed annuity carriers only six were rated "A-" or higher by A.M. Best two years before they failed. Ratings matter.         However, regardless of the rating, the odds of not getting back  your covered money in a failed     bank or annuity carrier is less than the risk of a "AAA" bond defaulting. Getting back even the non-insured or non-guaranteed money is roughly equal to not get paid on the “A-/BBB investment grade bond.   Interest Rate Risk If you buy a bond this month for $1000 and the stated interest rate is 4%, but if next month the same type of $1000 bond is paying 5%, no one is going to give you $1000 for your 4% bond. They'll give less principal until the equivalent yield to maturity is 5%. That is interest rate risk.   Because interest rates fell from 1981 though 2012 any interest rate risk was temporary as rates roller coasted down. However, there is a belief in many quarters that this is the nadir for interest rates and that rates will be higher down the road. Although almost no one expects double digit Treasury bond yields again, there is a feeling that rates will go up and it doesn't take much of a bump to cause a loss to principal.
AAA 0.60%
AA 1.50%
A 2.91%
BBB 10.29%
BB 29.93%
B 53.72%
CCC-C 69.19%

This chart starts with a $10,000 portfolio of long-term investment-grade corporate bonds and shows what the market value was ten years later. For example, the second column begins on 1 January 1946 and concludes 31 December 1955. Over this period, bond yields moved up from 2.86% to 3.38% – a half percent increase – but that 0.5% knocked $800 off the value of the bonds. Going forward, if you'd bought $10,000 worth of new bonds on the first day of 1956 and sold them December 31, 1965 when yields had increased to 4.85% – up a percent and a half – the value of the $10,000 in new 1956 bonds was now $8200 for an 18% loss.   A 1.5% increase in bond yields caused an 18% loss in bond value due to interest rate risk. This can avoided by using bank savings instruments and many fixed annuities.   What this highlights is the effect that even small upward movements in interest rates can have on principal loss. By contrast, the principal value of a non-brokered bank certificate of deposit or fixed annuity without an MVA is not affected by rate changes. Even though there are liquidity costs, the penalty is a known cost if you wish to surrender early. Even if the annuity has a market value adjustment that increases the surrender charge in a rising rate environment, there are usually limits on the amount of the increase.   *There is an additional principal risk that affects bonds and that is financial rating risk. If the financial rating is lowered after the purchase it would not affect the value at maturity, but it would cause its market value to drop when compared with the previous higher rating. A lowering of financial rating of the bank or carrier has no effect on the surrender value of a certificate of deposit or fixed annuity.  

Summary: Three  interest earning financial instruments are bonds, bank savings tools and fixed rate and fixed index annuities. The risk of principal loss due to entity failure in a bank account covered by FDIC or a fixed annuity covered by a state guaranty association has historically been about the same as a default risk of an "AAA" rated bond – i.e. effectively zero. However, the odds of losing even uninsured/non-guaranteed principal in a bank or fixed annuity account due to failure is remote; along the lines of the default risk in an "A-/BBB+" bond (with the edge to the fixed   annuity making you whole based on history). If a goal is to minimize principal risk of loss due to issuer failure, the loss with "AAA/AA" rated investment grade bonds and covered bank vehicles and fixed annuities have similar historical results. However, the bonds also subject you to interest rate risk, a risk either avoided or minimized with the bank or fixed annuity.  

1 Fixed Annuity Carrier Safety. (2011)Advantage Compendium. 3, 2  
2 Municipal Bond Fairness Act. Report 110-835 House Committee on Financial Services, September 9, 2008. p.5
 


Independent Agent FIA Sales Continue To Decline (12/14)
Based on a composite analysis of sales tracking services, overall fixed index annuity sales have
   increased at an annualized rate of 10% a year since 2008 and sales in the independent agent channel have increased by 4.5% a year. However, the average initial purchase (premium) has been increasing at a rate of 6.4% a year.

The number of FIA policies sold in the independent agent channel has been declining for years.

What this means is while the overall number of FIAs purchased is increasing – because the percentage of total dollar sales growth is greater than the increase in the average premium, the number of annuities sold in the independent agent channel is going down – since the percentage sales growth is less than the increase in the average premium; the reason independent agent sales have gone up is    because the size of the premium is increasing faster than the decline in the number of policies sold.

This was predicted. A September 2009 Index Compendium article stated that the independent agent channel "has matured and thus any future growth would result mainly from increased average policy size." A February 2012 story reported that the number of FIA policies sold had been flat since 2005. The same story said that although the independent agent channel had matured and that for "those carriers and marketing companies competing in the independent annuity producer world any growth in sales will come from their competitors", it also said that "this does not mean that index annuity sales have reached maturity because the bank and broker/dealer markets are virtually untapped'".

The other channels were tapped. In 2008 the bank and broker/dealer channels represented 5% of total FIAs sold; in the third quarter of 2014 they were roughly 30% of total FIA sales. The number of FIA sales in the independent channel will continue to decline. Part of this is agent demographics; an exceptionally large percentage of these agents are now in their mid 60s to 70s and they are retiring, but fewer younger agents are being recruited. Simply put, there are fewer annuity agents selling FIAs. Another large factor is a reduction in the number of tax-free [1035] exchanges. Depending on your source, two-thirds to three-quarters of FIA sales resulted from surrendering existing FIA policies. However, the ubiquity of guaranteed lifetime withdrawal benefit riders that result in a loss of income guarantees if the policy is surrendered is reducing the number of exchanges (Ruark 2011, 2013). GLWBs make an annuity stickier and less likely to move.

The third factor is a higher suitability standard. Due to the adoption of NAIC Suitability in Annuity Transactions Model Regulation #275 by most states, carriers are turning down annuity applications that would previously have been accepted. It is highly unlikely that the decline can be stopped, much less reversed. If there ever was a time when the core consumer market should have been buying FIAs from independent agents it was during the last six years of near-zero bank rates, but the channels that benefited were banks and B/Ds.FIA Carriers have been and will continue to adapt to the change by targeting other distribution channels. Individual independent agents can continue to prosper by broadening their offerings to include other insurance products. Marketing companies will continue to feel the brunt of the systemic change. Some have persevered by targeting other channels, but the remainder continue their vestigial business model by trying to take agents from other MOs. Unfortunately for them, the annuity world has evolved.


Annual Reset Approach Often Beats Reinvested Dividends (7/14)  
If you could have invested $10,000 on the first day of each year since 1951 in the S&P 500 and cashed in ten years later you would have averaged turning that $10,000 to $21,482. Not a bad return for ten years. The S&P 500 Index does not include reinvested dividends, a point that those that dislike fixed index annuities are quick to make. If we look at those same ten year periods, but this time include reinvested dividends, our average ten year period turns $10,000 into $28,918 – it's true, reinvested dividends substantially increased the index return. However, if we look at those same years, do not include reinvested dividends, but take an annual reset approach where negative years are treated as years with zero gains, the average period turns $10,000 into $30,094.  

Although reinvested dividends result in $28,918 an annual reset approach gives $30,094  

The annual reset approach doesn't always win – only 59% of time – and a long and strong bull market makes the reinvested dividends approach the easy winner. For ten year periods ending in 1997, 98 and 99 the S&P 500 with reinvested dividends changed $10,000 into $50,005, $51,129 and $55,297 respectively, roughly $7000 better than the annual reset approach. Indeed, if your ten year period ended during the bulls markets of the late 1980s and 1990s the dividend approach the clear winner.  

However, if you look at periods ending from 2002 through 2013 the average $10,000 grew to $29,186 using an annual reset versus $19,089 using reinvested dividends – triple your gain versus double. Periods ending from 1973 through 1983 also had the annual reset approach ahead by often substantial margins. Even in the periods covering stock market years during the '50s and '60s the annual reset approach won 3 out 5 times.  

It could be argued that ten years is too short a period to reflect the compounding power of reinvested dividends. Very well, let's look at 20 years periods going back to 1951. On average, $10,000 invested in the S&P 500 grew to $46,544, in the S&P 500 with dividends the final tally was $85,018, but the S&P 500 without reinvested dividends and with an annual reset approach averaged $89,650. The annual reset approach still wins.  

It should be noted that this is taking an annual reset approach to the index. An annual reset approach treats negative returns as zeros and resets to begin next year's calculation. Although the vast majority of fixed index annuities use an annual reset manner to calculate credited interest these numbers do not mean that fixed annuities would have averaged higher returns than the index with reinvested dividends. Fixed index annuities often have caps or deduct yield spreads or offer less than full participation in the index performance derived by the crediting formula. But neither do these numbers reflect the effect of possible management fees, sales loads, advisory fees or taxes on an index product with reinvested dividends. Nor do these results reflect possible index annuity pricing in higher interest pricing environments – especially in the late '70s and early '80s – that would have mathematically permitted fixed   index annuities to offer 200% and maybe as much as 300% participation in any annual index gains.  

This analysis does not show how either fixed index annuities or index investments with reinvested dividends would have performed in the past. However, it defeats the argument that simply not having reinvested dividends means a fixed index annuity cannot be viable.  

S&P 500 is a registered trademark of Standard & Poor's Financial Services LLC. No investment or fixed annuity is sponsored, endorsed sold or promoted by S&P. This information is for educational use and is not intended as financial or investment advice or to persuade or induce anyone to do anything. Results are not warranted.  


Annuities Are An Asset Flyspeck (but the future looks good for flies) (6/14)
As of the close of 2013 American households had financial assets of $63.5 trillion dollars, owned real estate worth $19.4 trillion and personal property and other consumer assets of $5 trillion. All told, household assets were $87.9 trillion. Balanced against that were $9.4 trillion in mortgages and home equity loan and $3.2 trillion in credit card, student loan and other debt. The net worth of households is $75.5 trillion, up over $20 trillion from where we were 5 years ago.   Annuities and life insurance assets totaled $1.2 trillion (not including variable annuities). This represents 1.4% of total assets or 1.9% of financial assets. Over the previous 5 years while total financial assets grew by 36% annuity and life insurance assets were up 11%. However, the future looks brighter.   There's $12 trillion sitting in 401(k) and IRA plans and the government is saying Americans should buy annuities to safeguard their retirement. There's $7.5 trillion sitting in banks accounts earning less than 0.5% interest. And there's $20.6 trillion invested in the stock market with many investors that have forgotten that the market also goes down.   

 


Threats To The Fixed Annuity Distribution Network (2/14)  

This is an excerpt from the complete study available from Advantage Compendium

If you can see a threat coming you can often either adapt to deal with it or avoid it. I categorize threats as being internal or coming from within the industry, external threats which are those that come from outside of the industry, or self-generated meaning they are caused by or shaped by the fixed annuity industry and become an external threat that circles back. The problem in seeing threats coming is that fixed annuities do not exist in their own separate world, but are impacted by various external forces that each exist in their own network that is impacted by still other external forces. The interactions of these various networks are what make it so difficult at times to notice a threat before it happens since sometimes they appear to come out of the blue. However, if we understand that fixed annuities are affected by apparently unrelated occurrences it may cause us to stretch out our threat antenna and get an early warning of trouble brewing.

Internal Network Threats
Competitors change, marketing and distribution plans adjust, and changing economics affect the profitability of products. These are day-to-day complications of working in the network. However, internal changes can also create threats to the long-term stability of the network:

  • There are fewer independent annuity agents as old agents retire and few new ones enter which is having an effect on marketing organizations and carriers that rely heavily on the MO channel.
  • Guaranteed lifetime withdrawal benefit (GLWB) roll-ups and step-ups deter future sales that would typically result from 1035 exchange and transfers meaning that more organic growth from existing accounts is needed through investment returns and additional premiums to existing accounts.
  • Carriers introduced new suitability standards resulting in fewer annuity sales being approved.

    The implied threat from these complications was easy to see coming. It has been apparent for years that annuity agents in general were getting older. We knew that it would be more difficult to move an existing annuity with a GLWB that had a much higher income account base than cash value account base. And tightening the definitions of suitability would result in more declined sales and thus affect revenues. The threats created by these complications progressed step by step in a linear fashion. However, annuity distribution is affected by forces that seldom move in a straight line.


    An internal threat is one defined as a change to the equilibrium of the network (a threat to the status quo). The creation of deferred income annuities (DIAs) created by a fixed annuity carrier and primarily marketed by existing fixed annuity agents all occurred within the fixed annuity distribution channel. However, it conceivably poses a threat to the distribution of fixed immediate annuities and deferred annuities with guaranteed lifetime withdrawal benefits (GLWBs) since they all provide lifetime income.

    Self-Generated Network Threat
    There are times when the fixed annuity network is the cause of a change in another network that can swing around to create a threat. If you go back a decade there were increasing customer complaints about fixed index annuity sales practices. To wit, closed customer complaints increased from 15 in 2002 to 231 in 2007. These increased complaints caused FINRA (née NASD) to enact Notice to Members 05-50 giving broker/dealers the responsibility of supervising index annuity sales, made NASAA very vocal in demanding state securities departments should regulate index annuity sales, and, in my opinion, ultimately resulted in the SEC passing Rule 151a that declared index annuities to be securities.

    The fixed annuity network reacted to the threat posed by SEC Rule 151a and ultimately was able to get Congress to state that index annuities were not securities and could continue to use existing fixed annuity distribution channels. Thus, the annuity network was ultimately able to avoid much of the threat to distribution created by the securities regulatory network. However, the reason for the securities regulatory action in the first place was a reaction to the perceived threat of bad fixed annuity sales practices. The industry could have avoided the problem by not creating the threat in the first place.

    External Network Threats
    Actions of the Federal Reserve created a threat to fixed annuity distribution because its changes resulted in lower interest rates that squeezed fixed annuity margins, but there are many other external threats: new competitors created outside of the industry, regulatory pressures, political changes, health/medical changes affecting longevity, annuity "like" products in other channels, and this doesn't even mention some of the more extreme threats that are out there:

    • Abandonment of Fiat Money – the U.S. returns to the gold standard because paper money isn't trusted
    • Alien Invasion – Extra-terrestrial beings without green cards enslave or exterminate the human race
    • Anarchy – loss of governmental power and imposition of martial law
    • Cosmic – Major meteorite impact creates new living space for cockroaches
    • Cyber Warfare – A foreign power hacks into all computers and zeros out all financial accounts
    • Hyperinflation – the dollar and fixed dollar assets, such as fixed annuities, become worthless
    • Long Longevity – Medical advances cause people to live until age 140
    • Long Shortevity – Medical errors cause people to live until age 140 but they are so ill they require constant care
    • Nuclear War – on the plus side the effects of radiation would reduce longevity risk
    • Pandemic – A highly infectious and fatal disease destroys humans or animals or plants
    • Sovereign Default – the U.S. does not make a bond payment

    A new external political threat introduced within the last week was a senator’s proposal that would create a government run retirement program with the only option being a lifetime government directed annuity. This would have a strong negative impact on the fixed annuity distribution network.

    Conclusion
    We tend to be myopic when looking at threats because the ones nearest to us appear the largest, but the greatest damage may result from a barely visible threat on the horizon. If one thinks about fixed annuity distribution as being a network tied to and interwoven with dozens of other networks it helps to improve our eyesight in looking for danger. I have shown a few examples of how other network "causes" have generated fixed annuity channel "effects" and tried to list some things that I see as current threats. However, my list is neither comprehensive nor sufficiently forward-looking because I also have blind spots. Effectively, what this paper means is that we need to look at every event – even if it is apparently unrelated to annuities – and ask ourselves "could this impact fixed annuities and what would be the effect". This task is not simple, but it is necessary.


    Sen. Harkin's USA Retirement Funds Act (2/14)
    The rationale given for introducing the Universal, Secure, and Adaptable (USA) Retirement Funds Act of 2014  are: a) 75 million people don't have a workplace retirement plan (this contrasts with other data I have seen that puts the number closer to 45 million and roughly 23 million of the U.S. workers that aren't in a workplace plan have IRAs), b) this plan will reduce the cost of retirement by 50% (apparently based on the assumption that only they have discovered the mortality credit and the pooling of money of many people to provid 401(k) plans (but identical to plans that use fixed annuities) this plan will shield workers from market volatility.

    This proposed legislation would legally require employers with 10 or more employees to offer a payroll-deduct retirement plan with a lifetime income option or offer the USA Retirement Fund. "Existing plans would not have to change anything" (but would have to offer a lifetime income option). The default contribution percentage is 6%, but employees could decrease their savings or opt out altogether. Individuals could contribute up to $10,000 per year pre-tax and employers would also be able to contribute up to $5,000 per year for each employee, provided the contributions are made uniformly. Low-income individuals would be eligible for a refundable savers credit.

    The USA Retirement Fund account balance cannot be accessed unless 1) you are over age 60 and need a hardship withdrawal or 2) you are over age 60 and prove to the trustees you have buckets of money coming in from other sources or 3) you are under age 60, have a pittance in your USA plan, and want to roll it over to another plan. The benefit will be paid out as a lifetime pension with survivor benefits.

    This is called a privately run plan, but it is approved and overseen by the Department of Labor. The company is run by trustees; I am unclear how these trustees get appointed. However, the summary states "Unlike most retirement plans, USA Retirement Funds would be democratic. Participants would have the ability to petition the trustees to remove services providers, comment on the management and administration of the fund, and approve or disapprove of the compensation for the trustee" (so each participant would have as much power to influence the board as an investor with one share of stock has to change a corporation).

    In summary, 1) this plan requires the worker to annuitize the account balance for life upon retirement – even though consumers have spoken with their pocketbooks for years and said they want more freedom with their retirement choices, 2) prevents you from ever seeing your money until you retire, 3) is a government run program competing with existing annuity companies, and 4) forces small businesses to offer a retirement plan when every one of their employees can open an IRA today. The only novel aspect is a low income worker can get a tax credit for a contribution, but this same tidbit could be just as easily added to existing qualified funds contribution rules.


    Harkin's plan is bad for annuity carriers, bad for annuity agents and bad for small businesses.


    Annuity State Premium Tax (11/13)
    The good news is 44 states do not assess a premium tax on annuities (Florida could, but makes it easy for the carrier to avoid it). The taxes, when applicable, are charged upon purchase of an immediate annuity. When they are assessed on a deferred annuity depends on the state. Although my department contact at the state of Maine told me not to worry about it because the insurance company paid the tax and not the consumer (which is like saying you don't really pay sales tax because the store is the one that remits the money) after a little digging I was able to find out how it works in Maine and the other five states.

    California says the insurer can choose to pay it upfront or if and when the contract is annuitized. CA is one of only two states that assess a tax on qualified funds. [§12222]
    Maine charges the money when the premium is collected on all non-qualified premiums. [Title 36, §2513]
    Nevada says the insurer can choose to pay it upfront or if and when the contract is annuitized and only on non-qualified funds. [NRS 680B.025-039]
    South Dakota charges the money when the premium is collected on all non-qualified premiums; the tax rate drops to 0.8% on the premium portion over $500,000. [10-44-2]
    West Virginia is the other state that taxes both qualified and non-qualified premiums. WV says the insurer can choose to pay the tax upfront or if and when the contract is annuitized. [§33-3-15].
    Wyoming charges the money when the premium is collected on all non-qualified premiums. [§26-4-103.]

      Non-Qualified Qualified
    CA 2.35% 0.50%
    ME 2.00% 0%
    NV 3.50% 0%
    SD 1.25% 0%
    WV 1.00% 1.00%
    WY 1.00% 0%

    Whether the carrier passes along this tax depends on the state and the carrier. Generally I found if the state required the tax to be paid at purchase the amount was deducted from the premium, but this was not always the case. If you are in one these states, ask your carrier how they treat the premium tax.


    Why 2014 Will Be Good For FIA Sales (10/13)  
    For the first time in three years I am very optimistic about the coming year’s index annuity sales. In spite of the shenanigans in Washington, the Fed’s floundering and a bull market that is long in the tooth I believe 2014 will be a very good year for FIA sales.

