It is often said in sales “don’t build people a watch when they just want you to tell them the time.” However, with how often these indexed interest insurance contracts are mis-represented – by agents and especially non-agents, I feel that a relatively simple (to me) explanation of how these contracts work can only help – particularly for the ‘engineer’ types.
So, how can these contracts offer principal protection AND market-linked performance?
Which contract would YOU pick?
Years ago, I was with a broker/dealer firm and I sold variable annuities that had lifetime income benefit riders and these contracts directly invested in mutual fund sub-accounts. I had a decent enough knowledge of how these contracts worked and it was before the crash of 2008.
When I compared these variable annuity insurance contracts to some of the fixed indexed annuity insurance contracts, one of the comparisons I would go to was the surrender charge schedule.
The surrender charge schedule is set by each insurance company and is individual to each particular product. In short, if you take out more than 10% of the anniversary value of the contract, your withdrawal can be subject to a liquidity charge.
A common variable annuity surrender schedule – 7 years:
7 – 7 – 7 – 6 – 5 – 4 – 3 – 0%
A common fixed indexed annuity surrender schedule – 12 years (or longer):
10 – 10 – 10 – 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 0%
(This is an example only and does not represent any particular company or contract – charges shown could be higher or lower depending on your contract.)
Without any further analysis other than knowing that fixed indexed interest insurance contracts don’t credit “all of the upside” of the market… it looks like a raw deal. (Notice that we didn’t talk about the variable annuity costs of mortality & expense, mutual fund sub account charges, or the living benefit rider charges – that all combined could be about 3-3.5% per year.)
And this is when the myths show up.
“They only sell these products for the commissions.”
“Look at that surrender charge schedule – that should be criminal!”
Personal note: I generally to stick to the “10-10” rule: No more than a 10% surrender charge in a given year and no longer than a 10-year surrender charge schedule. There are many fixed indexed annuities that fit that criteria and they are available for a wider array of ages than those contracts that have longer time frames and/or higher surrender charges. However, my mind is open to see if there are any contracts that are longer and/or higher charges and why they could make economic sense for clients. (I just haven’t really found out any reason to offer them as of yet, but those reasons could be out there.)
So, what’s the truth of these contracts?
These contracts have a number of underlying parts to them and I’m going to attempt to try to explain them in layman’s terms. If a company actuary reads this post, I hope they say “he’s got it generally right” rather than not.
Indexed Insurance Contract Factor #1: The insurance company general investment account
The insurance company general investment account is generally invested in cash, government bonds, and long-term corporate bonds. Generally, very safe investments to produce a consistent yield over time.
Let’s assume that the prevailing returns are about 3%. If that’s so, then if you take 3% from $1,000 – you would have about $30. You can leave $970 in the general investment account to grow back to $1,000 and use that $30 to purchase stock market call options.
The higher the prevailing interest rate environment, the more that the company can invest in stock market call options and the higher your contract can earn – based on the performance of the underlying index.
Indexed Insurance Contract Factor #2: The pricing, strike price, and expiration of the various stock market index call options.
What is a Call Option? Investopedia gives us this definition:
What is a 'Call Option'?
Call options are an agreement that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset.
A call buyer profits when the underlying asset increases in price.
Breaking Down the 'Call Option'
Call options give the holder the right to buy 100 shares of an underlying stock at a specific price, known as the strike price, up until a specified date, known as the expiration date.
For example, a single call option contract may give a holder the right to buy 100 shares of XYZ stock at $100 up until the expiry date in three months. There are many expiration dates and strike prices for traders to choose from. As the value of XYZ stock goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at that time.
The market price of the call option is called the premium. It is the price paid for the rights that the call option provides. If at expiry the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.
If the underlying's price is above the strike price at expiry, the profit is the current stock price, minus the strike price and the premium. This is then multiplied by how many shares the option buyer controls. For example, if XYZ is trading at $110 at expiry, the strike price is $100, and the options cost the buyer $2, the profit is $110 - ($100 +$2) = $8. If the buyer bought one contract that equates to $800 ($8 x 100 shares), or $1,600 if they bought two contracts ($8 x 200).
If at expiry XYZ is below $100, then the option buyer loses $200 ($2 x 100 shares) for each contract they bought.
I remember taking my Series 7 class 14 years ago and learning about options. At the time, I remember thinking that “with options, I could ‘guarantee’ a portfolio from loss!” However, I also learned that any gains would be offset by the costs of the purchasing of the options themselves. I didn’t think it would be worth doing if you end up sacrificing your higher gains in order to purchase these guarantees on the portfolio.
Indexed Insurance Contract Factor #3: Overhead and Managing the portfolio of stock market call options
It takes people and computers to make this work on behalf of insurance companies. Software must be written, option traders employed, indexing segments created, and other regulatory overhead requirements that must be satisfied.
All three of these factors contribute to the creating of index interest segments as well as the pricing of these insurance contracts.
And you see NONE of these things happening IN or directly with your contract! All of this is “behind the scenes” at the insurance company using their general investment account, NOT your indexed interest insurance policy.
This is how you get to have “most of the upside with none of the downside” with principal protections and guarantees.
Here is a 2:30 video from Ameritas Life that pretty much summarizes what I typed out above. They just call this process "hedging".
