Allan Roth takes a closer look at the role of fixed index annuities as part of an “efficient” portfolio, and as usual makes some great observations. The first thing about fixed index annuities is that no two are the same – the insurance companies don’t want to create a standardized product where they have to compete with each other on price. There are surrender charges, confusing indexes, caps, spreads, market value adjustments, participation rates, just to name a few. Even in the analyzed article, they had to use a theoretical FIA product that nobody can actually purchase. (Comparability is what makes MYGAs and SPIAs different than other annuities.)
The second thing about fixed index annuities is that within nearly every contract, the insurance company can significantly change the crediting rules after purchase.
From Annuity.org:
The growth of indexed annuities aligns with the performance of a particular stock index, such as the S&P 500. Interest rate caps denote the maximum amount of interest an annuity can earn — regardless of the change in the index. Insurance companies have the right to adjust these caps every year.
From Roth’s article:
Every FIA contract I’ve reviewed has the unilateral right of the insurance company to change the terms of the contract, such as lowering that 12% cap. Pfau agreed that insurance companies have that right. I asked Pfau how low those caps could go, and he responded, “As low as 1-2%.” I’ve seen 0.25%, meaning the contract owner would get between 0% and 0.25% annually. This right of the insurance company to slash returns was not mentioned in Pfau’s paper.
Here’s some fine print I just pulled off the internet for the first FIA product I could find:
The rates are guaranteed for the length of the crediting period. They are declared at issue and at the end of the crediting period. The minimum monthly cap for the monthly sum with cap crediting method is 0.50%. The minimum annual cap for the annual point-to-point with cap crediting method is 0.25%. The maximum annual spread for the annual point-to-point with spread crediting method is 12%. The minimum participation rate for the annual point-to-point with a participation rate and the 2-year MY point-to-point with a participation rate crediting methods is 5.0%. The minimum interest rate is 0.10%.
Note that the rates are only guaranteed for “the length of the crediting period” (one year is common, but can be up to 5-7 years). As of this writing, the current “annual point-to-point with cap” is 6.5% for the S&P 500 index. But in the next crediting period, they could lower it down to 0.25%. The current “annual point-to-point w/ participation rate” for the PIMCO Tactical Balanced ER Index+ is 120%. But in the next crediting period, the terms reveal they could lower it all the way down to 5%.
FIAs don’t offer easy comparison shopping that encourage consumer-friendly pricing, the index it tracks never includes dividends (that I’ve ever seen), and the insurance company keeps the power to change the return calculations after purchase. Hard pass.
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There are numerous indexed annuities that guarantee their rates for the duration of the surrender charge period, FYI.
You are not totally incorrect in your thinking but there are FIA’s that guarantee their caps and rates for the length of the products surrender charge period. Investors Heritage has a product built that way
Sure, but not all, and for the rest, what about after the surrender period ends? This is still an important clause that consumers need to know about. Consumers should know the guarantee here can last only from 1 to 5 years in some cases, and could be wildly different afterward.
Erik Thirsk – would you mind sharing the details of the Investor’s Heritage annuity? Also, are you comfortable going with an insurance company with a Fitch BBB- rating? Thanks. Allan
I made index annuity products for Transamerica for 7 years they are far worse than people think https://commonsense401kproject.com/2022/05/11/annuities-are-a-fiduciary-breach/
Yeah that’s a total no-go. Thanks for highlighting this.
Guaranteed Rate cap for term products do exist in the market with highly rated carriers and high consecutive scores.
Protective Life has one.
In a quick defense of Mr. Pfau:
* While it is quite possible that annuity products AS IMPLEMENTED are dominated by bond portfolios where the objective function is lifetime income adjusted for inflation, it seems to me (knowing precious little about these products, which have never interested me) that it remains possible that annuity products IN THEORY may well be on that efficient frontier. This is primarily because (1) publicly traded fixed income products, including TIPS, tend to have maturities of not more than 30 years, a source of reinvestment risk; and (2) the insurance company is spreading the risk that this particular annuity investor will live to 150 and beyond.
* The fact that an annuity involves the payment of substantial fees and expenses does not preclude its ability to form part of an optimal portfolio. Assets such as farmland and Old Masters have substantial transaction and holding costs associated with them, and are still part of a theoretical “optimal portfolio.” The efficient frontier is all about COVARIANCE; these fees and expenses impact return, but by no means disqualify a product a priori.
* In support of the possibility that this was simply a presentation to be understood in light of its assumptions, it is common to value stock options without considering the risk that the OCC fails (something I honestly worried about in 1987). Just sayin.’
* I was somewhat confused by the disclosures made by Mr. Pfau about the publication in which his report appeared. Are we to infer that his report intentionally glossed over facts that would nullify the arguments therein? It seems to me that the point was just to demonstrate the potential utility of these products.
In any event, I have never felt the need to dig into the details of annuities. Then again, I own neither farmland nor Old Masters.
The average surrender charge on an indexed annuity is ten years, so this would mean that the rates on aforementioned annuities are guaranteed for ten years. sjm