    Reason 1: Annuity rates, FIA caps & even GLWB roll-up rates will continue on their upward path.
    Simply put it’s much easier to sell the potential of a 6% cap instead of a 3% cap and rising bond yields are making that possibility. It isn’t only that bond yields have been low, they’ve been kept artificially low, so even if the Federal Reserve Board is more restrained in allowing rates to rise, rates are heading up. This has also relieved the pressure on reducing guaranteed lifetime withdrawal benefit (GLWB) rates and payout factors and even resulted in some increases. However, with index caps in the 5%-8% range next year agents won’t feel as great a need to sell the roll-up rate and can return to concentrating on telling consumers how they can earn higher hard dollar returns.

    Reason 2: Product Index Innovations
    Three years ago I mentioned that while using standard indices in an index annuity can help marketing – because the consumers may have heard of them – that creating your own index means you could provide higher nominal participation by using stock options with lower volatility and underlying higher dividends. Although carriers have not rushed to create their own index some are getting involved with indices designed for lower volatility. An index such as this can offer higher caps – or no cap – because the likelihood of a high index return is very low, but an uncapped return has stronger marketing appeal and the actual returns of these new indices could track higher. We will see more of these innovative designs in 2014.

    Reason 3: Wall Street doesn’t get decumulation
    The studies since 2008 find a large number of people want a guaranteed income for life – not a formula, best guess, or hope & prayer. The problem is the Wall Street model is built on collecting annual fees for managing a chronic problem of trying to make sure the income lasts for a lifetime. However, an annuity providing a guaranteed lifetime income solves the payout problem so there is no reason to keep paying fees. The biggest problem faced by this industry is consumers aren’t aware of index annuity GLWBs. As the word gets out, and it is, consumers will start demanding these annuities and Wall Street will have to create a new model.

    Reason 4: Consumers don’t understand how bonds work
    When overall bond yields go up the value of existing bonds go down. That’s Investing 101. But a survey by broker/dealer Edward Jones of its own investors found 66% of these bond owners weren’t aware of this elementary fact. What this means is...

    Agents should be asking every prospect they meet if they own bonds, and if the answer is yes, ask them if they are aware what happens when interest rates go up. You could also throw in that you have a way to transfer this risk of loss to someone else so they don’t get stuck with underwater bonds.

    Reason 5: Bank rates are not going up
    I hit this in the August issue, but for several reasons savings and CD rates are going to increase much more slowly and less dramatically than annuity rates. There are trillions of dollars sitting in banks waiting for the next big up move in rates and it ain’t going to happen. It’s annuity time.

    Reason 6: Demographics
    There are 20 million more people ages 50 to 74 than there were ten years ago. Another way to look at this is there are one-third more prime   annuity prospects than there were a few years ago. Over half have over $100k of annuitable  assets and over a third have over $250k.

    Reason 7: Attitudes
    The mindset for the first half of the last 30 years was that one didn’t need guarantees because the math showed putting your money in the stock market was the road to retirement success. Biases that cause people to continually buy high and sell low hurt their accumulation and the effects of two horrendous bear markets affected their thoughts on decumulation. Numerous studies have found that today not running out of money in retirement is the most important concern and that means using an annuity.

    A Great 2014
    Due to all of these reasons I believe both fixed rate and fixed index sales will be strong in 2014 and keep getting stronger as the year progresses. This will be a wonderful for those that preach the benefits of fixed annuities.


    Senior Designations (7/13)
    Although this discussion was pretty much concluded in 2008, the CFPB issued a report April 2013 talking about the issues surrounding senior designations, listing the designations, and saying whether they were accredited, required coursework and disclosed any disciplinary actions on members. Although neither the SEC nor FINRA officially opine on whether a designation is good or bad, both NASAA and NAIC have model regulations saying they will not automatically consider a designation to be bogus if is accredited by the American National Standards Institute (ANSI), National Commission for Certifying Agencies (NCCA), or a Department of Education recognized Regional Accredited Agency – everyone else listed. Under those rules here is a list of accredited designations*:

    Accredited Asset Management Specialist - AAMS

    Accredited Domestic Partnership Advisor - ADPA

    Accredited Portfolio Management Advisor - APMA

    Accredited Wealth Management Advisor – AWMA

    Chartered Advisor for Senior Living – CASL

    Certified Investment Management Analyst – CIMA  (ANSI)

    Certified Financial Planner – CFP (NCCA)

    Certified Retirement Counselor – CRC (NCCA)

    Certified Senior Advisor – CSA (NCCA)

    Chartered Advisor for Senior Living - CASL

    Chartered Financial Consultant – ChFC

    Chartered Healthcare Consultant – CHC

    Chartered Life Underwriter - CLU

    Financial Services Specialist – FSS

    Chartered Mutual Fund Counselor - CMFC

    Chartered Retirement Planning Counselor - CRPC

    Chartered Retirement Plans Specialist – CRPS

    Graduate Certificate in Retirement Planning

    Registered Paraplanner - RP      

    Retirement Income Certified Professional - RICP

     * Altho I hope this is accurate, it isn’t warranted, and a regulator can still object to even an accredited designation if he or she thinks it is being presented improperly.


    Cost of Living: 1962 vs 2012 (12/12)

      1962 2012
    Median family income       $6,000/yr $50,054/yr
    Minimum hourly wage        $1.25  $7.25 
    New house                        $15,000 $256,900
    Gallon of gas                         25¢ $3.25
    New car                             $2,500 $30,303
    Pack of chewing gum             99¢
    Hersheys bar                          10¢ 99¢
    Dairy Queen sundae 25¢ $2.98
    Fast food hamburger 20¢ 89¢
    1st class postage stamp 45¢
    Pay phone (local call) 10¢ 50¢
    24” Color TV set $400 $178
    Daily newspaper 10¢ $1.50
    Refrigerator $500 $649
    Tennis shoes $5 $29
    Doctors office visit $5 $80
    Movie ticket 50¢ $10
    45 rpm record $1.00  
    MP3 song Download  

    $1.29

    No Gain From Forced Literacy (12/12)
    Many studies have demonstrated that people in general have a high degree of financial illiteracy. Some have suggested that companies offering retirement plans be forced to offer education and advice in personal finance and require that employees take part. However, a recent study found that when unsolicited advice is given that it has no effect on investment behavior; individuals who are simply given advice disregard it almost completely. However, if education and advice is made available as an option the people that do seek it out tend to improve their financial literacy and make better investment choices.

    An unrelated study also shows the problems with trying to force financial literacy. In this study low income borrowers were shown why it was more effective to pay off the debt charging the highest interest rather than pay equally on all debts regardless of interest charged. They worked out a plan to pay off the worst debt first and even telephoned the borrower when they were falling off schedule. The study concluded there was weak evidence that this had its intended effects on debt reduction because it was generally ignored. 

    The reality appears to be that programs that try to force-feed financial literacy do not make the illiterate literate because the illiterate don’t want to spend the time or effort to learn. The only people that benefit from the programs are those that would have already become literate on their own. My editorial comment is the government should not spend tax dollars and force companies to spend their money on another well-intentioned program to help people do a better job in handling their money because it will fail. The real problem isn’t a lack of knowledge on the right things to do, but lacking either the intelligence or desire to use the available knowledge.

    Hung & Yoong. Sep 2012.  Asking For Help: Survey and Experimental Evidence on Financial Advice and Behavior Change Pension Research Council Working Paper WP2012-13

    Karlan & Zinman. 2012. Borrow Less Tomorrow: Behavioral Approaches To Debt Reduction.  Financial Security Project at Boston College. FSP 2012-1.


    Agent Compensation: Adapting To Survive (11/12)
    A $2 million index annuity producer sells more annuities than 67% of his or her peers. Based on the average sale this would mean he or she is selling an annuity every 10 days and that effort should be amply rewarded, but the rewards are getting slimmer.Advantage Compendium research shows a decade ago the average index annuity commission paid was 10.4%. If the producer sold an average mix of products the annual income would have been $208,000. It could have been more. In 2002 there were 5 index products that paid 15% or more – one paid 17%. It is possible that a producer could have earned $340,000 on those $2 million of sales.

    In 2007 the average commission had fallen to 8.1%, The average mix generated $162,000. A tidy sum, but almost a quarter less than the same efforts returned in 2002. A reblend in product mix could increase that income – in 2007 there were still over a dozen index annuities paying over 10% comp and one paid 13%, but changes were in the wind. One factor affecting annuity compensation was the implementation of 10/10 rules in roughly a quarter of the states that limited the surrender term of an annuity to ten years and limited the maximum surrender charge. These limits also effectively lowered commissions because the carriers would have less time to recapture the expense. Another factor was a bond environment with steadily declining yields.

    Carriers make their revenues from the spread between what is earned on their investments and what is paid out to the annuityowner; from those revenues are deducted operating expenses, carrier profits, and producer commissions. Paying a large upfront commission puts a strain on that spread. If you reduce today’s commission payout you have more money left on the table to buy bonds and this generates more money down the road. Paying out 6% today and 2% tomorrow means not only does the carrier have the 2% available in the future, but also money earned from investing that 2%. Ideally, producer commissions would be paid over the expected life of the annuity, but agents have expressed reluctance on this method of compensation. However, from 2008 to 2009 typical bond yields fell roughly a percent and the future looked like more decreases. Something had to be done.

    In May 2009 American Equity bravely announced that producers would have to wait for a share of their commission for a year or possibly two (depending on product) with marketing companies waiting a bit longer to be paid in full. These “staggered commissions” were an alternative to simply reducing commissions, but bond yields still continued to fall. Carriers first cut index interest caps and then reduced guarantees, but with falling yields 2012 has seen a steady stream of cuts to annuity commission rates. Today, typical first-year commissions are in the 6% to 7% range on even 10 year products meaning $2 million of average FIA sales generates $120,000 to $140,000. There are still a few products out there at 8% or even 10%, but the future is clear. Commissions will decline further in 2013 and the situation won’t improve for several years. Based on talking with several carriers I believe the new average commission for long-term products by the middle of next year will be 5%, with 4% the new average for annuities with a six to eight year surrender period. It will still be possible to find a few products with 7% to 8% commissions, but the higher commissions will require trade-offs in other areas.

    A $2 million producer that earned $200,000 in 2002 may be lucky to average $100,000 in 2013.

    I’ve also talked with carriers that are strongly considering only offering more levelized commissions. This could mean that a producer’s real options would be to take 4% plus a 0.25% trailing commission or even a steady 1.25% a year. The $2 million producer that earned $208,000 a decade ago, and $162,000 five years may be lucky to average $100,000 in 2013.

    A Commission Mix Story
    Let’s suppose a decade ago you had decided that 20% of your business was to be in annuities that paid compensation of 1.25% a year on the accumulated value. In 2002 that meant $1.6 million averaged 10.4% or $166,400 and $400,000 at 1.25% earned $5000. All told, you made $171,400 instead of $208,000 in 2002. However, first-year commission rates were steadily falling. As stated, the average commission in 2007 was 8.1% which translated into $162,000. However, because you’d been placing 20% of your business in annuities that pay ongoing commissions your total comp was $164,717 in 2007. And each year thereafter the first year/trailing mix paid more than the first year alone plan. By 2012 relying solely on first year comp meant the average $2 million producer earned $130,000, but the first year/trailing mix paid out $180,299. Perhaps even more important, if the producer can’t work next year the trailing commissions left undisturbed would be $76,300.
    The chart compares the compensation received on $2 million FIA sales assuming the average commission was earned on 100% of sales versus 80% first year and 20% trailing earning 1.25% on the annuity value growing at 4.36%/year the average annualized FIA yield for the last 10 years.

    Producers Really Won’t Have A Choice
    There are two main arguments used against accepting lower first year comp combined with trailing commissions.
    The first is the annuity won’t stay on the books; either the selling producer or a new producer will move the money and create a new sale in four to six years by transferring the annuity. The reality is it is becoming much more difficult to do an annuity exchange. This is because, depending on the carrier, 50% to 90% of the sales involve a living benefit with a guaranteed income roll-up rate. These annuities are being sold for the express purpose of creating income and existing annuities almost always have much stronger roll-up rates and payout factors than new policies. Exchanging one of these old policies for a new one damages the annuityowner.

    Along with this, carriers are becoming much tougher when it comes to accepting annuity exchanges, especially when a living benefit is involved. Although I estimate that two-thirds of existing fixed annuity sales are the result of the exchange of an old annuity for a new one, this will drop to a quarter of all sales by 2017. Annuities will stay on the books longer so trailing commissions become even more important.

    The second argument is that the producer can’t afford the cut; that they can’t get by on less than they are currently receiving. Well, it is happening whether you can afford it or not. Commission rates have already dropped by a third in the last 10 years and will drop a bit more. Although there are some carriers still paying 8% comp this cannot be sustained in a 4% bond yield environment. Annuity producers need to prepare for a 4% to 5% world. Since it will take four to five years before trailing commissions offset lower first year comp the producer needs to expand their business model. If they are securities registered this means selling more securities; If they are not this probably means selling much more life insurance.

    Adaptors Survive
    It’s a new world; the old one is dead. It is not coming back. The good news is the survivors will have a more diversified book of business and an ongoing revenue stream that acts like a “Commission Annuity” for the producer. This means an income when the producer can’t work and an asset that the producer can sell.
    The securities industry went through the same thing in the ‘90s. Not only did they survive, but they became stronger than ever. A combination of income sources and types of revenues is a sustainable business model for the annuity producer. It will be much tougher to create a new sale by exchanging an old annuity, one reason why trailing comp is so important. To survive until trailing commission income is sufficient producers needs to broaden what they offer   for agents that means more life insurance sales.


     October 1, 2023 

     Dear John,
    I have a confession to make; I’ve been cheating on you. It all started ten years ago, after the spring 2016 market crash. You told me that even though we’d been hit hard that we’d be all right. But John, you sounded like a broken record after saying the same thing in 2001 and 2008. Frankly, I couldn’t take it anymore.

    That $100,000 you noticed missing from the checking account that year, I really didn’t spend it on shoes like you thought. I bought a fixed annuity with a lifetime benefit rider. Buying the annuity turned out to be a smart move since strife and uncertainty in the Middle East caused extreme stock market volatility in 2017, 2019, 2021 and 2022. Through it all the annuity kept growing and the guaranteed income grew even faster.

    I remember you suggesting at one point that we simply sell our stocks and mutual funds and put all the money into gold. Of course, after that Iranian nuclear accident in 2017 caused all the spiders to begin spinning webs of gold the bottom fell out of the market – I understand gold is down to $35 a ton.

    I know that President Gaga says this recession is simply because we were born this way and if we keep our poker face showing to the rest of the world that we will be on the edge of glory, but since China now owns our national parks as payment for our Treasury debt I’m just not as optimistic as I used to be. Fortunately, that annuity will allow me to retire this year with an income far higher than I ever dreamed and the certainty that it will be around as long as I am...a certainty you were never able to give me.

    John, you’ve been a great stockbroker, but I’ve left you for my annuity agent.

    All my love,

    Mary


    Guaranty Funds No FIA Has Lost Money Because A Carrier Failed (6/12)
    On 8 May 2012 Shenandoah Life Insurance exited Virginia state receivership becoming a subsidiary of the Prosperity Life Insurance Group LLC. Shenandoah Life Insurance Company entered receivership on 12 February 2009. What this means is Shenandoah will return to normal operations and fulfill all of its commitments to policyholders. What this also means is it is still true that no index annuity owner has ever lost a dime because their carrier failed. The news release for Shenandoah Life says it is a rare thing for an insurance company to successfully exit receivership, but in the index annuity world a successful rebirth is not an unusual outcome. 

    Standard Life Insurance Company of Indiana entered state control on 18 December 2008. On 22 December 2010 the Indiana Insurance Commissioner announced that agreements had been reached for the $1.7 billion in policies and financial obligations of Standard Life to be assumed by Guggenheim Life and Annuity Company. This was accomplished in 2011 and Standard Life index annuity owners received the full value of their annuities.

    On 2 March 2004 Western United Life Assurance entered Washington state receivership after being brought down by problems related to their parent, Metropolitan Mortgage & Securities and Summit Securities Inc. Western United was acquired by a joint venture formed by Global Secured Capital and DLB Capital in June 2008 and continues to operate as before.

    Finally (or first) a small index annuity player named General American Life entered Missouri rehab on 10 August 1999 due to a liquidity crisis. General American Life was sold to MetLife on 6 January 2000 and the existing account values for all index annuity owners were not diminished.

    Since inception of the index annuity industry in 1995 four index annuity carriers have entered receivership and the annuity customers of these four carriers have reemerged on the other side without loss. A four-peat clearly shows that the current state regulatory system works and it allows the bragging rights mentioned earlier which is no index annuity owner has lost principal because the carrier failed.* It also points out two big differences between banks and carriers.

    4 FIA Carriers have entered state receivership, but not one annuityowner has lost a dime of their principal and credited interest

    Liquidity – When FDIC takes over a failed bank another healthy bank is usually found that will handle the deposits, and account balances covered by FDIC insurance are available at the new bank the next business day. If a bank isn’t found to take over the account, checks are immediately mailed out to bank customers payable up to the limits of FDIC coverage. By contrast, when an annuity carrier enters receivership withdrawals are usually banned, except in cases of extreme hardship. Yes, all of the index annuity customers of these four carriers were eventually able to access their cash value, but they might have had to wait up to three years to do so.

    Coverage – Although FDIC covered accounts are immediately available, balances over the limits that are uninsured mean the customer is treated as a creditor. These additional amounts are paid out as assets of the failed bank are sold and there is no guarantee that the customer will ever be made whole. Indeed, in one case only 65% of the uninsured deposits were ever repaid, but a more typical result was recovering 90% to 100% of these uninsured deposits. By contrast, all index annuity owners eventually were made 100% whole whether they had one dollar or one million dollars in their policy.

    Once again the state insurance regulatory system has shown that it works well in protecting policyholders in the even the carrier fails. Once again annuity agents can show why fixed annuities are a safe money place.

     * Of the seven fixed rate annuity carriers that have entered receivership since 1995 ultimately two of them did not fully protect account balances that exceeded guaranty fund limits.


    How Prevalent Is Elder Abuse? No One Really Knows. (5/12)
    A 2000 article in Consumer Digest titled “The Fleecing of America’s Elderly” says at one point that there “may be at least 5 million financial abuse victims each year.” If you do a web search on how prevalent elder financial abuse is almost every source contains this sentence as proof that financial abuse of seniors is rampant. And yet, this conclusion is based on a combination of a reporter’s poor reading skills and his unsubstantiated opinion. The actual number, based on the study he used, should have been 137 thousand, not 5 million. In doing research for a new study I delved into the prevalence of elder abuse, particularly the financial exploitation of elders; an elder is defined, in most states under elder abuse laws, as someone age 60 or older. That elder financial abuse occurs is without question. There are tens of thousand of claims reported to state agencies each year of financial elder abuse and from a quarter to half of these are substantiated after an investigation. The vast majority of the cases involve family members or caregivers (96%), but there are also con artists and the unscrupulous preying upon the elderly. However, the real number of victims is completely unknown.

    Part of the reason for not knowing the total of abused elders is past studies have shown that many more cases of abuse are not reported than reported. The National Center on Elder Abuse (NCEA) tries to be the national clearinghouse for elder abuse research. It has endorsed the “iceberg theory of elder abuse” that says there are roughly 6 cases of unreported abuse for every reported case. In the largest study conducted up to that point a 1998 NCEA report said there were 70,492 reported cases of all types of elder abuse including 21,427 of financial abuse. They then estimated that total abuse cases are 450,000 a year (both reported and unreported financial abuse would have been 137,000). Based on the population at the time, their estimate is 1% of elders over age 60 are abused and 0.3% of elders are financially abused, but they admit they could be off by half in either direction.