What is a ‘segment’? A segment is a particular index interest strategy within your indexed interest insurance policy. You can’t legally call it a ‘fund’ as that implies that you are directly investing in the underlying index securities.
Two particular limitations on these strategies and why:
1. You do not receive dividends from the underlying index. The reason is because dividends are paid to actual shareholders of stocks and indexes, not those who purchase the stock options on these indexes.
2. You cannot “time the market” on these contracts. Let’s say that the market went up by 50% in 6 months (an insane amount) after you bought your contract and you want to “harvest your gains” and sell off the growth. In your contract, there would be no gains yet posted. The reason is because most of these contracts only credit indexed interest to your contract every year. They do not participate in the market performance until after each year and the indexed interest calculation is done. In the meantime, there is no additional gains (or losses) that affect the value of your policy.
The difference between annuity and life insurance index segments
Because of the reserve requirements between annuities and life insurance, the amount that can be used to purchase stock market call options is lower with fixed indexed annuities. This is why their annual “point to point” index interest segment is often much lower than it would be for a life insurance contract offering the same method for earning indexed interest.
Today, the annual point to point rate may be around 5% for annuities while it can be around 10-12% for life insurance. The reserve requirements make that distinction. However, for annuity contract holders, there are often other index interest segments you can choose from that could bring about a higher amount of credited interest. See your contract for details.
How can insurance companies offer these index interest segments without charging fees against my policy?
The insurance company prices it all within the index interest segments they offer. And I do think it’s just smarter and easier that way. They also figure that it’s just easier to help recapture some of the costs only by charging those contracts that quit the plan too soon.
This is how John L. Olsen, CLU, ChFC, AEP and the author of several books on annuities for both consumers and advisors alike – explains the various ways that insurance companies could do things and why they opted for the surrender charge schedule way to recapture costs:
Mr. Prospect, we’ve talked about these surrender charges which will cost you money if you take money from this annuity in the first few years, but not why those charges exist. Let me explain.
Insurance companies know that when they issue a deferred annuity contract — or a life insurance policy, for that matter — it will take time before it can recoup the initial costs of putting that policy on the books. These so-called “acquisition costs,” including the company’s regular overhead costs (salaries, operating expenses, agent commissions, etc.), always exceed the first year’s premium. The company will literally lose money if the policy is not kept in force for long enough to see the insurer’s investment return for investing the premiums equal those acquisition costs.
There are three things the insurer can do to make sure it doesn’t lose money. 1) It can impose an initial sales charge — say 6 percent — and credit your contract only with 94 percent of your premium and credit interest only on that 94 percent. Does that strike you as something you’d like to buy? The answer, in my experience, is always no. OK, I thought so. 2) The second thing the insurer can do is pay you less interest that it could afford or impose annual fees. How’s that sound to you? Again, the answer is always, “No. I don’t like that.” Right. 3) The third thing the insurer can do is to recognize that it only loses money when some buyers cash in the product early, and that it can simply impose on those buyers — and only those buyers — an early surrender charge, which will not be imposed on those buyers who do not cash in early. How’s that sound? Does that strike you as a fairer arrangement? In my experience, the answer is always, “Yes, I prefer that arrangement. “ Well, that’s why I’m recommending an annuity that does that. If you don’t cash it in early, you won’t ever pay these charges. But let’s make sure that you won’t. Is there any chance that you’ll need the money in this contract in the first [insert length of surrender charge period] years, given that you have the other liquid assets you’ve told me about? Original article here: https://www.thinkadvisor.com/2013/08/27/how-to-explain-annuity-surrender-charges-to-avoid/
A common belief among non-agents (or non-index trained agents):
"If you have a cap, then that means the insurance company keeps the gains above that! What a ripoff!" Um... no. That's not how these contracts work. With all the explanations above, I'm certain that my readers understand that that isn't what happens. (In fact, if that really WAS how it worked, then these would be variable insurance contracts with mutual fund sub-accounts, subject to market risk and require securities licensing for all agents that sell them.)
Can the insurance company change my caps, participation rates, costs of insurance, or anything else just because “they’re greedy”?
I hope I have outlined above that there is a thought process and an investing process that goes on behind the scenes… and it is heavily dependent upon the prevailing interest rate environment, processes, and overhead of the insurance company.
Now that doesn’t mean that the insurance company won’t have different “new money” indexed interest segments compared to “old money” indexed interest segments for contracts that are already on the books… but that difference should be negligible. And I would ask your agent to see if there is ANY history of the insurance company you are considering raising indexed interest segment caps on “in-force” business as interest rates increase. (That form may not always be “approved for use with consumers”… but I don’t see any harm in showing how the insurance company treats their current policyholders.)
This isn’t an easy process to offer from the insurance companies.
In my opinion, that’s why the early versions of these contracts weren’t as good as they are today. The insurance companies were making the early investments in how to structure these contracts and figuring it out. Today, these contracts can be generally simpler and far better for the consumer than when they were first introduced.
For more about indexed interest strategies on indexed life and annuities, I created this video to help 'de-construct' some of these terms. They aren't necessarily misleading, but it's easy to misunderstand. I hope this video provides some additional clarity: