Good financial products are bought, not sold. We are continuing our series of articles analyzing some of the most aggressively sold financial products – those which are advertised on television. This is the second installment in our series. The first installment, on Lear Capital, can be found here.
An ideal retirement product should provide steady, secure income and upside participation in the stock market. That’s why advertisements that promise performance that will be “up with the market and never down, forwards with your money and never backwards” are so tempting. That’s exactly what Ty J. Young claims in his advertisements that are frequently aired in the Boston area, where I live. I’ll explain why investors should be extremely wary of the products his firm sells.
In fairness to Mr. Young, he is one many firms that make such claims. This article is not about his firm specifically. One of our readers alerted me to Phil Cannella, who pitches his "crash-proof retirement" in the Philadelphia market. Young and Cannella’s firms are insurance-marketing organizations (IMOs), independent companies that market products from a roster of insurance companies.
But this article is not about IMOs either. It is about the specific product Young, Cannella and other IMOs are selling – a fixed-index annuity (FIA), also known as an equity-indexed annuity (EIA).
I will explain why the FIAs sold by Young’s firm are a poor investment, and how their complexity positions them to exploit uninformed customers.
How an FIA works
The concept behind an FIA is simple: the investor gets a portion of the upside returns from the stock market, along with downside protection against market losses. This is a laudable design goal. It’s the implementation in specific products that is lacking.
I spoke with a representative, whose title is “advisor,” at Mr. Young’s firm and asked him to describe his firm’s most popular product. This turns out to be an FIA offered by American Equity Investment Life, an Iowa-based insurance company, called the “Bonus Gold Index 1-07.”
I was told that this product offers a number of “crediting methods” from which the investor can choose. The most popular is monthly point-to-point crediting, where the investor gets 60% to 80% of the upside in the market (the S&P 500 without dividends) each month (the “participation rate”), subject to a cap of 2% per month. At the end of the year, the value of the annuity increases by the cumulative value of those monthly amounts, subject to the provision that the minimum annual return is zero (i.e., it never loses money).
I was told that the participation rate varies depending on how long the investor is willing to lock in his or her money. You can lock in your money for six to 16 years, after which you can withdraw 10% per year of the accumulated value without incurring penalties (“surrender charges”). Those penalties are steep; they start at approximately 20% in year one and scale down to zero if you own the product for 17 years or more.
The first thing you should recognize is that this is not an annuity. It is a vehicle that can grow in value over time, but pays no dividends and offers no income. Income comes only if the investor withdraws money. The product is more like a zero-coupon bond, with returns linked to the equity market, than an annuity.
There are options to annuitize the accumulated value of the FIA, but I did not analyze those.
There are no fees for this product in the traditional sense. The product is constructed in such a way as to ensure it is sufficiently profitable for the insurance company and for the IMO, which pays a commission to its “advisor.”
The deceptive marketing behind FIAs
I’ve already pointed to factors that should be serious concerns. The first is that the representative at Young’s firm has the title of “advisor.” But the firm does not operate under the fiduciary standard. Moreover, FIAs are not regulated as securities. They are insurance products and this representative is an insurance salesperson.
Second, the index used is the S&P 500 without dividends. I’ll come back to this in a moment.
Here’s where the deception comes in. The marketing brochure from American Equity contains this chart:
This shows the supposed merits of the FIA. For the 15-year period, starting on September 30, 1998, a $100,000 initial investment in an FIA would have ended with $191,063, assuming no withdrawals (the green line). The minimum return offered by this product would have been $151, 258 (the blue line), and an investment in the S&P 500 would have returned $137,337 (the red line).
This is deceptive in three ways. It uses a starting date near the peak of the dot-com bubble, when equity valuations were at historical highs. Had it used a different starting date, say in 2002, the results would be dramatically different. Second, it uses the S&P 500 without dividends as the benchmark. The S&P 500 with dividend reinvestment for that period would have produced an ending value of $218,383, which exceeds the FIA’s value, even after deducting the expense ratio (0.06%) for an index fund. The description in the brochure that accompanies this graph does not mention that the S&P data is without dividends.
But the description does mention that FIA depicted in this graph is no longer available, and that participation rates and caps on FIAs are subject to change by the insurance company. That is the third deception.
I went back and calculated how the FIA described to me would have performed over this period. I assumed 80% participation in upside monthly returns, a 2% monthly cap, a minimum annual return of zero and an index of the S&P 500 without dividends. The resulting cumulative value was $139,627, less than the product shown (and about equal to the S&P 500 without dividends). That is an annual return of 2.25%.
As I mentioned, a more appropriate benchmark for this product is a zero-coupon bond. A 15-year zero-coupon Treasury bond, purchased at the beginning of the period, would have returned approximately 6% (I had to interpolate between the 10- and 20-year rates to get that number), more than twice the return of the FIA.
But a Treasury bond is completely liquid with no surrender charges. Moreover, it is risk-free. While Young’s company claims its products provide “guaranteed” income, they offer no such thing. The FIA carries the credit risk of the underlying insurer, American Equity. While state regulators maintain some funds to protect against the failure of an insurance company, there have been bankruptcies that have resulted in the failure of an annuity to provide its “guaranteed” payments.
Will the DOL fiduciary rule help?
This FIA is a complex product. I spent several hours calculating its historical performance in Excel. But someone who is thinking about buying this FIA would need to do a more thorough analysis. It requires a Monte Carlo simulation, based on assumed equity market returns and volatility, and an analysis of the sensitivity of the outcomes to those assumption. Even at that, the analysis would be incomplete, because the insurer has the right to change key features, such as the participation rate and cap.
Unless you are prepared to construct such a model and accept the risks that the insurer does not go bankrupt and will not change the features of the product, you should not buy this FIA.
The typical consumer purchasing this product faces a daunting challenge. There are few resources for education. If you do a Google search, you will find sites that claim to explain FIAs or to review different FIA offerings. But those sites are maintained by IMOs seeking to sell you their own featured FIAs. You have to dig deep into a Google search to find an article such as this, which is an academic study that validates my analysis.
The sale of FIAs will require firms such as Young’s to use the best-interests contract exemption (BICE), if the DOL fiduciary rule goes into effect in April. Either the IMO or the insurance company will need to qualify as a “financial institution.”
Will that overcome the challenges posed by the complexity of FIAs?
Ron Rhoades, an authority on the fiduciary rule, is not optimistic. He believes that explaining and ensuring the client understands all the important facts about an FIA is too significant a hurdle to be overcome by the BICE. Indeed, the BICE presents its own challenges, as Rhoades wrote in this article, B.I.C.E.: Financial Advisors Beware. Rhoades’s argument is essentially that the BICE requires an institution to adhere to the fiduciary standard and, in the case of complex, commission-based products such as an FIA, it is unreasonable to expect a firm to achieve that standard. Ultimately, he claims, economic incentives will cause firms to not act in their clients’s best interests, and legal liabilities and reputational damage will result.
Until FIAs are designed that can be sold in a fee-based, fiduciary environment, investors should avoid them.
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