    Back to Consumer Digest
    The reporter apparently didn’t realize the 450,000 number from the NCEA study included estimates of unreported cases because he somehow concluded that were 220,400 verified cases of financial abuse – when there were really 21,427. If it isn’t bad enough that the article overstated the number of cases by a factor of 10, the reporter then decides not to use the 6 to 1 iceberg theory ratio used in the study he’s citing, but
    instead uses a factor of 25 based on “interviews with elder advocates” (he even says it might be 100 to 1 which would mean half of all seniors  are being financially exploited each year). The reporter admits that his speculations are not supported by the facts saying that he contacted every state in the union and turned up “low numbers of abuse,” but says real numbers do not matter because “most of these crimes are never reported.”

    Every elder advocacy organization (and elder abuse lawyer) web site that I clicked on showed the 5 million cases quote, including the NCEA one that did the original study. I sent an email to NCEA explaining the error in the Consumer Digest article they were quoting from and they promised to not cite the article in the future, but it’s still printed in their Fact Sheet.

    So, how prevalent is elder financial abuse?
    Other studies have come out with real numbers saying around 0.3% of the 60 plus population have been abused, and this would mean 0.1% to 0.2% are suffering from financial abuse. This indicates out of the roughly 56 million seniors that 168,000 have verified abuse claims and as many as 100,000 of these are financial abuse. How many unreported cases are there? Using the iceberg theory there might be 300 to 900 thousand elders subjected to financial abuse annually. 

    Why should you care?
    Because agents could be falsely targeted as abusers. The reality is maybe there are a few thousand cases a year where financial advisors or agents exploit seniors – this would mean that, maybe, 0.005% of seniors are abused by financial professionals; statistically there isn’t a problem.
    However, it’s hard to get funding for your elder abuse organization or new legislation passed if there appears to be few victims, so some try to create the idea that there are more victims and abusers than there really are. My concern here is that the actions of a few bad agents will be used as fuel to create legislation or regulator actions that make life more difficult for all agents. 

    What can you do?
    Be aware that elder financial abuse exists. Also be aware that half to three-quarters of financial abuse claims are not substantiated due to the fact that many are brought because someone didn’t get the money they thought they should have. And be aware of what typically constitutes abuse.According to 164 deputy district attorneys, law enforcement, adult protective service workers, and public guardians for elder abuse to occur:*

    1. There must be an emotionally or mentally vulnerable senior with assets

    2.  Either the financial transactions or the senior are kept secret or controlled

    3.  No independent determination was made that the senior could act in their own best interest

    4.  The benefit received was not proportionate to the assets transferred

    5.  The transactions are not in writing, are poorly disclosed and represent a conflict of interest

    If all of these are present there is elder abuse.

    Talk to your local elder advocacy organizations and ask them how you can help identify possible abuse; let them see that annuity agents care about the problem. And be sensitive to the reality that someone may be unhappy that an annuity purchase means that they will no longer have free and easy access to the elder’s money.

    *Kemp, B. & L. Mosqueda. (2005). Elder financial abuse: An evaluation framework and supporting evidence. Journal of the American Geriatrics Society. 53, 7: 1123-1127


    CDAs, SALBs HSIAs A Very Limited Market (4/12)
    In the previous issue I referred to a study I did on contingent deferred annuities (CDAs), also called stand-alone living benefits. Essentially the way they work is to add a lifetime income benefit to an investment. Unlike a variable annuity this is not a separate account of the carrier, it is a separate account of the investor. The investment is treated and taxed as an investment, the annuity component is treated and taxed as an annuity.  

    The question a CDA raises in the index annuity world is if the primary attraction to the buyer of an annuity is the growth of the lifetime income benefit, why would they purchase an index annuity where there are caps and limits on this growth? If an investor could buy, say, an equity mutual fund or ETF, and add a GLWB to that vehicle for a competitive price, the investor would have 100% market participation plus reinvested dividends less a fee. On its face, this CDA combination could provide for much greater growth than an index annuity, but the extent of this growth would depend on whether there were any restrictions on the equity investments and the fees charged for the benefit.  

    The first marketed CDA product launched on 13 March 2008 when Lockwood Capital Management Inc. and PHL Variable Insurance Company introduced Guaranteed Retirement Income Solutions. This was followed in May by Genworth and AssetMark offering the LifeHarbor series of managed portfolios. In May 2008 Allstate introduced their CDA that could be added to the ClearTarget mutual fund, bringing a new dimension to the managed portfolio concept. All of these products were withdrawn from the market after the crash of 2008.  

    The new CDAs introduced within the last year charge fees that are currently 0.9% to 1% a year, but can increase to 1.5% to 2.0%. It should be noted that index annuity GLWBs average fees have also increased to around 1%, although their maximum fees are typically lower. On the fee issue currently both CDAs and GLWBs are in a similar place. However, due to the market volatility realized since 2008 CDAs have attempted to reduce their exposure by placing greater restrictions on the allocation of assets typically the investor must maintain a bond allocation of at least 30% at all times. The limitation on equity allocations dilutes the value proposition of a CDA, which is that a CDA offers greater potential growth of the lifetime income than could be realized with an index annuity GLWB.  

    The typical index annuity GLWB guarantees that a delayed withdrawal payout will increase from 6% to 7% per year for at least the next 10 years and many allow the guaranteed growth period to be extended. A CDA offers no “roll-up” growth  and requires a significant portion of the investment to be placed in bonds that act to limit growth. The question looking forward is is it likely that a portfolio with a minimum 30% bond allocation will beat the 6% (or higher) guaranteed growth of the index annuity GLWB?  

    A CDA buyer occupies a very specific niche. You have someone that is afraid of outliving their money due to market risk, but passes up the sure thing offered by a guaranteed annual increase in potential income offered by index annuity GLWB roll-ups. The rationale for doing this would be that the investments would outperform any guaranteed roll-up rates, but every CDA limits the exposure to higher risk-higher return investments. The CDA target market are those investors that are sufficiently risk-averse to fear the risk of outliving their money, but sufficiently risk-oriented as to accept the market risk that they can outperform the guaranteed roll-up growth offered by many GLWB annuities. These contradictions require a rather unique individual. CDAs will be getting more exposure in the media in the years to come thus educating more consumers on the availability of lifetime withdrawal benefits. This gives index annuity providers excellent opportunities to show why their GLWB is better for the consumer than a CDA.


    Guaranty Funds Myths (3/12)
    State guaranty associations protect a minimum of $100,000 annuity cash value if a carrier enters receivership and the state guarantee fund mechanism is activated; 33 states provide $250,000 or more of coverage. The guaranty associations provide an additional level of protection to annuityowners and thousands of annuityowners have benefited from this protection. These are facts, but there are also many myths floating around that need to be set straight. Myths:

    #1 There Is A Guaranty Fund
    The term guaranty fund is wrong because there isn’t a fund. Unlike FDIC where banks pay in to create a Deposit Insurance Fund to cover future failed banks annuity carriers are assessed after a carrier has failed, so there isn’t an existing pot of money to draw from. The result is while FDIC pays out the next business day to covered bank depositors payments to annuity customers can take years.

    #2 If The Buyers Asks I Can Talk About The Guaranty Association
    The insurance laws of every state say, at a minimum, something like no agent or affiliate of an insurer shall use the existence of the insurance guaranty association for the purpose of sales, solicitation, or inducement to purchase any form of insurance. The reason an agent is likely to mention the guaranty fund is to improve the odds of closing the sale and state laws say this can’t be done even if the buyer asks about it. A few states have rules that say an agent can’t mention the guaranty association ever, even after the sale.

    #3 The Maximum Annuity Coverage Is “Per Carrier” So You Should Spread The Premium Around Among Several Carriers
    In eight states (IA, MD, MO, NE, NY, NC, SC, WI ) the guaranty association language states the maximum coverage is based on the individual. So, if you have $250,000 in each of 100 banks and they all fail FDIC will pay $25,000,000. If you have $250,000 with each of 100 annuity carriers you will be paid a total of $100,000 or $250,000 or $500,000 depending on which of these eight states you live in.
     What if the language is unclear? When I asked one association that question the answer I got was that coverage would be decided after the failures had occurred. 

    #4 The Annuity Account Value Is Covered
    In most states the annuity cash value is covered up to the state limits. However, in recent years, several states have added language that gives the association the right to readjust the account value. Typical language allows the guaranty fund to look at the last four years interest credited and then recalculate it using the average yield of the Moody’s Corporate Bond Yield Average for the same four year period and then subtracting 3%.

    As a example, say you had placed $75,000 in a fixed rate annuity and earned 6% for the last four years giving you a cash value of $94,686. Say that the Moody’s average bond yield was 5% for the same four years. The guaranty association would have the right to recalculate the annuity interest at 2%/year (5%-3%) and the fund payout would be based on your redetermined cash value of $81,182. 

    Since that didn’t mention index annuities several states (CA 1067.02.5.; MN 61.B.19 (12)(13); MO 3.376.715) have added additional language saying the fund shall not cover any portion of a policy to the extent that the rate of interest is determined by use of an index or other external reference stated in the policy or contract employed in calculating returns or changes in value. Index linked interest may also adjusted downward.

    Not A Myth: Everyone Covered By A Guaranty Fund Has Been Made Whole
    Guaranty funds do have limitations. Agents can’t talk about them, not every type of annuity (or annuity rider) is covered, the coverage has been interpreted as per individual account and not per carrier, and it can take a long time to get your money, but every annuityowner covered by a state guaranty association eventually received up to their state’s guaranty fund limits in every case. Since each state is different, be familiar with the guaranty association statutes for your state.


    The Most Volatile Stock Market In 40 Years (2/12)  
    The general impression is that the stock market has been more volatile in recent years and I wanted to see whether this was true. The answer is a resounding yes.

    What I Did
    A typical stock market month has 21 trading days after you subtract weekends and holidays. By that reckoning there were 10,851 consecutive trading months between the end of 1968 and the start of 2012 (2 January 1969 to 1 February 1969, 3 January 1969 to 2 February 1969 and so on). I calculated the day-to-day changes in closing values of the S&P 500 during each of these trading months and then calculated the standard deviation of these daily changes for each month. The standard deviation can be thought of as a measure of volatility since you are comparing the amount of change in a particular month’s daily index values with an average month. Essentially what I did was calculate the day to day volatility of the S&P 500 over each trading month and then compared the months to see whether some months were more volatile than others.

    * These are not independent data points since periods overlap and share the same data with subsequent and preceding periods. However, I also did this analysis using completely independent periods and the data also supported the conclusion that the last four years were abnormally volatile.

    This chart shows the volatility (standard deviation of daily closing values) of stock market months since 1969*. The most noticeable spikes happened in 1987 when Black Monday resulted from the index shedding 20% of its value in a single day, and another spike occurred after the bankruptcy of Lehman Brothers in 2008. There are also clumps of periods with higher volatility clustered around the turn of the millennium and the bear markets of the ‘70s. It appears that the market has been more volatile since 2008, but let’s try to make the picture clearer.

    Instead of showing volatility over a sequence of years, we can rank the volatility from low to high and see which time periods were the least volatile and the most volatile. This means that March 1972 and June 2004 or June 1969 and October 1997 might be next to each other on the line because those months had the same volatility. In addition, since what we really want to focus in on is the periods from 2008 to now we can mark those periods with a gray line so they standout. Here’s what we get.

    The black line shows the volatility ranked from the lowest month to the highest. The gray bar reflects the months from the start of 2008 to the end of 2011. There are gray bars at the left end of the chart which means that the last four years did have some quiet months in the stock market – most of which occurred in 2010 – but the gray bars on the right high-volatility side form a wall. The chart shows that the last four years have been much more volatile than other four year periods going back to 1969.

     

    Very High Volatility
    In any broad distribution of data over 94% of the individual data points will be within 4 standard deviations of the average. Of these 10,851 periods I discovered that 345 of them produced data points that were more than 4 standard deviation from the average. These can viewed as very volatile months and they are uncommon, because they only represent 3.2% of all the months going back to 1969. 

    If these very volatile months were equally distributed it would mean that over any given period that approximately 3% of the monthly periods would be extremely volatile, but these volatile returns are not equally distributed. Indeed, months since 2008 account for over 55% of all periods with a standard deviation greater than four.  

    What This Means For Investors & Annuities
    Periods of high volatility can be very profitable for short-term traders. However, research suggests the typical investor in or near retirement does not have access to a super computer and is not day-trading his IRA. The usual response to high volatility is to remove oneself from the situation and this has been witnessed as investors became net sellers of equity mutual funds in 2011 and money market account balances reached record highs.
     

    Extreme volatility means the stock market paeans such as buy & hold, dollar-cost-averaging and the 4% withdrawal rule have been turned into dirges reflecting the death of retirement dreams. Index annuities offer a way for these battered investors to still enjoy an index-linked return, but without the downside volatility. Guaranteed lifetime withdrawal benefits offer a means of guaranteeing an income that will increase in the future regardless of volatility. Most of these investors are unaware of how index annuities really protect both their money and their dreams. They are waiting for your call.  


    Yes to EquiTrust Takeover  (1/12)
    On 16 December 2011  the Iowa Insurance Division approved the plan of Sammons Enterprises, Inc. and GPFT HOLDCO, LLC  (a Guggenheim Capital subsidiary) to acquire EquiTrust Life Insurance Company finding that insurance carrier standards required by the state would continue to met (Sammons is not expected to be directly involved in the operation and management of EquiTrust after the acquisition). The $471 million purchase has now closed.


    Wall Street Discovers FIAs (11/11)
    In one recent weekly issue of
    Investment News there were three articles on fixed annuities – this from a periodical that in the past might have mentioned fixed annuities three times in a year. One of the articles was titled “Warming to indexed
    annuities” centering on how wirehouses are now embracing them. As a Merrill Lynch managing director said “Five years ago, nobody hated the product more than me, but now I’ve seen the light.” Wall Street has discovered index annuities. Why now? They say it’s because the products have changed and are no longer “bad” but that’s not the real reason. Wall Street is looking at index annuities because 1) they failed to kill them and 2) their traditional solutions aren’t working well.

    As index annuity sales grew after the millennium bear market Wall Street and its minions wheedled securities regulators with exaggerated stories of index annuity sales abuses and how agents needed to be stopped. In truth, there were sales abuses, but never even close to the extent that the naysayers proclaimed. Because the annuity industry remained silent and let the securities industry write the story the media was full of tales – actually a few tales repeated ad naseum – of how bad index annuities were. The result was SEC Rule 151A which would have killed index annuities. However, the annuity industry finally rallied and managed to kill the rule instead; meaning index annuities would still be competing for consumer dollars.

    After the Crash of 08 Wall Street kept coming up with products that might increase the marginal return at a given level of risk, but failed to grasp that now the goal of many consumers wasn’t to make an extra percent or two, but to keep safe one hundred percent of what they already had. As Wall Street started to realize this they reexamined their choices and discovered that fixed index annuities provided an excellent solution. If you can’t beat them, join them.

    Wall Street’s embrace of index annuities will continue to strengthen because the financial markets continue to look very uncertain. The good news is it’s hard to bash something that you’re doing too, so there will be an increasing number of media stories about how good index annuities are and consumer demand will shoot up. The bad news is the independent agents that have had index annuities almost all to themselves will face increased competition. However, I believe, overall, that the good outweighs the bad.


    Not Unprecedented, But Scary Times (10/11)
    Within the last 60 days the yield on the 10 year Treasury dropped by 1%, the S&P 500 dropped by 12%, and option volatility (VIX) roughly doubled driving up the cost of call options. The effect on index annuities has been swift cuts to fixed rates and index caps, refiling products with regulators to allow for lower minimum caps and rates, commission cuts, and pulling products. Unfortunately, it’s not going to get better any time soon. Although I think the 1.70% yield that the 10-year Treasury hit in September was an overreaction to events – and that these rates will move slightly higher in the near term – this isn’t an indication of rising rates, but merely correcting the Treasury yield to where it should be (the spread between investment grade bonds and the 10-year Treasury is too big based on history).

    I also believe option prices will fall a bit at some point. Even though I’m seeing articles saying that high financial market volatility is the “new normal” the reality is the economic world cannot effectively function in this environment, so high volatility is unsustainable over the long-term. It should be noted that similar claims were made in 2002 when the VIX was at 50 and then these same pundits were telling us in 2006 when the VIX hit 9 that the “new normal” was a market with low volatility. It will cost less to buy the option for an index-linked return in coming months, but because of low interest rates there will be less money to buy that option.

    The Advantage Insurer Bond Index, which is meant to be a rough indicator of new bond yields in an insurer’s portfolio, ended September at 4.43%. By comparison, the index a year ago was at 4.83%. However, during much of the previous decade the yields were near 6% territory and we saw periods where index annuities offered double digit caps. Foreseeable bond yields are not going to permit 10% caps anytime soon, but they do permit caps to be higher than 2%, providing other costs are in line. All in all the next 18 months will be the most challenging time for the fixed annuity world in 30 years, but carriers and agents have faced and survived other tough periods.

    What We Can Learn From Other Tough Times
    From 1957 to 1964 bond yields were roughly where they were now and insurers and agents prospered. Indeed, for much of the ten years before that bond yields hovered around 3% and agents and carriers survived. One difference
    between 1961 and 2011 was compensation. During that period of low bond yields the data I could find says the agent commission on a single premium fixed annuity was 3% to 4%. These were primarily captive agents with the carrier providing an office, a sales manager and benefits which added, perhaps, another 2% to the effective commission. So, the agent cost to the carrier was 5% to 6% – maybe 6.5% – to get the annuity on the books. In 2011 the average index annuity commission paid is around 6.5% with additional overrides of 2% to 2.5% for a total outlay of 8.5% to 9%. In this interest rate environment the carrier cannot offer a competitive index annuity after paying out 8.5%. Commissions and overrides have to drop.

    The Strong Producer Will Excel
    Based on being able to tell a high yield story, the average annuity sales size, and an 8% or 9% commission, one could make a living as an annuity producer by selling an annuity a month, and many did. However, it will be much more difficult for some to sell an index annuity without

    being able to dazzle the consumer with the prospect of earning a high yield. The sales process will need to become more consultative with the producer showing how an annuity can help solve the consumer’s problem, rather than simply selling rate, and many producers will not be able to make the transition. This difficulty, compounded by earning a lower commission, will cause many marginal annuity producers to leave the business.

    The good news for those that remain is there will be increased demand for index annuities. A 3% or 4% index-linked interest cap still compares very favorably to a CD rate and a lifetime withdrawal benefit that is guaranteed to increase looks pretty good when compared to the continued uncertainties of the stock market. Yes, commissions will be lower, but the number of sales, and the average sale size, will go up.

    Add Arrows To Your Quiver
    In 1981 you could buy a fixed rate annuity yielding 11%; the problem was 6 month CDs were paying 16%. In July 1981 a second recession began a year after the last one ended. Unemployment was double digit, the price of gold had skyrocketed, and the stock market was falling. A key difference from today was the sense by consumers that interest rates would be a lot higher
    tomorrow than today, so why lock up your money in an annuity. Today’s rates are so low that some consumers have given up shopping for yields and are simply parking their money in the bank until the world looks better. Both then and now you had blocks of potential annuity consumers that had elected to not be annuity buyers.

    However, they do need other services. Both then and now consumers were looking for advice on what to do. Thirty years ago the result was a flood of agents becoming financial planners so they could offer a variety of solutions to consumers. Now it is agents becoming investment advisors for similar reasons. Expand what you do. Consumers always need insurance. In a rising interest environment the industry developed universal life. In this environment whole life and index life fill a need for those consumers looking for protection. A story with guarantees looks very attractive. The sales story is guarantees.

    We Will Survive
    These are uncertain times, but times are usually uncertain. The politicians in Washington managed to turn the Great Recession of 1930 into the Great Depression of 1930 with bad choices, and then prolonged the Depression by cutting spending and raising taxes in the middle of a weak recovery. Bad choices in Washington in the late ‘60s and ‘70s created a succession of recessions. I’m not optimistic that Washington will be any smarter this time around, but we survived then.

    This country has the most productive, highly educated population on the planet. We are the most creative people in the history of the world. We look out at a world that is creating the largest consumer class in history, and those people want and need what America has to offer. For now, hunker down, work hard and work smart. It’ll be tough going for awhile, but the other side of the mountain looks pretty good.


    Summertime (and the livin’ ain’t easy) (6/11)
    Sales are down roughly 20% from their third quarter 2010 record high. I have talked with many agents this spring that told me their sales are down, and they believe the reason is because it's harder to get someone to buy an annuity when the interest cap is 2% to 4%. The exception I found was with some agents in banks, who are having success in converting 1% CD owners into index annuity owners. The low caps combined with a still rising stock market has also cooled interest in FIAs from the broker/dealers I've spoken with, and they have returned to selling variable annuities. The reality is you can do all the cheerleading you want, but the index annuity sales environment will remain challenging until caps and rates go up. Sales are down, but by no means dead. Even if this environment continues index annuity sales would still be would be comparable to 2005-2008 years. However, average commission rates are also down about 20% from where they were two or three years ago, so agents need to sell more to make the same income. 

    Selling the lifetime income benefit is helping sales, but it needs to be done correctly. If the annuitybuyer believes the income benefit roll-up rate also applies to the cash value, then the agent can get in trouble – as shown later in this issue. Instead, make the selling point the actual income. Saying “I can get you $1,000 a month for life guaranteed” sets an agent apart from the uncertainty of Wall Street and allows them to offer a unique selling proposition. 

    My belief is that rates and caps will go up, because bond yields should increase for a number of reasons. I hoped it would be happening by now – and rates were rising earlier – but concerns about the strength of the economic recovery caused them to dip again. However, if they don’t go up there are different ways to repackage index annuities so they can still offer high caps in a low yield environment providing an attractive sales story. Today’s low caps are a temporary thing. 

    It’s going to be a tough summer. This means an agent needs to talk to more people to get a sale, change the index annuity spiel from talking about high potential returns to one of lifetime income with principal protection, be open to selling non-annuity products such as life insurance, and look for market niches that are underserved. Indeed, for some agents 2011 will be their best year ever


    Financial Reporters Overlook The Consumers They’ve Killed (2/11)
    There continue to be a number of potshots taken against index annuity returns, but these reporters conveniently forget when following the
    reporter’s advice would have damaged investors. In the September 2010 issue of Kiplinger’s Personal Finance Magazine Kim Lankford wrote an article titled “An annuity you really should avoid” concluding “you get a lot less than investors in the actual index would receive because of caps on returns and other limitations” However, she conveniently overlooks what happened if you had followed her advice a decade earlier.

    In the April 1999 issue of Kiplinger’s Kim Lankford wrote an article titled “These investments are less than meets the eye” She honed in on my research that said index annuities paid 8% to 17% in 1998 while the S&P 500 was up 29%. She relates a story of a financial planner that “rescued” a couple owning an index annuity that had “only” earned 13% in 1998, and had them cash in the annuity, incur surrender penalties, and invest what was left in a “real index fund”. What was not reported was how the client fared later.

    The S&P 500 was at 1335 in April 1999. It ended April 2003 at 917. After including reinvested dividends, the “rescue” had by then cost the couple about 25% of what the financial planner had started with. By contrast, if the couple had been left in the index annuity not only would they not have incurred surrender penalties and kept the 13% earned the previous year, they would have participated in an additional 19% gain in 1999, and due to the annuity reset feature they would have protected these gains from market loss and been positioned to earn even more interest when the millennium bear market finally ended. By the way, the index fund starting point of 1335 back in 1998 was not reached again until the summer of 2006. Unfortunately, reporters are not legally responsible for damages caused by their words, and they seem to have a selective memory that conveniently forgets when they err. So it is important the we all help them jog their memory.


    Summit Files Bankruptcy (2/11)
    On 26 January Summit Business Media Holding Co. filed for bankruptcy in Delaware. The company owns 16 magazines including Agent’s Sales Journal, Life Insurance Selling, Senior Market Advisor, and National Underwriter as well as several websites including producersweb.
    Summit says all vendors and employees will be paid during the reorganization process. The company blamed the recession, sector downturns, and an acquisition binge that started in 2006 for contributing to its financial situation, as well as the ongoing media shift from print to digital.
    The goal is to eliminate $140 million of debt and emerge from bankruptcy sometime in late spring. Case: U.S. Bankruptcy Court, District of Delaware, No. 11-10231.


    Annuity Producers – Evolution Or Extinction (12/10)
    A decade ago the average index annuity commission paid was over 10%, caps were 10% to 15%, and the term suitability wasn’t even mentioned in polite annuity circles because the guiding principle was market conduct and that was more of an issue for carriers than producers. As long as the consumer could fog a mirror the annuity business was processed. Today, the average commission paid is 5% to 6%, caps are 3% to 5%, and since the securitization attempt was defeated some securities regulators are now going after index annuity producers under the argument that they are offering investment advice. Due to new regulations carriers are reviewing applications for suitability – and rejecting those that aren’t. 

    The index annuity sales model for the last decade has been to offer consumers the hope of earning a much higher return than they could get from CDs. If expectations weren’t met the old annuity was exchanged for a new one, with any surrender charges “covered” by the new premium bonus. And with 10% commissions even marginal producers could earn a living. That model is dying. One killer of the model is tougher regulation. This has translated into shorter surrender periods pushing commissions lower, greater scrutiny of annuity exchanges, and more attention paid to all annuity sales and sales practices. However, the major model killer is lower yield.  

    My Compendium Composite Bond Index blends corporate with Treasury bond yields. As recently as 2008 the composite bond yield was over 7%; for the last several months it has been 4.8%.After you subtract out a 2% spread to cover the insurer’s costs, and cover the minimum guarantee, there simply isn’t much money left to cover commissions, premium bonuses, and provide index-linked interest. And based on the Treasury plan to buy bonds, yields could drop even lower in 2011. What this means is it will be much more difficult for producers to sell on rate, much more difficult to transfer the old annuity to a new carrier, and more sales and higher average sales will be needed to earn a living. Producers need to evolve to succeed.

    Sell Benefits, Not Rate If I earn $1000 in CD interest I will have to pay taxes on that interest, even if I don’t need use it. If that $1000 is in an annuity I decide whether to pay taxes this year or not. Owning an annuity means I control my taxes – not the IRS. 

    Educate Consumers An index annuity may only offer the potential for 3% to 5% interest, but financial decisions are always comparisons. If the consumer thinks it’s too low, ask them what else they would do. CD rates are 1% or less and there are investors that have not recovered from the last stock market crash. If the index annuity captures a 5% return in 2011 that is equal to 5 years of bank interest.

    Sell Safe Income, Not Growth The annuity story has always been about guarantees. You can tell the consumer exactly what premium is needed today to produce an income of $12000 a year tomorrow. The producer is talking to retirees that have witnessed the interest income from that $100,000 CD fall from $5000 to $750. Tell them you can guarantee them $5000 in income for a lifetime.

    Diversify In a world of uncertainty whole life insurance offers guarantees, which is why it is still around. Over half of retirees have set money aside to try to cover nursing home expenses – do they know about annuities with LTC benefits? In a low yield environment more consumers are tempted by investments, wouldn’t they be better served by a securities advisor that comes with a risk-transfer mindset rather than a risk-managed one? 

    Evolve Low bond yields could stay with us for years, but even if rates do begin to track back up the old annuity producer model is gone. There will be a winnowing of producers next year, but the producers that remain will do more business with a more diversified model that will result in long-term success.


     The (F)law of Small Numbers (11/10)
    A principle of insurance is the law of large numbers which says if you can determine the odds of an event occurring for one large group the odds will be darn near the same for another large similar group. For example, the odds of a typical 58 year old man dying before they turn 59 is 1% (www.ssa.gov/OACT/STATS/table4c6.html). If you had a random pool of 1 million age 58 males roughly 10,000 would be dead before their next birthday. An insurance company offering life policies to millions of people uses this law to help compute the premiums charged. But even though 1% of a million 58ters will die this year doesn’t mean that in a group of 100 age 58 males that 1 will die next year. Part of this can be due to the make up of the sample – a group of 100 alcoholic tightrope walkers should have more deaths than a group of 100 vegetarian actuaries. However, the other part is simply that the sample is too small – if no one in this group of 100 dies but 10,001 people die in next group of a million the overall death rate is still 1%.

    The problem is most people treat the results of a small sample as being as valid as a large sample. In statistical circles this is humorously referred to as the law of small numbers” because the joke is it isn’t a law and often leads to the wrong conclusions. Being aware of this problem enables us to make better decisions by realizing the limits of the data.

    An example of having too small a sample is the 5-year average return number reported in this issue. The average annualized 5-year return for the index annuities participating was 3.9%, but what does this really mean? Does it mean index annuities average 3.9% returns over time? No, these returns were for a period from September 2005 to September 2010 and one 5 year period is not representative of multiple time periods. Does it mean the average index annuity return over the last 5 years was 3.9%? No, there were 320 different product choices available and my survey includes only 36 results – again, too small a sample to be representative. 

    So, what do the results mean? They directly refute a contention that index annuities, as a class, can never best index fund returns because the results show that at least some index annuities produced higher returns. The results show that protection from market loss provided a greater financial benefit than reinvested dividends in this period. The results indicate that index annuities can produce returns even in periods where the index finishes lower than it started. A small sample size may not permit us to draw conclusions about the whole world, but it does let us draw conclusions relating to the sample.


    My Favorite Statistics Problem

    There is a fatal disease that affects 1 in 1000 people. The test to detect the disease has a false positive rate of 5% (5% of the time the test will say someone has the disease when they don’t). You have tested positive; what are the odds you have the disease?

    When they asked this of Harvard Medical School doctors half of them said if you tested positive the probability was 95% you had the disease, only 20% correctly said the answer was 2%.

    The way to see the correct answer is to count the people. If we have 1000 people only 1 has the disease. This means 999 don’t, but 5% (999 x 5%) or 50 people will test positive (I rounded up that 49.95 of a person). To figure the odds that you’re the 1 you add together the 1 that actually has the disease with the 50 false positives and divide by the real odds [1/(50+1) = 1.96%] which I rounded to 2%. Even testing positive there’s only a 2% chance you have the disease. This math problem makes two points. Your first “intuitive” stat answer may be wrong, and if your doctor says you have an incurable disease tell him to run the test again.

    How large a sample is needed to be meaningful? It depends. If the sample is completely random then as few as 20 data points can be meaningful. If you ask 20 randomly selected people “what is your favorite color?” and 12 people (60%) say “green” we can be very confident that in a much larger random group – say a million people – between 38% and 82% will also say green is their favorite color (60% plus or minus 22%). If we want to tighten the range in our confidence level we simply increase the size of the sample. For instance, if we asked 1000 people and 60% responded with “green” we would be confident that 57% to 63% of a million people would also say green. The reason we know these ranges is because they have been validated by years of testing (the reason the typical poll shows a percentage result “plus or minus 3%” is they typically survey roughly 1000 people). However, a 20 person survey answer with a range of 38% to 82% may be acceptable if our goal was to see whether more than 33% of people like green. If it is truly random a small sample can still be useful.

    The problem with many surveys is they aren’t random. An example is a web poll where anyone visiting the web site may vote – people that are passionate about a certain outcome are more likely to vote than regular folks, and so the results are skewed. Another might be where 9 out of 10 people told you that Insurer Y is the best carrier, but if 8 out of 10 people worked for that carrier then the results are suspect. And a common mistake I see are folks using mostly the bull markets of the ‘80s and ‘90s as a random example of stock market returns.

    A non-random base may be fine – if you’re trying to see if any index annuities beat index fund returns over the last 5 years then a survey sample of one may provide the answer, but if your goal is to determine the average return, you’d need to be able to pick returns from random annuities and not simply those that participated. To see whether the sample results are meaningful look at what’s being sampled, how big is the sample, and determine what the results really mean. The (f)law of small numbers can cause us to make bad decisions, but by looking beneath the headline we can see the real story.  


    RBC Sells Liberty Life (11/10)
    Athene Holding Ltd. is buying Liberty Life Insurance Co for $628.1 million. Athene’s core business is reinsuring fixed annuities and issuing GIC-backed notes and funding agreements and investing in a diversified portfolio of fixed income securities. When the deal closes (early 2011 estimate), Liberty Life will reinsure its life and health insurance business to  Protective Life Insurance Co. and a portion of its annuities to Athene.


    InSource and Ash Brokerage Merge/Futurity First Buys BHC  (9/10)
    Effective 1 September Ash Brokerage and Insource  merged to create Indianapolis based Ash InSource , LLC. Futurity First Financial Corporation acquired BHC Marketing Ltd (27 September).


    The Dow Jones Industrial Average Companies (9/10)


    June 1, 1959 -

    Allied Chemical   

    Aluminum Company of America  

    American Can 

    American Tel. & Tel.

    American Tobacco

    Anaconda Copper

    Bethlehem Steel 

    Chrysler

    Du Pont

    Eastman Kodak Company

     

    January 27, 2003 -

    3M Company

    Alcoa Incorporated

    Altria Group

    American Express

    AT&T

    Boeing Company

    Caterpillar Incorporated

    Citigroup Incorporated

    Coca-Cola Company

    DuPont 

     


    General Electric Company 

    General Foods  

    General Motors Corporation

    Goodyear

    International Harvester 

    International Nickel

    International Paper Company

    Johns-Manville

    Owens-Illinois Glass

    Procter & Gamble Company 

     

     

    Eastman Kodak Company

    Exxon Mobil Corporation

    General Electric Company

    General Motors Corporation

    Hewlett-Packard Company

    Home Depot Incorporated

    Honeywell International Inc.

    Intel Corporation

    International Business Machines

    International Paper Company

     

     

    Sears Roebuck & Company

    Standard Oil of California

    Standard Oil (NJ)

    Swift & Company

    Texaco Incorporated

    Union Carbide

    United Aircraft

    U.S. Steel

    Westinghouse Electric

    Woolworth

     

     

    J.P. Morgan Chase & Company

    Johnson & Johnson

    McDonald’s Corporation

    Merck & Company, Incorporated

    Microsoft Corporation

    Procter & Gamble Company

    SBC Communications Incorporated

    United Technologies Corporation

    Wal-Mart Stores Incorporated

    Walt Disney Company

    June 8, 2009 - Kraft replaced AIG, Travelers replaced Citigroup, Inc. and Cisco Systems, Inc. replaced General Motors Corp.

     

    3M Company

    Alcoa Incorporated

    American Express

    AT&T

    Bank of America Corporation

    Boeing Company

    Caterpillar Incorporated

    Chevron Corporation

    Cisco Systems, Inc. 

    Coca-Cola Company

     

    DuPont

    Exxon Mobil Corporation

    General Electric Company

    Hewlett-Packard Company

    Home Depot Incorporated

    Intel Corporation 

    International Business Machines

    Johnson & Johnson 

    J.P. Morgan Chase & Company

    Kraft Foods Inc.

     

    McDonald’s Corporation

    Merck & Company, Incorporated

    Microsoft Corporation

    Pfizer Incorporated

    Procter & Gamble Company 

    The Travelers Companies, Inc.

    United Technologies 

    Verizon Company

    Wal-Mart Stores Incorporated

    Walt Disney Company

     
    Aluminum Company (Alcoa), AT&T, DuPont, Proctor & Gamble, Standard (Exxon) have been in the Dow over 50 years General Electric since 1907 Green are new within last 12 months  Source - “
    Dow Jones Industrial Average Historical Components, Dow Jones & Company, Inc. 8 June 2009


    Limericks (5/09)  

    There was once an agent from Ames  
    That gave clients annuity gains  
    It isn’t his interest they said  
    That put them ahead  

    It t’was the risk of loss that he tames  

    As the bear market this way came rarin’  
    Annuity folks braced for business a blarin’  
    But as bond values flopped  
    And ratings were dropped  
    Those carrier shelves became barren  

    A calculating actuary from Gider  
    tried to create a new life income rider
    Of “joint life” he’d heard  
    But he added a third  
    And made the rider a little bit wider  

    A commissioner named Mary Shapiro  
    Tried to be the regulatory hero  
    She planned and she plotted  
    And was with power besotted  
    But we all know the fate of poor Nero  


    “We find that women are more likely to choose the annuity”* (5/09)
    There is sufficient research so that I believe women are more risk averse than men and less financially literate than men. Related studies show that consumers that are risk averse and less financially literate tend to buy more annuities. Professor Agnew led a study that badmouthed annuities in one case, badmouthed investments  in another, with neutral faming of both annuities and investments in a third. She found that when the choice was presented fairly, and both men and women had the same level of financial literacy and the same degree of risk aversion, that significantly more women chose the annuity. What this means is with everything equal women still focused more on the possibility of outliving resources and selected the annuity.

    When the investment was negatively framed only the men were more likely to choose the annuity – the percentage of women choosing the annuity option was essentially the same whether or not the investment was badmouthed. But when the annuity was negatively framed both men and women were less likely to choose the annuity.

    What could this mean for GLWB sellers? If you are trying to convince a man to buy an annuity, slamming the investment may make it more likely that the man buys the annuity. However, slamming the investment will have little effect on the woman. Women like the annuity story. Even after adjusting for risk tolerance and financial knowledge more women than men chose the annuity because of the benefit of not outliving their income. What this could mean is annuity and GLWB sales materials should place greater emphasis on the lifelong income payout and less on the income growth factor when marketing to women. Another sales opportunity exists in showing how an annuity GLWB may be used to offset the 50% reduction in Social Security income that often results from the death of the husband.

    *Agnew, J.. L. Anderson, J. Gerlach, L. Szykman. December 18, 2007. Who Chooses Annuities? An Experimental Investigation of the Role of Gender, Framing and Defaults. Working Paper.


    Senior Decision-Making Issues (5/09) 

    Historic Ways to Overcome Dementia
    The belief that mental powers decline with age is not a new one, nor is the argument over what causes it and what can be done to combat it. Cicero said it was due to laziness and argued stimulation would keep the brain fit. At roughly the same time as Roman Emperor Commodus reigned (180 A.D.) Galen said that in old age the body’s inner warmth grew colder leading to inner phlegm and unbalanced humors. This phlegm theory was generally accepted until the mid 1700s when Antonio Fracassini of Verona theorized that aging caused a hardening of the vessels to the brain and thus caused the decline.

    Schäfer, D. 2005. No old man ever forgot where he buried his treasure. Journal of the American Geriatrics Society. 53:2023–2027

    Seniors Look At Quantity Not Value
    Many studies find seniors tend to choose the product with the greatest number of benefits instead of the product with the greatest value, even if the benefits aren’t important to them. As an example, a senior that was strongly interested in having an annuity that waived surrender charges upon death would be more likely to choose an annuity that waived surrender charges for critical illness, nursing care needs and unemployment – and did not waive charges for death – over an annuity that only waived charges for death because three benefits are a bigger number than one. Seniors tend to ignore information on the importance of the benefits and make selection based on quantity of benefits.

    In a similar vein, in decisions where the odds are presented younger consumers tend to follow the odds and choose payoffs based on highest probability, by contrast seniors treat all choices as having equal probability even when the odds are presented. This could be the reason why seniors congregate at the slot machines instead of enjoying the better odds at the blackjack and craps tables, and why showing the highest, lowest and median hypothetical index annuity return deludes seniors into thinking they have a 1 in 3 chance of earning 12% a year forever.

    When Is There Elder Financial Abuse?According to 164 deputy district attorneys, senior law enforcement detectives, adult protective service workers, and public guardians and victims: 

    • There must be an emotionally or mentally vulnerable senior with assets  

    • Either the financial transactions are kept secret or the senior is controlled  

    • There was no independent determination made that the senior was able to act in their own best interest  

    • The benefit received was not proportionate to the assets transferred  

    • The transactions are not in writing, are poorly disclosed and represent a conflict of interest  

    If all of these are in place then there is elder abuse.  

    Kemp, B. L. Mosqueda. 2005. Elder financial abuse: An evaluation framework and supporting evidence. Journal of the American Geriatrics Society. 53.7:1123-1127  

    No Evidence That An Active Brain Remains Young  
    It is widely assumed that keeping mentally active will prevent or at least slow mental decline. The problem is there is a lack of evidence supporting this contention. A 2006 study concluded that, “there is currently little scientific evidence that [engaging] in mentally stimulating activities alters the rate of mental aging” and that the “mental-exercise hypothesis is more of an optimistic hope than an empirical reality.” The study does not prove keeping mentally active does not work, it says that it cannot find direct results that say it does work. The author also says that keeping mentally active will not hurt you, should contribute to quality of life, and that future research may be more supportive.

    Salthouse. T. 2006. Mental exercise and mental aging: Evaluating the validity of the ‘‘use it or lose It’’ hypothesis. Perspective On Psychological Science. 1:68-87


    Annuity Financial Crunch Is Happening On Schedule (4/09)
    One year ago S&P 500 volatility, as measured by the VIX index, was in the low 20s. This was roughly double where it had been in the spring of 2007 – reflecting concern of how subprime mortgage troubles would affect the market – and indicating short-term option prices had gone up. But it still meant index annuity carriers were able to buy longer term options, albeit more expensive ones, and offer somewhat competitive cap or asset fee index-linked crediting. This spring the VIX has hovered in the 40s – a point only reached during the worst of the millennium bear market. This hints that option seller concerns over future exposure have essentially stopped them from offering any big potential payoffs in index-linked interest, but carriers are still able to offer competitive capped yields. Index annuity carriers found a way to deal with the option side of the annuity contract and still offer product.

    It is a different story with portfolio yields. From 2004 thru 2007 the spread between 10 year Treasuries and Baa Corporate Bonds was around 2%. Since 2009 began the spread has hovered around 5½%, meaning in mid March the yield on a lower range investment grade corporate bond was 8.4% while the Treasury yield was 2.9% - a spread about 1.5% higher than during the worse of the last recession. Aaa corporate yields averaged 5.4% representing a 2.5% spread – which is as bad as this rating class got at the worst of the millennium recession.

    Rating cuts and trying to reduce annuity sales are neither new nor unique elements

    An investment grade portfolio made up of half Aaa and half Baa yielded just under 7% in mid March, the best springtime yield since 2002, providing enough yield to make index annuities work. However, the problem is the reason the yield is so high is because bond prices have fallen and the market is betting on more rating downgrades, and therein lays the rub.Even the carriers that did not buy subprime mortgage bonds are getting caught by the backlash questioning the strength of all bonds in a scary recession. Less than stellar rated bonds are demanding higher yields to compensate for perceived higher default risk, which is translating into lower bond prices. Unless carriers owned only U.S. Treasuries and AAA corporate paper – a low yield portfolio strategy – they are writing down the value of their bond portfolio, and these write-downs result in lower stated capital. 

    Carriers need to set aside reserves to cover the present value of future benefits. This means the reserves must never be less than 100% of the cash surrender value of the annuity and could be several percent more. If you are taking write-downs on the assets that are backing the annuity business already on the books you now have less capital supporting this business; so carrier ratings may well be lowered. Even if you have survived thus far, both carriers and carrier rating agencies are concerned that a worsening recession may cause write-downs of bonds that are okay today, or further write-downs of bonds already being carried at reduced value. In addition, it is proving more difficult to bring in new capital to beef up the balance sheet, so if you need additional funds to increase capital the money may not be available. Because of this, many carriers are limiting the amount of business they will accept and are trying to do this by offering less competitive rates or reducing distribution.

    This situation is not unique. In the last recession index annuity carriers were forced to limit sales. Most chose to do this by making their products  less competitive, but a few simply quit accepting new business for awhile. Last summer I wrote a blurb titled “Will “B+” Be The New “A” predicting future rating cuts atannuity carriers and it is happening as forecast. When will it get better? When the people believe the recession is ending and the financial climate won’t get worse. My guess is the fourth quarter will look much rosier than today.


    The Great Depression & Index Annuities (4/09)
    The Dow Jones Industrial Average ended August 1929 at 380.3 – a monthly close it would not exceed until November 1954 over a quarter century later. By June 1932 the Dow was at 42.8 – down 89% from three summers prior. Altho there have been a lot of media folks comparing today’s stock market with the Great Depression I doubt that our current crisis will push the Dow down to 1575 by Flag Day in 2011. But all of this talk does makes me wonder how an index annuity approach would have coped with the Crash of ’29.

    My question was what would the annualized 5-year returns have been if I could have bought an annual reset index annuity every month beginning in August 1929 for the next five years. What I’m doing is buying an index annuity in August 1929 and seeing what the annualized return would have been over the five year period ending August 1934. I then buy one in September 1929, October 1929, and so on with a final purchase in August 1934. So, the first five year period ends in August 1934 and the last one ends August 1939. What I’m trying to see are the range of returns if you had been brave enough (or smart enough) to go for an equity index-linked return during the worst ever stock market period in America’s history.

    The 1930s  
    It was a horrendous times for investors. Even tho the market rallied back from its 1932 low of 42.8 to close at 187 by February 1937, its 1937 high was still less than half of where it had been in the summer of 1929. Adding insult to injury, the Dow then gave back roughly half of these partial gains by 1938.

    The Hypothetical Results  
    During the five years ending August 1934 the Dow lost 75% of its value, by contrast the 30% participation rate method would have produced an annualized return of 2.3%, and the 8% cap method’s return was 1.6% for this first 5-year period. Over the 1930s annualized 5-year returns for the 30% method ranged from 1.8% to 10.8%; the cap method return range was 1.5% to 6.5%. If you could have purchased one of each every month beginning in August 1929 your average annual index annuity return over the Great Depression would have been 6.4% for the 30% rate method and 3.9% for the 8% cap method. All of this during a decade that ended 65% lower than where it began.  

    This was an exercise. These results do not show what index annuities would have done in the Great Depression nor are they a prediction of future returns in the current financial climate. However, I believe they do illustrate that even if the future has lousy financial markets that the index annuity concept has the potential to provide competitive returns.  


    Is it Better To Be Saved By Luck Or Killed By Knowledge? (12/08)
    I have talked with hundreds of producers that have told me the way they present index annuities to the consumer is by saying potential losses make owning stocks and mutual funds too risky, which is why the consumer should move to index annuities. The problem is this was usually a personal opinion presented as fact, and as such, it drove financial advisors nuts. Many advisors have conducted extensive research on the market performing thousands of stochastic (means random) Monte Carlo simulations (also known as Vegas Roulette Spins) where past periods are presented in different future patterns and the probabilities assessed. Based on these statistical measures these planners and other securities experts knew that the probability of a massive loss was almost nonexistent and therefore could generally be ignored.

    Because avoiding almost certain stock market losses is a good sales story some consumers were persuaded by annuity producers to move money from investments into index annuities where they have avoided loss. Based on these documented statistical measures many investment advisors kept a significant portion of consumer portfolios in the stock market where they may well have lost a third or more of their client’s money since the first of the year. There were two wrongs here. The first one is that opinion should be presented as opinion and not as fact. A key reason for the regulator attention to index annuities is when the securities people complained about losing assets to index annuities the securities regulators were able to find several cases where annuity producers acted as if they were giving investment advice and not personal opinion, without being registered to do so. The first amendment should allow a producer to say, “I feel the stock market is too risky and this is why I like fixed annuities,” but it may be securities advice to say, “my research shows the stock market is too risky.”

    The second greater wrong was the arrogant presumption by the securities folks that they thought they could predict the future. I believe the securities world relies too heavily on a frequentist statistical approach (assumes one can objectively predict the correct odds of an event occurring). What this meant was because the current financial meltdown was statistically improbable it was mostly ignored. The planners used their flawed, but well documented logic to show the regulators that annuity producers were making unfounded statements about stock market risk and should be silenced, and one result is the SEC is presently examining the whole index annuity question at least partly based on the securities industry saying that annuity producers were lying to consumers by saying stocks and mutual funds were too risky.

    The securities world was wrong because they relied too heavily on frequentist statistical theory and did not optimally combine that with a Bayesian statistical approach (where probability is subjective and open to personal interpretation). The argument behind a Bayesian approach is that relying too heavily on historical data may provide a more misleading picture than trying to use informed guesses reflecting beliefs about the current financial environment. This Bayesian view is well expressed in Gary Smith’s paper, The Next Best Thing to Knowing Someone Who is Usually Right” where he says “the fact that, over the last 80 years, long-term Treasury bonds have yielded an average of 5% and stocks 10% is not a persuasive reason for assuming that the expected values of the returns on bonds and stocks during the coming year are 5% and 10%.” Unfortunately, the securities world and the SEC did accept that logic. 

    The annuity producers were right because they were lucky (and this could mean that annuity producers were not lucky but are unknowingly followers of Bayesian probability). In the future, annuity producers need to generally do a better job of ensuring the consumer understands when a personal opinion is expressed, and securities folks need to realize that the prospectus language “past performance does not predict future results” is there for a reason.


    The Financial Meltdown: Causes & Corrections (12/08)
    The comic strip Pogo many years ago said, “we have met the enemy and he is us” and that pretty much summarizes the findings of a World Bank study (WPS4757) looking at causes of the current financial meltdown. The problem was triggered by “manifest failure of respected statistical models for assessing and pricing credit risk.” It wasn’t mainly caused by greed, or by the failing of a few banks, instead “the principal source of financial instability lies in contradictory political and bureaucratic incentives that undermine the effectiveness of financial regulation and supervision in every country in the world”.

    The study says when Congress deregulated the financial markets financial institutions spent their time looking for loopholes that would escape any regulatory oversight, and created off-balance sheet global securities to avoid scrutiny. When the problem was eventually discovered the Federal Reserve and foreign treasuries at first threw money at the banks and kept the bubble expanding, rather than forcing writedowns that would have hurt, but not nearly as much as the present wounds, “the SEC and banking supervisors refused to take on the political and practical challenge of establishing and maintaining their ability to see and to discipline these complicated and outsized risk exposures.” This lack of oversight was combined with a system that penalized people that tried to ensure, or even question, that the people backing the financial promises – on any level – had enough money to cover their obligations.

    Altho most of the blame is placed on regulators, the study says credit rating organizations must be criticized for missing so many downgrades and defaults. The study points up the inherent conflict in the rating system in that the issuers getting the ratings are the ones paying the raters. A suggested solution is the raters would pay independent parties to rate the rater’s ratings and assess penalties if required.

    How to avoid this in the future?
    Banks & Bond Issuers: Compensation must be linked to long-term performance rather than to short-term profits. Relevant information must be given to investors to make it truly transparent so they can see what they are really buying.

    Regulators: Set up strong incentives for supervision and make regulators accountable for not keeping on top of it all. Monitor the credit-rating agencies and hold them accountable for bad ratings.

    Politicians: Have regulators establish and regularly test a well-publicized benchmark plan for crisis resolution so that crisis-management decisions can be made in an open debate outside of an actual crisis. Ensure government money in a crisis is only available to the stronger entities that will survive and lead the recovery, rather than bailing out incompetent companies for political reasons. The study also notes that the world has endured hundreds of financial meltdowns in the past and one element is constant – we never learn from our past mistakes.


    Guaranty Associations (10/08)
    were created by state legislatures to protect life, annuity and health insurance policyholders and beneficiaries of an insolvent insurance company. All insurance companies licensed to write life or health insurance or annuities in a state are required, as a condition of doing business in the state, to be members of the guaranty association. If a member company becomes insolvent, money to continue coverage or pay claims is obtained through assessments of other insurance companies writing the same kinds of insurance as the insolvent company. 

    What They Cover (Fixed Annuity related)
    They do not cover any portion of a policy in which investment risk is borne by the individual, and they may or may not cover guaranteed investment contracts (a/k/a GICs) or unallocated annuity contracts purchased by retirement plans as a funding vehicle for participants. Every state (plus Puerto Rico) provides $100,000 in withdrawal and guaranteed cash values for all other annuities (California: 80% of the present value up to a maximum of $100,000). Thirteen states (and one District) have higher limits: [as of October 2008]

    • $100,000 ($250,000 IRA) in Virginia
    • $130,000 (adjusted for inflation) in Minnesota
    • $200,000 in Utah
    • $250,000 in Iowa
    • $300,000 in Arkansas, DC, North Carolina, Oklahoma, Pennsylvania, South Carolina and Wisconsin
    • $500,000 in Connecticut, New York and Washington.

    Guaranty associations limit protection to residents of their own state. You are covered if the failed insurer was licensed in your state of residence. Policyholders who reside in states where the insolvent insurer was not licensed are covered, in most cases, by the guaranty association of the insolvent insurer’s state of domicile. Altho believed accurate this information is not warranted, individuals should contact their state insurance department for their own situation.

    If The Insurance Company Fails
    Insurance companies are regulated by the state governments of the individual states where they are licensed. When a state determines that an
    insurer is insolvent, and there is a shortfall of funds needed to meet the obligations to policyholders, the remaining member insurers doing business in a particular state are assessed a share of the amount required to meet the claims of resident policyholders. The amount member insurers are assessed is based on the amount of premiums they collect in that state on the kind of business for which benefits are required. If the insolvency affects three or more states the National Organization of Life and Health Insurance Guaranty Associations becomes involved. NOLHGA coordinates the development of a plan to protect policyholders. 

    "every holder of a covered...annuity...policy who has made the required premium payments has been given the opportunity to have the policy assumed by another healthy carrier or had the covered portions of their policies fulfilled by their guaranty association itself"  www.nolhga.com/insolvencycorner/main.cfm/location/fundamentals

    My research indicates that in the last twenty five years there were only 5 failed carriers that did not provide all of the annuity value for all of their annuity customers. There may be other carriers out there that have not returned a 100 cents on the annuity dollar, but I can’t find them.

    No index annuity owner has ever lost money because the insurer failed.  

    How Safe Is My Annuity?
    Annuity guaranteed values up to state guaranty funds limits have been protected when an insurer fails, altho it can take time, often years, before the values are paid out. Every state guaranty fund covered at least $100,000 of cash value in the event of carrier insolvency.


    It’s A Time For Calming Consumers (10/08)  
    My safemoneyplaces.com site lets consumers ask Safe Money Sue & Sam financial questions and usually gets one question a week; now it’s getting thirty. The current topic is how safe are their savings.
    The main question is “are my accounts FDIC insured.” Consumers seem to be confused about what is covered by FDIC. People ask whether credit notes, money market mutual funds, and 401(k) plans are FDIC insured. The answer is no, it must be a deposit of a bank to be eligible. Scarier to me are questions from consumers telling me they have X dollars in checking and Y dollars in savings and saying their bank told them they were fully FDIC insured. In the last situation I looked at $140,000 of the consumer’s money appeared to be FDIC insured because of sloppy account titling. I am not getting many questions about fixed annuity safety, even after the recent AIG news, but I believe this is because consumers have not yet reached the annuity line on their worry checklist. Wall Street woes and failing banks are not a good thing for annuities. Altho it might seem attractive to pitch annuities as an island of safety standing apart from the mainland crisis, most consumers will figure out that annuities are really a peninsula rather than an island, because they are still a part – albeit a more protected one – of the same financial mainland and thus could also fail. In times like these consumers need to be reassured that the entire system will be restored. This mean not bashing investments or banks, but reminding people about the safety of fixed annuities.

    • I'm reminding people that we survived 2900 banks closing during to the Savings & Loan Crisis of 20 years ago  as well as the loss of Executive Life & Mutual Benefit (and none of their annuity customers lost a dime of principal if they didn't bail)  and to take a deep breath and keep selling strong annuity carriers. 

    • Direct consumers to the NAIC web site where NAIC President Sandy Praeger said "The federal bailout of the non-insurance portions of AIG does not negatively change the solvency strength of its insurance subsidiaries. The key distinction here is that AIG’s insurance subsidiaries did not cause this crisis, rather, they will play a critical role in the solution." 

    • The reality is both life insurance and annuities are attractive assets because the surrender charges allow the carrier to maintain policy liquidity by regulating outflow, and if the parent gets in trouble the carrier life/annuity companies are purchased for their assets, or the policy blocs themselves are purchased. As an example, when Metropolitan Mortgage got into trouble annuity policies of two of the annuity subsidiary carriers were purchased by GALIC, while Western United was eventually purchased in whole by another company and is still functioning.

    • The exposure in an index annuity for the typical insurance company is the cost for the option link  a set and predetermined cost. If you had a dollar, made 6 cents interest and spent the 6 cents to buy an option on the index, and the index went down 20% what is your maximum loss? 6 cents. How much do you still have? $1

    These are tough times but annuities have survived many tough periods before because annuity carriers buy very few stocks, junk bonds, and real estate; because annuities are required to set aside additional reserves in addition to the premium paid in; and even tho some annuity carriers have failed in the past, it is worth remembering that every annuityowner was protected up to state guaranty fund limits. Tell your clients to take a deep breath. We will survive this crisis too.


    Easy To Predict (04/08)
    Last month The New York Times used the “D” word in a story titled “Depression You Say? Check Those Safety Nets” showing that concerns over this turn of the economic cycle had reached panic levels among reporters looking for a catchy headline. Keeping in mind that my rough research of Wall Street economists finds their predictions are wrong 80% of the time, and that I cannot claim a better accuracy rate, I still wanted to opine on what I see as cycle realities.

    It was easy to see coming
    In August 2005 I wrote that a bear market and recession were coming. I said this would happen by the end of 2006 (not counting on the effects of blind greed and the greater fool theory delaying the start for another year). Part of my concern was interest rates had remained too low in the recovery. The Federal Reserve Board, still fighting the last inflation war, didn’t seem to realize that altho low interest costs might keep corporate borrowing costs low and therefore corporate prices low, it also kept monthly payments too low. American homebuyers do not understand actual value they understand monthly payments, and low interest rates made it possible to pay more and more for the same low value without needing to accept that fact that this was dumb. Financial experts helped by creating new mortgage types that further distorted the value relationship. And the mortgage companies expanded the number of buyers able to buy real estate by not requiring homebuyers to have any skin in the game. Essentially the real estate market turned into a huge poker game where some of the gamblers kept bidding up the size of the pots with the knowledge that if they were lucky they could keep the winnings, but if they lost they wouldn’t be responsible for the losses.

    The financial firms blithely ignored the reality that many of the mortgages were worthless because they were paid based on the number of mortgages written and not the ultimate quality. They created instruments that passed along the risk to others, but then failed to evaluate whether the buyers of this risk had the wherewithal to cover the risk. A reason for this oversight is they made themselves believe the financial quants 99% rule. The 99% rule essentially says if a possible outcome is more than four standard deviations from the average outcome it can be ignored. Since the likelihood of a liquidity crunch caused by bad mortgages was 25 standard deviations away from the expected outcome (Index Compendium Sep 07) it was treated as an impossibility. The shell game was Company A sold the default risk on a package of mortgage bonds to Company B and Company B would be responsible for paying off in case of a default. However, because the risk of default was so low – the 99% rule – no one required Company B to actually have the money to cover the risk. Since the default couldn’t happen, based on the computer models supporting the 99% rule, Company C gladly lent money to Company B to pay for this risk. Of course if a default did happen Company B would not be able to payback the loans to Company C or cover the original mortgage investors in Company A. Good bye Bear Sterns.

    Inflation
    The other part of my concern was the effects of $60 a barrel oil (in 2005) on the economy and the deficit spending in Washington (an aspect that is still being more or less ignored). The Consumer Price Index calculates that offering a 25” TV next year for the same price as a “24” inch TV this year offsets the inflationary impact of the price of bread going from $1.50 to $2 a loaf and results in net inflation of zero. The screwy way that changes in the CPI are deduced meant the Fed was able to delude itself that what they were doing was working and inflation was low. In reality, costs on real consumer goods were soaring. 

    The Economist uses the Big Mac index to compare international prices; I use the Taco Bell indicator. In 2003 you could buy a bean burrito from the Taco Bell value menu for 99 cents. By 2004 the value menu had been revamped with the 99 cent bean burrito replaced by this really gnarly 99 cent bean & rice burrito. The nearest edible food was a new combo burrito for $1.19. Price of the new combo burrito increased to $1.39 in 2006 and $1.59 in 2007. The bottom line is five years ago I could get my Taco Bell lunch for $2.10 with tax and today it costs $3.37 – a 60% increase or an annualized inflation rate of 10% a year. It is not only Taco Bell prices that are up. The average family has seen their monthly gasoline bill increase 140% during this time impacting all aspects of their life, and food prices have soared due to poor global wheat harvests and a politician-driven policy on gasohol. Rising prices and recession fears have caused some reporters to dust off old articles on stagflation from the ‘70s. 

    And annuity markets?
    One nice thing about being retired is you don’t have to worry about losing your job. However, recessionary fears cause stock markets to swoon meaning the retirement nest egg gets smaller, and efforts to lower interest rates mean that the interest earned from certificates of deposit and money market accounts drops. Inflation means the cost of staples are going up whilst income is going down. All of this creates a positive environment for fixed annuity sales.
    Falling rates means that fixed annuity rates and index annuity caps will continue to fall. The good news is bank rates will fall farther and faster. The 5% fixed rate or 7% index cap that is meeting some sales resistance today will turn into fast selling 4% fixed and 6% cap rates six months from now because CD rates will be at 2%. The sales environment for fixed annuities will steadily improve.

    Safety
    Northern Rock was a British mortgage lender that got into trouble in 2007. By early 2008 the Bank of England had dumped $108 billion in loans and guarantees to Northern Rock. FDIC has $52 billion on hand. It is interesting to note that the failure of one bank caused British regulators to kick in more than double what FDIC has on hand to cover $4.35 trillion of deposits.Commercial banks originated and purchased mortgage packages and I think we will see several bank failures as a result. I also believe that FDIC coverage will be provided for all covered deposits (tho uncovered deposits in failed banks will get back less than a hundred cents on the dollar).

    I have only looked at the balance sheets of a few annuity carriers; some own suspect mortgage loans and some do not. I would not be surprised to see an annuity carrier fail as the mortgage crisis fallout continues. However, it is important to remember that insurance carriers look at the financial world in a different way. Most of the financial world seems to use that 99% rule where if the risk is less than 1% it is ignored. By contrast insurance carriers are trained to look for hidden risk and act accordingly. Insurers do not ignore 1% risks they target them and hedge to cover the risk. This is why I believe fixed annuity carriers will generally weather this financial storm better than banks. FDIC can borrow all the money they need from the Treasury, so if a bank fails the insured deposits should be available the next day. State Guaranty Funds are funded in arrears meaning that after an annuity carrier fails other carriers are asked for any needed money. This means that even tho an annuity covered by a Guaranty Fund would eventually be paid in full the entire annuity balance may not be immediately available.

    Crystal Ball
    I think this will be a nastier recession than the last two and that the stock market still has some way to fall (but the fall won’t be as bad as the millennium bear market). I think interest rates will drop in 2007 and then go up because this time there really is price inflation. I also believe fixed annuity sales will increase as bank rates fall and consumers get out of stock market investments and look for a safer place to put their money (however, it probably makes sense to diversify annuities between carriers). All in all 2008 and 2009 will be tough years, but the cycle will turn once again.


    Can Seniors Make Wise Decisions  II (3/08)
    Last summer I looked at research on aging to see whether there was any consensus that the decision-making capabilities of seniors decline as they age. At the time I said the results of the research were contradictory. However, a research article published last December prompted me to take another look at the topic of aging and decision making because the article proclaimed that 35% of the older adults in the study were mentally impaired due to aging and provided evidence that they made bad decisions7. The University of Iowa study went on to say that their research shows why a sizable portion of seniors fall victim to fraudulent advertising, and posit this could explain why seniors are often victims of fraud in general.

    Are 35% of Seniors mentally impaired? 

    The claims of the Iowa study are so specific that I went back and looked at over 50 additional academic journal studies on aging and cognition published thru the end of 2007 to see whether the view that many seniors are impaired was supported or contradicted by other research. My article begins with a look at the Iowa study, and then compares their results with other research.

    Background
    The dominant view in gerontology says that neural tissue in the frontal lobe or, to be specific, the ventromedial prefontal cortices (which is the part of the brain on top of and slightly back from the eyebrows)  is more likely to be damaged by
    aging1. This frontal lobe hypothesis has many supporters with these researchers saying that premature frontal lobe aging is probably why some seniors make bad decisions, because the frontal lobe supports the working memory that contains all of the current data we are comparing, and if it is on the fritz we are doing an incomplete job of thinking thru all the possible outcomes and will wind up making lousy decisions1.

    The Iowa Study
    To measure this hypothesis the researchers used a test called the Iowa Gambling Task (IGT) to see whether a person’s decision-making was up to snuff.
    The Iowa study had 40 young adults (age 26-55) and 40 old adults (56-85) take this test. It found that 37 of the 40 young adult subjects eventually wound up choosing solutions that maximized long-term rewards. However, of the 40 older adults only 15 were “unimpaired” in that they strongly made decisions to lower long-term punishment, and 14 older adults were “impaired” in that they continued to make decisions to maximize immediate rewards even though the long-term punishment was higher; the remainder of the older adults produced mixed signals.
    Another part of the Iowa study took the 15 unimpaired and 14 impaired older adults from the IGT study and had them examine ads that were viewed as deceptive by the FTC. An example was a luggage ad talking about “American Quality Luggage.” Because the ad did not specifically say, “made in U.S.A.” the unimpaired adults were more cautious about the “American Quality” claim, while the impaired adults did not have the same red flag mentally flip up and did not think to question where in America the luggage was made. In fact, the luggage was made in Mexico. The authors concluded, “From a public policy perspective, our research has immediate implications for the voluntary and regulatory control of advertising.”

    What could the IGT studies mean?
    If it is true that 35% of older adults may suffer from impaired decision-making without displaying any clear outward signs of impairment, the impact could be enormous. Older adults are making life and death decisions about their own medical care, and protecting their beneficiaries and themselves from financial risk. If these findings are supported that one out of three people over age 55 are decision impaired, what do we as a society do? The necessary fix would be far greater than banning lunch seminars.

    Should older adults be subjected to mandated decision-making tests every so many years, and if found impaired should the court then order a conservator to make all meaningful decisions for the impaired adult? 

    Other Views
    There are studies that specifically debate the very validity of the Iowa Gambling Task in determining impairment
    8 or say the interpretations of the findings are fundamentally flawed6. It should also be strongly noted that this was only one study involving only 14 “impaired” people, for me this raises concerns that the sample size is too small to accept the findings without comment. This does not mean that I dismiss the findings. Rather than accepting or rejecting the Iowa study results I looked to see whether alternative aging theories provided alternative explanations.

    Changing Goals Change Our Decisions
    There have been numerous studies that conclude our working or short-term memory gets worse as old age progresses
    15. A part of the socioemotional selectivity theory of aging says our goals change as we realize death is nearing and we shift from seeking knowledge to deriving meaning from life and ensuring good feelings11.
    Because of this, emotions become more important in processing information and seniors use more emotional cues to enhance memory rather than factual details.   

    In a 2005 study seniors were less likely to remember whether the hot food was on the left or the right, or whether the car in the picture was red or blue, but they were just as likely as young adults to remember which food was rotten and which car was dangerous11 (and they were just as likely as young adults to remember if the price of a can of soup was higher today than last time5). Seniors were remembering what was important to them – the value of the knowledge that could impact them rather than the minutiae (perhaps the reason seniors sometimes do not remember specific annuity surrender charges is because they have no intention of surrendering the annuity and so these charges are perceived as irrelevant and therefore forgotten). This theory indicates that the decision-making process does not necessarily become impaired as we age, but transforms into a process that intentionally becomes more driven by the emotional context of the decision rather than the simple facts. It is not “impaired” decision-making but rather “appropriate” decision-making based on the senior’s needs and goals. Socioemotional selectivity theory may offer an alternative explanation for some of the Iowa study results and help explain why some seniors do not get overly concerned about the origin of the Mexican luggage. 

    Less Deliberation But....
    A 2007 article pointedly asked the question “Are older adults’ decisions abilities fundamentally compromised by age-related cognitive decline?” The author’s conclusion was yes. Essentially, their research echoed the results of similar studies by finding that seniors tend to seek less information before making a decision and rely more on mental rules of thumb using past decisions as a guide to future decisions
    10. The “however” in all this is that often this is enough information and brain power to make a good decision. A 2006 study agreed that seniors do not dig as deep as young adults when getting data for the decision, but found the magnitude of errors was the same for both groups12.
    The authors said while young adults do better on cognitive tests they do not perform better than seniors when confronted with real life problems. As an example, seniors were more accurate than young adults in coming up with the best answers for complex financial planning problems12.

    Multitasking & Too Much Info
    Altho studies show that multitasking hurts decision-making accuracy for both young and old the inaccuracy of seniors whilst multitasking is greater
    15. What this means is while everyone can suffer from the negative effects of too much information seniors are more likely to make decision errors when they have too many choices and too much information is given13. One way to cut down on decision errors is to use distinct symbols for the values of the decision components13.

    Declines Are Compensated For
    Many studies say seniors do process information more slowly than young adults; however, some argue that the loss of speed is traded for greater accuracy
    1. Seniors use their lifetime experience and concentrate on the decision at hand – rather than trying to multitask – to reach decisions that are every bit as good as young adults. A 2000 study said that altho senior responses took longer the ultimate responses were as accurate as the responses of young adults, so it could be possible that as front brain neurons become impaired other parts of the brain are use to compensate. These results appear to largely contradict the findings of the Iowa study, but the scope of these studies were sufficiently different to make direct comparisons difficult.

    Conclusions
    A long list of studies says judgment and knowledge are relatively spared in the aging mind
    4. Essentially, these studies conclude that if the data is presented in a clear manner, and the senior is given enough time to make a decision, they will make a good decision. By contrast, the frontal lobe hypothesis school might say this is only true for those seniors that do not have impairment – for impaired seniors all the time in the world will not help.

    Altho there are other studies that offer alternative explanations to the conclusion reached by the Iowa study they in no way invalidate the Iowa findings. It is likely that more “normal” seniors than young adults have impaired decision-making powers. What is the extent of this impairment, and whether it is treatable with drug therapy or perhaps with a form of decision-making training, will require a lot more research. It should be noted that the Iowa study did not attempt to reduce impairment. However, there are things that can be done to help seniors (and everyone else) in making better decisions.  

    Much of the research concerning aging and decision-making has been to determine whether aging worsen these skills. After conducting this new research I believe that decision-making powers probably do get worse for some otherwise normal seniors. More research is needed on both the magnitude and timing of age impaired decision-making as well as developing ways to cope with the impairment.


    Can Seniors Make Wise Decisions? I (8/07)
    In the 46 years since the U.S. Senate established the Special Committee on Aging there have been many regulations proposed and passed by both Congress and various state legislatures designed to protect senior citizens. Recent attention has focused on how insurance agents interact with seniors, with this attention ranging from banning the use of designations if they contain the “s” word to requiring that insurance transactions with seniors follow more restrictive rules than would be required for other consumer segments.It should be noted that these senior protection regulations would not offer new protection to consumers with Alzheimer's disease or dementia, or some other condition that may in and of itself make any legal contract voidable – contracts made by adults viewed as legally incompetent are not enforceable. Instead, it appears the legislators are saying that the decision-making capabilities of senior citizens in the insurance and annuity realm are not as good as younger citizens and therefore additional mandated protection is required.

    Who is a senior citizen? Although the U.S. Senate Committee on Aging describes senior citizens as anyone age 60 or older, most of the state regulatory acts and proposals  seem to define a senior as a citizen age 65 and beyond. The various studies on aging and decision-making I read used “old age” subject groups from as low as age 50 to as high as age 82. Based on my research any attempt to define a “senior citizen” by coming up with a stated age is entirely arbitrary because people age differently. The decision-making capabilities of the average 55 year old appear to be very similar to the average 70 year, and a specific 55 year old may have much worse mental acuity than a specific 85 year old. I use the word “senior” in this article to describe one that is older than middle-aged, and I will leave it to the lawmakers and scientists to decide the magic age at which a citizen become old.The question this article attempts to address is: 

    Has the decision-making capability of senior citizens, however defined, declined to such an extent that they need to be protected as a separate class? My research involved a review of over 40 peer-reviewed articles that discussed or tested the effects of aging on decision-making. Unfortunately, the articles revealed conflicting views of the decision-making capabilities of seniors.

    Decision-Making Overall
    A 1998 study found that seniors made equivalent risk-taking decisions to those of young adults
    1. A 2005 article found “older adults’ decision behavior is similar to young adults, contrary to the notion that economic decision making is impaired with age”2. On the other hand, a 1999 study said seniors’ decision-making was similar to young adults with frontal-lobe brain damage3. Indeed, a 2000 study said the decline in decision-making ability started at age 50 and steadily increased4. Another 2005 study punted by saying although the ventromedial brain sector (which supports reasoning and decision-making), may undergo disproportionate aging in some older persons, the overall empirical evidence is decidedly mixed5.

    I found everyone agreed that aging negatively impacted mental powers to some extent. After a certain point memory skills slide, and the older you get the more likely you are to rely on mental shortcuts to reach a decision rather than examining the problem anew (if a senior is facing a complicated decision they are more likely to apply the results of a similar previous decision to the new one, rather than decide based solely on the circumstances of the new situation). However, there was disagreement as to whether aging caused the average senior to make worse economic decisions than young adults.

    Knowledge & Emotions
    Seniors  know more than young adults, but perhaps even more importantly, seniors know what they know and don’t know – seniors are much more willing to admit when they don’t know something than young adults
    2. Seniors are also affected more deeply by positive emotions in
    decision-making.Several studies said seniors spend more time trying to feel emotionally good and tend to block out negative emotions, and if  negative information is received, seniors disproportionately forget it 6. Although the stereotype of seniors is often the complaining curmudgeon, seniors are more likely to be in a good mood more often than young adults, and seniors work hard to keep themselves in a positive frame of mind7. They are more affected by appeals to emotion than logic and react positively when asked to recount life experiences. And although all people are subject to vividness bias – whereby we react more to the brightest color, biggest number, loudest noise – seniors are more susceptable to this bias6. There are numerous implications to the annuity world if these findings hold up:

    • Showing a picture of a smiling annuity owner of the annuity being pitched should be much more effective than loading up the laptop with pie chart slides. Seniors react to “feel good” messages more strongly than cold facts.

    • If you are trying to get a senior in a better mood asking the senior to recount some aspect of their past will usually do the trick.

    • If you ask seniors whether they understand something they are more likely to tell you yes or no – and mean it – whereas a young adult may try to bluff instead of admitting they don’t know. Therefore the agent needs to frequently check how well the senior understands what is being presented.

    • Seniors are more attracted to the most vivid data, as opposed to the best data, in making a decision. If the proposed annuity rate is shown in orange and the competitor’s rate is shown in light gray the proposed rate should make more of an impact, even if it is lower.

    • Carriers and agents need to place additional emphasis on the negative aspects of the annuity offered because seniors tend to ignore negative data and try to forget it. When I read senior complaints about the annuity purchased they often claim they were unaware of the surrender penalties when they bought, even though the senior signed disclosures at time of purchase stating these penalties . Based on the research it is possible that any discussion of surrender penalties by the agent is ignored, and even if the senior understands the consequence of the penalties at purchase that the senior works to forget this negative information. What this may mean is carriers and agents need to spend more time covering surrender penalties with seniors, and perhaps increasing the prominence of the surrender penalties, and any other negative facts, on sales materials and disclosures.

    Decision Time  
    Several studies have found seniors deliberate for less time, look at fewer facts, and tend to replay the same decisions they made earlier in life in similar circumstances
    7. All of this could lead to seniors making bad decisions. However, a recent study has found that when seniors are given more time to study and remember new data that they perform as well as young adults8.
    The study says if seniors are not pressured and not rushed they tend to make decisions as well as anyone else. In addition, if given the deliberation time needed, seniors do not tend to be more risk-averse or conservative than young adults3.  

    Conclusion  
    Do the decision-making capabilities of senior citizens decline as they age? I don’t know, the research is contradictory. It does appear that seniors may be manipulated by strongly appealing to their desire for positive emotional balance, and a stronger reliance on vividness in processing information may lead to bad decisions. But it also appears that if seniors are given sufficient time they can overcome these characteristics and make good decisions. More research is needed.
    Should seniors be protected as a class? An 85 year old may well be sharper than a 55 year old. Until there is more evidence showing mentally capable seniors need to be treated as a protected class it make more sense to treat all the same.  

    1 Itiel, Katona & Mungur, (1998); Age Differences in Decision Making: To Take a Risk or Not?; Gerontology; 44, 2    

    2 Kovalchik, Camerer, Plott & Allman, (2005); Aging and decision making; Journal of Economic Behavior & Organization; 58; 79–94  

    3 Denburg, Bechara, Tranel, Hindes & Damasio, (1999); Neuropsychological evidence for why the ability to decide advantageously weakens with advancing age. Society for Neuroscience Abstracts; 25, 32  

    4 Ponds, Rudolf, van Boxtel, Jolles & Jellemer, (2000); Age-related changes in subjective cognitive functioning; Educational Gerontology; 26, 1; 67-81  

    5 Denburg, Tranel, Bechara, (2005); The ability to decide advantageously declines prematurely in some normal older persons. Neuropsychologia; 43, Issue 7; 1099-1106  

    6 Kennedy & Mather, (in press); Aging, affect and decision making; Do Emotions Help or Hurt Decision Making? New York, Sage.  

    7 Carstensen, Pasupathi, Mayr & Nesselroade, (2000); Emotional experience in everyday life; Journal of Personality and Social Psychology; 79; 644-655.  

    8 Spaniol & Bayen, (2005); Aging and Conditional Probability Judgments: A Global Matching Approach; Psychology and Aging; 20, 1; 165–181


    You are not going to die May 7, 2042 (and other misconceptions) (8/07)
    According to a Society of Actuaries study roughly three-quarters of folks surveyed felt they would live until age 80, but roughly the same percentage thought they’d be dead by age 85. I believe the reason for this groupthink, whereby everybody dies in the same five year period, is due to the media talking about life expectancy and the public misunderstanding it. We keep hearing about our life expectancy being 81.6 years or 83.1 years or such. It appears many people take this to mean that if they are age 48 today that they will die on May 7, 2042 exactly as their lifespan hits age 83.1 years, as if some cosmic actuary pulls the plug on their life cord.The reality is life expectancy is the point at which half of the people in your particular segment will be dead. This means half will die early – need more life insurance? And half will live longer – that GLWB might be very useful!

    A Maturity Date Is Not Life Without Parole
    One of the stranger conclusions I once read was that annuities lock up your money for 40 or 50 years, and the reason is the writer confused maturity date with the surrender period. Suppose an age 65 consumer purchased an annuity with a maturity date of age 95 and a 10 year surrender period. The consumer would probably incur a penalty if the annuity was cashed in before age 76. However, there would be no charge for almost every annuity on the market if the consumer cashed in the policy after 10 years. What about the age 95 maturity date? All this means is the consumer must begin to withdraw money from their annuity at age 95. The maturity date is the longest the consumer can force the insurer to keep the money, not the other way around.
    Fixed annuities have maturity dates that permit the consumer to keep an annuity until age 85, 95, or even 105. However, saying that this locks you in is like saying if you get on Interstate 80 in New York you can’t get off until you reach San Francisco. A fixed annuity is a financial highway, and just like on the Interstate the driver can choose to exit at any time, but they need to be aware of any early tolls.

    The PE Ratio Does Not Foretell The Future
    How often have you heard some wag say something like “since the average market P/E ratio is much higher than the long-term average this means the stock market will head lower”. Wonderful line, the problem is it’s not supported. The ratio shows how many times higher the price (P) of a stock is when compared with the stock’s earning (E). A P/E ratio of 2 means the stock is selling for 2 years worth of earnings and a P/E ratio of 24 means a stock is priced at 24 times earnings.
    A higher P/E is viewed as a bullish indicator of the company’s expected future. A lot of folks say a really high overall market P/E ratio is too bullish and this means the market will go down, and a really low P/E ratio means the market is too bearish so it will go up (maybe it’s kind of like reverse psychology).

    However, a study published in the Journal of Portfolio Management looked at 128 years worth of P/E ratios and concluded “they provide unreliable forecasts of future returns”. They also said “there is no statistically significant relationship between P/E ratios at the beginning of a year and returns during the following year”. There is nothing in the past to support the idea that a high P/E ratio this year means bad stock market returns next year, or a low ratio today means the market will go up tomorrow.

    What Everybody Knows
    What “everybody knows” in the financial world often is wrong, or at least only part of the story. It is usually a good idea to question everything, especially those facts that “everybody knows” to be true.

    Society Of Actuaries; Key Findings and Issues Longevity: The Underlying Driver of Retirement Risk 2005 Risks and Process of Retirement Survey Report; July 2006 

    Fisher, & Statman, (2000); Cognitive biases in market forecasts; Journal of Portfolio Management; 27;  73


    Financial Math (9/06)
    I believe the reasons why so many people seem to be intimidated by math were too many poor math teachers (ones that were good at solving math problems but not necessarily good at teaching) and a lack of essay questions on math tests (meaning students couldn’t bluff through the math answers and actually needed to study hard). The problem with not understanding math is others with a little more math savvy may then use math to deceive. What I’m going to try to do is talk about financial math, how it can create a false impression, and the additional information you might need to find out the facts.

    Mean (Average)
    We all know how to figure out the Average or Mean of a bunch of numbers. You simply add up the numbers, divide the total you get by how many numbers there were, and the result is the average. With the exception of golf scores and the rate of inflation higher averages are usually a good thing.
    Say that you were looking at two financial instruments. Instrument A had an average past return of 5% and Instrument B had an average past return of 6.5%. If you believe the past will repeat, which one would you pick? The obvious answer is B.

    But suppose A’s returns look like this

     4%       6%        6%
     5%       4%        5%

    Instrument A has 6 outcomes of which 2 are 4%, 2 are 5% and 2 are 6%. If you divide the number in each outcome (2) by the total sample or population (6) you get 0.33. So, based on the past, there is a 1 in 3 chance or 33% shot of earning either 4% or 5% or 6%.
    B also has 6 outcomes of which 4 are 1%, 1 is 10% and 1 is 25%. If you divide the number of 1% outcomes (4) by the total (6) you get 0.67; if you divide each other outcome (1 or 1) by the total (6) you get 0.17. So, based on history, B has a 67% chance of producing a 1% return and only a 17% shot of returning 10% and a 17% shot of 25%.  

    But suppose A’s returns look like this

     4%       6%        6%
     5%       4%        5%
     

    The average return of A was 5%. From an odds or probability standpoint you have a equal chance of earning 4%, 5%, or 6%, so regardless you’re going to be within one percent of hitting that average. The average return of B was 6.5% and your real return won’t even be close to the average. You could zoom right past it and get 10% or 25%, but B has a 67% probability you will earn 1%.  

    Averages can often be misleading because a couple of very high or very low numbers can distort the picture. You need to go beyond averages.  

    Does this mean B is worse than A? No. B still offers a 1/3 possibility of earning 2 to 6 times more than you’d earn in A next year and over time should produce a higher overall return than A based on the data we have. However, if your main concern was never earning less than 4% A would be the better choice – and you’d never know this if you were only told the average.  

    Standard Deviation  
    The Standard Deviation shows how widely the returns differ (deviate) from the Average. I’m not going to show how it’s calculated (you can find it in any statistics book) but I want to discuss what it means. In a normally distributed population 68% of the results will be within one standard deviation of the mean, 95% will be within two and essentially all results will be within three standard deviations of the Average. Here’s what that means in our examples:  

    The Standard Deviation (SD) of the population for Instrument A is 0.89. What that means is roughly two-thirds of the returns fall between Average 5% plus or minus 0.89 (or between 4.11% and 5.89%), and 95% fall between Average 5% ± 0.89 + 0.89 (or between 3.22% and 6.78%).  

    1 SD contains 68% of the possible returns                        2 SD contains 95% of the possible returns  

    The Standard Deviation of the population for Instrument B is 9.07. What that means is roughly two-thirds of the returns fall between Average 6.5% plus or minus 9.07 (or between -2.57% and 15.57%), and 95% fall between Average 5% ± 9.07 + 9.07 (or between -11.64% and 24.64%).

      Instrument A
      5.0% Average
      SD 68% of Returns  4.1% and 5.9%
      SD 95% of Returns  3.2% and 6.8%
      Actual Range of Returns  4% to 6%

    By knowing only the standard deviation we can conclude there is a very strong chance (95%) that A would earn somewhere between 3.22% and 6.78%; a pretty tight band of returns around that 5% Average. Based on B’s Standard Deviation, we have a 95% chance of losing up to 11.64% or earning up to 24.64%; a 36% return swing from worst to best with each end a long way from B’s 6.5% Average.  

      Instrument A
      6.5% Average
      SD 68% of Returns  -2.6% and 15.6%
      SD 95% of Returns  -11.6% and 24.6%
      Actual Range of Returns  1% to 25%

    The returns of Instrument B are a lot more volatile than those of Instrument A. With A you’re almost certainly going to earn at least 3%; B is much more of a crapshoot. Does this suggest that a low standard deviation is automatically better than a high one? No.  

    A higher Standard Deviation means more volatility, not better or worse  

    Suppose a new Instrument C has an Average Return of 4.5% and a standard deviation of only 0.05. This would mean a 95% shot of earning between 4.4% and 4.6% with C. But we know Instrument A has a one-third chance of 5% returns and a one-third chance of 6% returns, and the worst we could do is earn 4%, which isn’t all that much lower than the best possible Instrument C return.  

    To Sum Up  
    A lot of folks look only at the average and assume that is pretty much what they’re going to earn – and that could be true if the standard deviation is low. By comparing the Average and the Standard Deviation, you can get an idea of the range of the returns. If the Standard Deviation is large you may want to look at the actual returns and get an idea of the real top and bottom. A larger standard deviation means more volatility, but it’s not an issue of good or bad. A person may pick B over A because of the chance of earning 25%, and another person may pick C over A because they feel they’ll at least earn 4.4%. The final comment is all of this analysis only holds true if the past repeats and your model works. Consider if we’d used degrees on the thermometer instead of percentages and the data represented temperatures during a Minnesota winter. All of this data would be ka-ka if we were trying to use it to predict next summer’s temperatures in Duluth.


     

    Variable Annuity & Index Annuity Parallels (8/06)
    The index annuity industry in 2006 appears a different one from that hatched in 1995. Instead of a few carriers offering index annuities there are now over fifty. New riders and new wrinkles are appearing in products on an almost monthly basis. And the regulatory and litigation environment is generating unwelcome attention. There are also ongoing changes in market share and sharp disagreements over the future direction of the industry. But all of these index annuity issues remind me of another industry I have followed for the last 20 years.

    Although variable annuities have been around for decades sales only began to take off in the mid ‘80s. The VA industry has also experienced an explosion of vendors, rapid sales growth, ongoing product innovations, and was forced to face challenges from the regulatory world. It seemed to me that in many respects the index annuity industry was writing a similar story to that of the variable annuity one. This article attempts to look at some experiences and issues in the VA world and note any similarities with the index annuity one. 

    Sales Curves

    Even after a decade and a half of growth VA sales had only reached $4.5 billion by 19851. By contrast, even though the first index annuity sale happened in February 1995, sales were over $4.0 billion only four years later. If we use these similar sales starting points we see both industries enjoyed generally similar rising sales stories over their respective eight year periods. Although the future sales for index annuities have not yet been written we do know what happened to VA sales – They exploded in the 1990s.

    VA 1992 sales tripled in the next five years and prompted forecasts of 2000 sales hitting $182 billion and then growing ever higher4. We have seen similar hubris in the index annuity world wherein seers extrapolate one year’s growth pattern into the future without regard for market forces and realities. However, much of the rapid growth in both industries appears to have resulted from distinct and cyclical forces. 

    Market Share
    Although the top players in variable annuities shift position, no one really has a commanding share of the market. Back in 1990 Prudential was the largest carrier with 9.68% of the market. In 2005 TIAA-CREF was the leader with a market share of 10.25%14. In recent years Hartford, TIAA-CREF and MetLife seem to swap around places, but all have very similar market shares.
    In the index annuity world Allianz has held a 30% share of the market for four years and been the market leader for six. Although the positions of the rest of the top ten are very fluid no challenger has come close to toppling the leader.

    Exchanges
    In 1994 91.6% of VA sales ($46.2 billion) were from new non-1035-exchange dollars6. In 2005 new money VA sales were $18.9 billion or 14.4% of total sales7. In other words, in 2005 over 85% of VA sales was the result of moving from one annuity carrier pocket to another and new money sales were a third of what they had been a decade previously even though total sales had more than doubled.
    What drove this growth in 1035 transfers? Indications are it was upfront premium bonuses.

    Although Prudential came out with one in 1989, the first big media mention of a premium bonus was in 1990 on the new American Skandia 5.5% “exchange credit” designed to offset the effect of old contract surrender charges8. Interest in premium bonuses was modest until the later half of the last decade, at which time concerns of possible abuse rose to such a level that the SEC and NASD stepped in – by 2000 each had segments on their web sites warning consumers about their being “no free bonus”9. 

    At the beginning of 2001 fewer than 10% of index annuity sales involved a premium bonus and, coincidently, I estimated that over 90% of the sales were new money to the industry – not the result of an exchange. By contrast in 2006, based on my conversations with carriers and an analysis of the percentage of sales involving upfront premium bonuses, I estimate that 50% of the index annuity premium received is coming from other annuities. The regulators have not, as of yet, focused their attention on index annuity bonuses. From my conversations I believe this may be because they are unaware of the level of exchanges.

    Innovations
    A problem for both variable and index annuities is that no carrier has a sustainable competition advantage. Any new product, new concept, new procedure can be quickly stolen and implemented by competitors. The only thing that is left is the loyalty of your distributing agents. I have been told that producer loyalty is worth about a half percent of commission or higher yield. What this translates into is a never-ending cycle of meaningful and meaningless innovations.

    In the early ‘90s innovation was technology based with telephone transfers and automatic allocation introduced, and the next wave was VA carriers cramming more and more subaccounts into the VA chassis10 even though giving a consumer too many choices can decrease sales [see May 2006 Index Compendium]. American Skandia was amongst the most innovative VA carriers in the business. They pioneered the use of using independent fund managers rather than insurance company employees, they introduced trailing commission to improve policy stickiness, and they gave away investment software that made financial advisors look smarter in front of their clients11. Even so, American Skandia wound up selling their VA operation to Prudential Financial in 2003.

    A round of innovations that began during the late ‘90s centered on riders designed to reduce risk. Variable annuities offered guaranteed benefits such as guaranteed minimum death benefits, guaranteed minimum income benefits, and guaranteed minimum withdrawal benefits. The riders attracted attention and by 2004 the income benefits rider was being added by 59% of VA purchasers, with a great deal of interest also being seen in withdrawal benefit riders12. I have heard speculation that these riders are the sole reason VA sales have rebounded.

    Index annuities used new crediting methods to attempt to differentiate themselves from one another. From three basic methods at product inception there came to be over 40 variations by 1999. The number of available methods decreased during the bear market, but within the past year or so the number of methods has once again jumped higher. Are the new methods increasing sales? With the exception of the now somewhat dated monthly-cap-forward-not-back method no other new method appears to have lit a fire under sales. Carriers have also played with offering different indices, trailing commissions, and even a rider to help pay taxes on accumulated interest upon death, but none of these truly excited the marketplace. The newest index annuity innovations, borrowed from the VA world, are riders that guarantee a better death benefit, greater certainty of income, or provide a few other benefits. Although I believe we will see swarms of these riders as they are adopted by other carriers it will be interesting to see what ultimate effect they have on sales. VA riders are all designed to lower the risk of owning an investment while index annuities already offer strong guaranteed death and income benefits.

    On the subject of riders, it is interesting to hear concerns in some quarters that VA carriers may not be charging enough to cover the costs of these benefits. By contrast, a couple of regulators have shared they are concerned index annuity carriers may be charging too much for their riders.

    Regulation, Litigation & Bad Press
    That variable annuities are regulated by both security and insurance regulators is an issue that was resolved many years ago. Regulator attention increased as VA sales increased. As regulator attention increased trial lawyers began looking around for new revenue sources and both parties excited the media to examine the variable annuity world. The three parties initially seemed to focus on the appropriateness of VAs in qualified plans, then looked at high fees and then bad 1035 exchanges. I am optimistic that better supervision is decreasing all of these issues.

    By contrast, the question on whether an index annuity is okay in an IRA is seldom raised – hopefully because the overriding reason people buy index annuities is for yield and not tax-deferral13. The fee question does not usually persist after it is explained that a participation rate is not a fee. And of the fifteen lawsuits mentioning index annuities I have read not one is saying the index annuity concept is bad, but usually is based on allegedly bad agent behavior. Although I am concerned about index annuity exchanges the outside world does not seem hung up on it. The media is perhaps the biggest problem because they keep trying to fit index annuities into their preconceived variable annuity box. However, index annuities have one unique regulatory issue – they are caught in a turf war between the NASD and state insurance departments. Industry growth has a cloud hanging over it because the SEC has not clearly defined which camp an index annuity must join.

    Advantage Compendium estimates there are $108 billion of in-force index annuity policies

    The Message
    The SEC says the message of variable annuities is as follows, “Although variable annuities are typically invested in mutual funds, variable annuities differ from mutual funds in several important ways: 

    VA & FIA Similarities

    A Prolonged Period Of Rapid Growth

    A Constant Stream of Meaningful (and sometimes meaningless) Product Innovations 

    Regulatory Attention As Sales Grew 

    New Sales Are Increasingly From Existing Annuity Exchanges 

    Uncertainty Over Where Future Growth Will Come From 

    The Original Consumer Message Has Stayed The Same

    First, variable annuities let you receive periodic payments for the rest of your life (or the life of your spouse or any other person you designate). This feature offers protection against the possibility that, after you retire, you will outlive your assets.

    Second, variable annuities have a death benefit. If you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount – typically at least the amount of your purchase payments. Your beneficiary will get a benefit from this feature if, at the time of your death, your account value is less than the guaranteed amount.

    Third, variable annuities are tax-deferred. That means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer.

     When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals. [from http://www.sec.gov/investor/pubs/varannty.htm]

    Currently only 3 out of 1000 variable annuities are surrendered due to death or disability19

     

    Here’s how index annuity carriers defined their product ten years ago:

    “You enjoy the safety and security that a traditional fixed annuity guarantees, combined with the potential of interest earnings linked to the S&P 500 Index”15. “You will only share in the increases in the index. Your index annuity value will never decline due to decreases in the index and previous increases once earned are locked in and guaranteed”16. Excess interest is determined annually and is based on your contract’s participation rates, which are a percentage of the performance of the S&P 500”17.

    In 1993 the number of new VA products filed increased 50% over 199220
    From 2005 to 2006 the number of available index annuities nearly doubled to over 250. 

    The messages of both variable and index annuities have stayed amazingly on target over the years. The GMIB, GMWB and GMDB riders all relate to the VA core message of income and death benefits, and are designed to enhance one or the other. Index annuities are still predominantly marketed as a traditional fixed annuity with higher interest potential due to an index link. 

    VA Market Leaders (Annual Sales in Millions)

      2005     1999
    TIAA-CREF   13,551   Hartford Life    10,586
    MetLife 12,486   TIAA-CREF   9,289
    Hartford Life    11,375   American Skandi 6,759
    AXA Financial/Mony 10.585   Equitable Life Assur 6,346
    Lincoln National          8,411   American General 6,087
             

    FIA Market Leaders (Annual Sales in Millions)

    Allianz 8,792   Jackson National Life  728
    American Equity 2,689   Conseco  672
    AmerUs Group 2,392   Old Mutual 669
    Old Mutual 2,383   American Equity 559
    ING 2.034   Allianz 501

    Summary
    A question for both products is are there enough consumers to continue past growth rates? The low percentage of new money entering the VA arena would indicate that the market for VA benefits is saturated. To illustrate, in 2005 similar amounts of outside fresh money came into the variable annuity and index annuity segments, but total variable annuity sales were five times those of index annuities.

    Index annuities, as with other fixed annuities, may well be an interest rate play that enjoys strong sales when CD rates are weak and poor sales when CD rates are strong. It is possible that all fixed annuity sales have a saturation point of $100 to $150 billion in annual sales and index annuity sales will plateau at around the $50 to $80 billion mark. Although demographics strongly support a growing need for all types of annuities the security industry has done a much better job of communicating their alternate retirement story to the public. Whether variable and index annuities track a parallel future course is unknown.

    1. Carey, Rick. Record 4th qtr. VA sales lifted 1995 to new high, National Underwriter, Feb 19, 1996; 00, 8, pg. 3

    2. ibid, Advantage Compendium, Ltd. (the source of all article index annuity data)

    3. ibid, Rick Carey, '97 VA sales at $87 billion, National Underwriter, Feb 9, 1998; 102, 6; pg. 1

    Rick Carey, 1999 VA sales totaled $121 billion, National Underwriter, Feb 28, 2000; 104, 9; pg. 1

    Rick Carey, Variable annuity sales fell 17.8% to $113 billion, National Underwriter, Mar 11, 2002; 106, 10; pg. 16

    Rick Carey, Variable Annuity Sales Climbed 11% In 2003, National Underwriter, Mar 8, 2004; 108, 9; p. 8

    Fran O’Connor, 2005 VA Sales Hit New High, National Underwriter, Mar 13, 2006; 110, 10; pg. 12

    4. Carey, Rick. Record 4th qtr. VA sales lifted 1995 to new high, National Underwriter, Feb 19, 1996; 00, 8, pg. 3

    5. Investment Company Institute, 2005 Investment Company Fact Book, May 2005, Table 2

    6. Rick Carey, Variable Annuity Sales Climbed 11% In 2003, National Underwriter, Mar 8, 2004; 108, 9; p. 8 

    7. Fran O’Connor, 2005 VA Sales Hit New High, National Underwriter, Mar 13, 2006; 110, 10; pg. 12

    8. Linda Koco, Annuity Exchange Plan Introduced, National Underwriter, Jan 22, 1990; 94, 4; pg. 29

    9. Jack Marrion, Selling VAs? Check out regulatory leanings, National Underwriter, Oct 16, 2000; 104,  42; pg. 17

    10. Matthew Schwartz, Cos. adding financial "bells and whistles" to VAs, National Underwriter, Apr 19, 1993; 97, 16; pg. 8

    11. Deborah Orr, Survivor, Forbes, May 28, 2001

    12. Tim Pfeifer speaking at the April 2005 LIMRA Conference

    13.  Omnibus Consumer Survey, February 10, 2006

    14. Rick Carey, 1999 VA sales totaled $121 billion, National Underwriter, Feb 28, 2000; 104, 9; pg. 1

    15. Interstate Assurance Company, Freedom 500 Index Annuity, 3158-D, 7/96

    16. Community National Assurance Company, Money$Worth Indexed Annuity, P-AN7, 8/95

    17. Unity Life. SPIDA, #9521, 1996 

    18.  Elizabeth Wine, Variable Annuities: Payday Or Peril?, On Wall Street, Jul 1, 2006; pg. 1

    19. Staff, What’s Wrong With Variable Annuities, Smart Money, August 2005

    20. David Shapiro, To compare VAs, it takes more than subaccounts, National Underwriter, Dec 27, 1993; 97, 52; pg. 12


    Index Annuities 1996 - 2006  (6/06)
    The first
    Advantage Index Annuity Report was released May 1996 and compared the seven index annuities offered by the five carriers that comprised the index annuity universe. The players and products were:
    Community National Assurance Company with Money$worth Indexed Annuity, Integrity Life Insurance Company with Omni Pathway 1, Keyport Life Insurance Company with KeyIndex Annuity 1 & 5 Year, Life Insurance Company Of The Southwest  with SecurePlus Flexible Premium Indexed & SecurePlus Single Premium Indexed, and Lincoln Benefit Life Savers Index Annuity.

    All of the annuities provided a minimum guarantee accruing on 90% of the premium and almost all had a maximum nonqualified issue age of 75 (Integrity went up to age 80). The first index annuity ever sold, the Keyport KeyIndex, offered a high water mark structure (with a May 1996 participation rate of 84%), and Integrity Life also offered this vanished method. The remaining annuities used annual point-to-point methodologies with a cap (participation rates were in the 85% area and the caps were 13% to 15%). To round off this summary the number of annuities in different surrender periods was 1 year – 1, 5 year – 1, 6 year – 2, 7 year -1 and 10 year -2. First quarter 1996 sales were about $300 million and Keyport had half of those sales.The number of carriers rapidly increased so that by the end of 1996 there were 23 index annuity providers and more than three dozen products. 1996 ended with over $1.5 billion in sales.

    Ten years later, the number of carriers offering index annuities will hit 54 later this month and the number of products is 275. There were six carriers in the first quarter of 2006 that had higher sales alone than the entire industry did for the same period in 1996 (Allianz sold more last quarter than the entire industry did for 1995 and 1996 combined). And the amount of inforce index annuity policies is hovering at $100 billion. There have been a lot of changes, but much has stayed the same. Of the original five companies both Lincoln Benefit and LSW are not only still around, but LBL still offers the same product it did ten years ago and LSW retained both the original name and similar structure for their current annuities. Keyport was acquired by Sun Life, but many of the people responsible for the first index annuity are still there and shepherding the industry into its second decade.

    Although the number of methodologies, surrender periods, and bells & whistles have exploded the core concepts have been left untouched. An index annuity is still a fixed annuity providing a minimum guaranteed return regardless of what the economy does, and index-linked interest that once earned and credited can never be lost due to the vagaries of the stock market. Since that first report index annuities have credited billions of dollars of interest and protected owners from principal losses during the worst bear market of the last 70 years. The financial universe is a better place for consumers thanks to index annuities.


    Index Noir (4/06)  
    She entered my office with a stride that made her look like potatoes fighting in a burlap bag sliding down an icy sidewalk.  I could tell she had trouble. From the top of her blue tinted hair to the bottom of her mary janes she quivered like an electric transformer guide wire caught in a windstorm.  In spite of the tension surrounding her she projected the aura of a classy dame.  Maybe it was the way she wore the AARP pin on her lapel, but I could tell I was in elite company.  I opened the parlay.  

    “How can I be of services, Ms?”  

    “Dame,” she responded, “Dame Ethel of Topeka.”  

    I was right about the class, she was Kansas royalty.  “How can I be of service, Dame Ethel?”  

    “My advisor, Ira Tacscut, is missing and I think there’s been foul play.”  

    “Perhaps you’d better start at the beginning,” says I.  

    “Well,” Dame Ethel began, “I was talking to my friend Betty last week about how the bank just wasn’t paying enough interest for a body to keep the larder full and she said that she used to have the same problem but that her advisor, Ira Tacscut, had positioned some of her money in an indexed annuity and I asked Betty what an indexed annuity was and she said it was a savings vehicle offered by insurance companies that provided a minimum interest rate plus the potential for additional interest if the index increased and I asked but what happens if the index goes down and Betty said that with an index annuity neither the principal nor credited interest was subject to market risk and I asked what kind of interest could I earn and Betty said that an index annuity had the potential to provide a higher return than other savings vehicles so I said…”  

    “And why do you think there’s been foul play?”  I quickly interjected so that Dame Ethel could draw a breath and refrain from turning a darker shade of blue.  

    “Well,” continued Dame Ethel, “After talking to Betty I called Mr. Tacscut and made an appointment to see him this morning.  When I arrived at his office the door was ajar, there were papers strewn everywhere and Mr. Tacscut was nowhere to be found.  I really wasn’t too concerned at that point I’ve heard advisors can be somewhat eccentric  until I noticed a Lowratte Federal Bank pocket calendar laying in the hall, as if someone had accidentally dropped it.  I then remembered that yesterday when I was at the bank visiting my money, I’d told Mr. Lowratte, the bank president, that I was going to be seeing Ira Tacscut. When I mentioned Mr. Tacscut’s name Mr. Lowratte got this funny look on his face and turned a little green. I don’t believe Mr. Lowratte wants me to see this advisor.”  Dame Ethel and I conversed a little more and I told her I’d look into it.  

    My thirty years of detective work convinced me that I should talk to Mr. Lowratte at the bank; that, and the fact that Dame Ethel remembered hearing Mr. Lowratte say as she left him yesterday “I’ll get Tacscut if it’s the last thing I do!” I left my office and walked the three blocks east to the Bank.  It was the dog days of summer and my dogs were feeling like red hots at Fenway by the time I eyeballed the statue in front of the bank. I always admired that statue.  It was a paper mache model of Treasury Secretary Ogden Mills made out of old passbook savings booklets.  

    I pushed through the revolving door and lolled over to the receptionist.  After she had finished her nails she looked up and asked what I wanted. I told her I was there to see the president about a missing person.  She relayed my message and within an hour and a half Mr. Lowratte appeared wearing a too tight smile that he probably saved for using with bank examiners when his loan reserves were low.  He took me back to his office. “What can I do for you?” queried Mr. Lowratte. I told him I was there about the disappearance of Ira Tacscut.  Lowratte turned as white as a gallon of milk sitting on an iceberg in the Arctic during a blizzard in January, but quickly recovered saying he knew nothing about the matter.  

    “You were aware that a lot of your bank customers had been seeing Mr. Tacscut, weren’t you?” I sagaciously implored.  Lowratte volunteered that he was aware that one or two of his customers had met with Mr. Tacscut.  

    I continued. “I bet you’re also aware that index annuities provide the potential for higher interest crediting than customers could earn from bank instruments and index annuities protect principal and credited interest from market risk.” Lowratte grudgingly admitted that this too might be true.  

    “In fact,” I orated, “Isn’t it true that you were afraid of Mr. Tacscut.  Afraid that his message about the benefits of indexed annuities might sway too many of your customers away from the bank.  Afraid that if your customers knew about the growing popularity of indexed annuities they would question the low rates your bank instruments are paying?”  

    “It isn’t true!” Lowratte screamed. “I had no idea of the growing popularity of index annuities.”  

    “You’re lying,” said I, and with that I leapt up and flipped over the magazines stacked on the corner of his desk.  Sure enough, underneath copies of Banker Geographic and Bank Illustrated was the current issue of the world famous journal Index Compendium shouting the headline “Annual Index Annuity Sales Set New Record”. “You got me,” surrendered Lowratte.  “I have Tacscut tied up in the basement and I’m forcing him to watch Human Resource department training videos.”

    “You inhuman monster,” I cried.  “It would have been more merciful to kill him.”  

    After Ira Tacscut was released and the savings police took away Lowratte, I made my report to Dame Ethel.  She asked if there was a lesson to be learned from all of this and I told her there was “The weeds of banks bear bitter fruit, CDs do not pay.  Buy an index annuity instead.”  


    Alphas, Betas, Betty & Barney (3/06)
     One of the scariest things I was recently told was that “so and so must be a really smart investment guy because I didn’t understand a thing he said.” If someone is trying to explain something and you can’t understand what they are saying the problem is probably not you. When it comes to investment terms and formulas the problem often lies with poseurs that have limited understanding of the statistics and theory behind the financial gobbledygook they spew out, but they figure you know even less you so won’t challenge them. But let’s look at three common terms often used and see what they really mean.

    Is Alpha meaningful – Probably Not

    Beta means how much one investment is expected to move around compared to a benchmark investment. For example, if one investment had a beta of 1.5 and the benchmark moved up 10%, you’d expect the other investment to go up 15% - 1.5 times 10%. The same respective thing is expected to hold true if the benchmark goes down – if the benchmark goes down 5%, the investment is expected to go down 7.5%. Beta is supposed to be a volatility measurement. A higher beta means greater ups and downs in the investment compared to the benchmark.

    Alpha is the difference between the return you think you’d get based on the beta and the actual return, but it’s more complicated than that. You take the investment’s actual return, subtract the yield from Treasury bills, and then subtract that beta excess return – in the example it would be the 5% over the 10% benchmark return. What’s left over is alpha. Why mention T-bills? That’s a stand-in for a “risk-free” rate. If your alpha is positive you’re doing better than you should based on your risk (the beta), if its negative you’re not getting adequately paid for the risk. Can you usually calculate the alpha of an investment? Yes. Is it meaningful? Probably not. In the few studies I’ve seen a high alpha is often attributed to the result of good luck and a bad alpha can be due simply to a higher investment fee on a product, and not the risk.

    Why are these two terms called alpha and beta? My guess is because the folks at the university doing the research were too busy to watch The Flintstones. If they’d watched, we could be talking about “Betty and Barneys” instead of alphas and betas, but mathematicians like to use Greek. But here’s a tip, if someone starts using Greek words on you and he’s not from Athens, cover your wallet. And another thing, a benchmark can be anything. You could benchmark your mutual fund return to how often your dog barks at night. It wouldn’t be a good benchmark, but benchmark is just another word for base line or “thing you are going to compare another thing to”. 

    < “In physics it takes 3 laws to explain 99% of the data; in finance, it takes more than 99 laws to explain about 3%” - Andrew Lo, MIT

    To try to get a better handle on volatility and risk-adjusted returns the Sharpe Ratio is cited by many. It uses beta, standard deviations, and risk-free returns to essentially see if you are getting paid enough extra return to pay you for the extra risk you assume.  Many tout the Sharpe Ratio to show how good an investment is. In fact, so much hype has surrounded the Sharpe Ratio that William Sharpe – the guy that did the math behind the ratio – publicly came out last year to say the Sharpe Ratio is often misused. He went so far as to say that “People should not take the Sharpe Ratio at face value”. And the basic reason is this.

    Financial terms and theories are used to create models to value investments. The models then make imaginative assumptions based on past historical performance. All is well and good until the real world fails to work like the model, and because the future didn’t perform like it was supposed to based on the past the model fails. This is the problem with relying too heavily on all these financial “laws”. Sharpe himself recently said, “Past average performance may be a terrible predictor of future performance.”

    So, the financial folks develop even more new laws and new theories. One of more heavily promoted methods is Monte Carlo modeling. This method goes back through history and calculates how many times various returns occurred based on your investment assumptions. It is designed to be a better analytical tool than merely going back and calculating the average return for a period – and it does do a better job than only computing an average. And it’s interesting to see that by doing it “this way” you would have earned at least 8% in over 70% of past periods, but by doing it “that way” you would have earned 8% in over 90% of past periods. However, Monte Carlo modeling, like all models, has a fundamental flaw, which is you are expecting the past to forecast the future, and except in the broadest sense that doesn’t work.

    “Economists seemed to have embraced (physics) formality without the corresponding benefits of accuracy or predictability” - Emanuel Derman 

    If you try to apply any of these theories to forecasting index annuity returns you’re wasting your time. Not only do you have the fundamental flaw in that the past doesn’t repeat, but with 95% of the index products some aspect of the crediting can change each year. You could, for example, select one index annuity with a current cap of x% because it performed much better under Monte Carlo modeling than another annuity. But what if next year the current cap drops in half, while the other annuity raises its index participation? All of your initial Monte Carlo modeling is in the toilet. None of this means that one should ignore financial models and formulas, they will be useful as long as the real world stays within the parameters of the models, and it often does. In the index annuity world I am a big believer in backtesting and have been creating hypothetical models for a decade to understand how different crediting methodologies work. One needs to look at alphas, betas, sharpes, hypos and barneys to get an idea of relative vehicle performance, but you need to be aware of the limitations, and beware those that won’t admit that every model has flaws. As Emanuel Derman of Columbia University wrote, “never forget that even the best financial model can never be truly valid because the world of securities and economics is much less amenable to the power of mathematics.”

    1 Ianthe Jeanne Dugan, Sharpe Point: Risk Gauge Is Mis-used, The Wall Street Journal, 31 August 2005 p C1

    2 Emanuel Derman, “Beware of Economists Bearing Greek Symbols” Harvard Business Review, October 2005


    What’s Tax Deferral Worth? – About 15 BPs (2/06)
    It has been a trying market for fixed annuities. Over the last year and a half certificate of deposit rates have more than doubled while fixed annuity rates haven’t really moved. If your choice is between a 5-year CD with a rate of, say, 4.35%, or an annuity locking in a rate of 4.05% for five years, why would you choose the annuity? The answer producers give me is because the annuity offers tax deferral.

    Okay. Let’s say you are in the 33% combined tax bracket and you put $10,000 into the CD and $10,000 into the annuity. The CD is earning 4.35%, but 33% of that 4.35% – or 1.44% – is lost to taxes, so you really only have 2.91% working for you. A rate of 2.91% compounded on $10,000 produces a balance of $11,542 in 5 years. Interest earned inside the annuity, on the other hand, is not subject to taxes and the full 4.05% goes to work for you. A rate of 4.05% compounded on $10,000 produces a balance of $12,195 in 5 years. At first glance the annuity apparently wins. 

    5 Year CD   5 Year Annuity
    4.35% Yield 4.05%
    -1.44% Taxes 0%
    2.91% Net Yield 4.05%
    $11,542 Balance $12,195
    -0- Taxes     - 724
    $11,542 In Pocket $11,471

    But wait, to make an honest apples-to-apples comparison we should look at the after-tax effect if the annuity is cashed out at the end of the fifth year. We have an annuity balance of $12,195, but $2,195 is interest and subject to our 33% tax rate. A third of $2,195 is $724 in taxes paid, and subtracting $724 in taxes from the $12,195 annuity balance results in cash in hand of $11,471 for the annuity versus $11,542 for the CD. The bank wins this round. The reality is in this rate environment when looking at a five-year or shorter periods, tax deferral only gets you 5 to 20 basis points of yield. To put this another way, if you are in the 15% tax bracket and the annuity has a rate of, say, 4.00%,if a CD has a rate higher than 4.05% the CD will put more money in your pocket if you cash out in 5 years. If you are in the 33% tax bracket with that same annuity, a CD rate higher than 4.20% will beat the annuity on an after-tax basis in 5 years. As I write this, I can find several 3 year and 5 year CDs that offer yields that are at least a quarter percent higher than similar term fixed annuities.

    Does this mean buying a CD today may result in a better return to the customer than buying an annuity? Yes. There are times when interest yield curves flatten out and short-term money can earn the same or higher rates than long-term money, and this is one of those times. The good news is eventually, at least based on history, longer-term money regains its ability to offer more yield than short-term funds. In fact, over the last sixty days or so, fixed annuity rates have generally risen more than CD rates, and I believe fixed annuities will regain a distinct yield advantage down the road. What about competing today? Consumers buy annuities for other reasons besides yield. If someone is on the cusp of being subjected to Social Security benefit taxation, moving money to a deferred annuity may keep their benefits untaxed. In addition, we only looked at a five-year period and assumed the annuity was cashed out. If annuity growth continues beyond 5 years the tax deferred yield advantage increases. Tax deferral is still a wonderful benefit and it becomes more powerful with each passing year. If yield is a concern there are fixed annuities with rates linked to external indices that offer a realistic opportunity of out-yielding the bank. Index annuities have been extremely competitive with CD rates over previous 5-year periods.

    Bank competition against fixed annuities is tough, but there are things you can do. Be aware of CD rates in your town (bankrate.com is a useful information source), look beyond the tax picture to see the other needs a fixed annuity might address, and take a look at index annuities. Tax deferral is a benefit, but you need to look at the whole picture.


    Index-Link Power (How It’s Done) (5/05)  
    An index annuity provides the potential for higher index-linked interest and protects principal and credited interest from market risk. One of the objections sometimes raised when the index annuity story is told is that it seems too good to be true. How can the insurance company provide both potential and protection? Let us look at how the index-link approach really works. 

    Another word for index-link is option. If you’ve ever given a car seller $50 to hold a car for you at a certain price you’ve participated in options. You put $50 on the table to hold a car, the car seller agrees to accept your $50, the seller is obligated to sell you the car at the agreed upon price. But as the option buyer you are not obligated to buy the car, you simply have a right to buy it at that price. You can walk away and the most you can lose is your $50.

    Equity options work the same way and I am going to use a real world example to show how the index annuity approach utilizes options to provide the potential for higher fixed annuity returns. To make this cleaner I am going to ignore transactions costs and will state this is not an inducement to sell or buy any security and is for purely educational purposes.

    Cheerios, Wheaties & Calls
    Let’s say we have $50. At the end of April the price of a share of stock of General Mills (symbol: GIS) closed just under $50. At the same time you could have purchased a nine-month certificate of deposit from IndyMac Bank of California with a stated annual percentage yield of 3.73%, which will produce 2.8% in interest for the nine-month period.

    We know if we buy the CD it will return 2.8% in nine months. What will be the return on the share of General Mills over the same period? We don’t know. It could be greater than 2.8% or it could be loss.

    There is a third choice. At the end of April a stock exchange listed call option giving the right to buy General Mills at $50 at anytime within the next nine months last traded for $2.05. If we buy the call option – or equity-link – we have the right to buy General Mills at $50 a share and this right costs $2.05.

    Protection & Potential
    Let’s say our first requirement is to ensure we still have $50 in our hands nine months from now. If we put $48.63 in the CD it will grow back to $50 at the end of nine months ($48.63 x 1.028). This leaves us $1.37 from our $50. A full option giving us 100% participation in any growth in General Mills stock costs $2.05, but we don’t have $2.05. The option seller says we can buy two-thirds of the option ($1.37/$2.05 = 66.8%) and he’ll keep the rest.

    The Scenarios
    It is now nine months later. What if General Mills stock is at $56 a share? We would use our option and buy the stock at $50, sell it at $56, and make $6. Our “participation rate” in this increase is 66.8%, so our share of the gain is $4 with the index seller keeping the other $2. The CD is now worth $50. We add the $50 from the CD to the $4 realized from our equity-link and the result is $54, or an 8% return on our $50. What if the price of General Mills stock had been $50 or less at the end of the period? We wouldn’t use the option and the $1.37 spent on it is gone. However, because most of our money was placed in the CD we still have $50, and if we wanted to we could try this option/CD combo again for the next period. This is how an index annuity works. The primary differences are the insurer uses bonds instead of CDs, index options instead of stock options, and an annual period instead of nine months.


       

     

Copyright 1998-2016 Jack Marrion, Advantage Compendium Ltd., McKinney TX (314) 255-6531.  All information is for illustrative purposes only, does not provide investment or tax advice. No index sponsors, promotes, or makes any representation regarding any index product. Information is from sources believed accurate but is not warranted. Advantage Compendium neither markets nor endorses any financial product.