Wade Pfau

Where Do Annuities Fit in Your Client’s Retirement Strategy?

May 17, 2023 2023, Media, Wade Pfau No comments

The wish to offer attractive principal-protected products while in a low-interest-rate environment prompted the proliferation of custom indexes and their inclusion in insurance products over the last decade. Most notably, in fixed indexed annuities (FIAs) we saw a persistent shift of premium allocations from benchmark indexes such as the S&P 500 to custom risk control indexes.

With the increased use of these novel, sometimes complex indexes, there are still misperceptions concerning how they work.

Recent lawsuits around annuities using custom indexes have sparked debate about sales practices and tools available to demonstrate performance and understand the functionality of these indexes, on their own and within annuity products. The roles and responsibilities of index providers, insurance carriers, advisors and ultimately end clients enter the discussion as well.

As a contribution to this debate, let’s take the opportunity to try to dispel some misperceptions concerning not only custom indexes themselves, but more importantly, their role when used in FIAs.

No Active Management, No Fiduciary

The first point to make is that a custom index is fundamentally different from an actively managed fund. With a custom index, there is no portfolio manager making decisions regarding composition, allocations or weightings through time.

Instead, a custom index is calculated according to a predetermined set of rules. The index provider sets these rules at the inception of the index and ensures the rules are followed thereafter. So, a custom index is in essence non-discretionary.

The index provider does, however, have a high-level responsibility to ensure that the index continues to meet its objectives over the years. To this end, index providers reserve the right to step in and exercise discretion to fix problems. But the index provider is not a fiduciary, and a custom index is not actively managed.

However, because the index is rules-based, the investment process is, in principle, fully transparent, meaning it can be replicated. This is in contrast to an actively managed fund, which is often opaque with no insight into the actions of a portfolio manager.

Another significant distinction is the absence of “style drift.” The way an index selects and allocates to different assets and asset classes is solely driven by the index rules. For example, if you chose an index because it selects low-volatility stocks, you will always get that, and never highly volatile growth stocks.

One potential source of confusion may be that many indexes are provided by large asset managers and banks that have asset management operations. But a custom index from such a provider is not to be confused with any fiduciary asset management services they may offer.

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The discussion is not meant to provide any legal, tax, or investment advice with respect to the purchase of an insurance product. A comprehensive evaluation of a consumer’s needs and financial situation should always occur in order to help determine if an insurance product may be appropriate for each unique situation.

It May Be Time To Swap The Old Annuity For A New One, Experts Say

May 17, 2023 2023, Media, Michael Finke, Wade Pfau No comments

MAY 16, 2023 • BEN MATTLIN

In the current interest rate environment, exchanging an old annuity for a new one may be a wise move, according to some experts. But there are caveats and exceptions.

As a strategy, annuity swapping “can make a lot of sense right now,” said David Lau, founder and CEO of DPL Financial Partners, an RIA consultant network in Louisville, Ky., that specializes in low-cost, commission-free annuities. “But care needs to be taken to review individual situations.”

The Case For Exchanging Annuities
The case for an annuity upgrade is pretty simple: Higher interest rates mean higher payouts for many types of annuities.

Fixed annuities, which pay a set amount over a specified time period, are most directly tied to prevailing interest rates. But variable annuities (VAs), which invest in mutual-fund-like subaccounts that rise and fall with the stock market, offer optional “living benefit” riders such as lifetime income guarantees (for an extra fee) that typically become more generous with higher interest rates.

In addition, many fixed-indexed annuities (FIAs), which reward annuity holders with a percentage of an index’s gains in exchange for complete downside protection, and registered index linked annuities (RILAs), which are VAs that credit a higher percentage of investment gains while providing a degree of downside protection, tend to increase the percentage of gains that are credited to the account, when interest rates move up.

Before a client rushes to upgrade an old annuity, though, be aware that it might be pointless. “Many fixed annuities will renew into the higher current rates automatically, so a new policy may not be necessary to benefit from today’s higher rates,” said Lau.

Surrender Charges
Another caveat concerns “surrender charges.” Most annuities have a “surrender period” of six to eight years after purchase, during which you cannot sell or take a substantial withdrawal without incurring a hefty fee.

Early-surrender charges would reduce the value of exchanging for a higher paying contract. But that’s not necessarily prohibitive. “It may be worth paying the charge if there is a large enough difference in return,” said Michael Finke, professor and Frank M. Engle chair of economic security at The American College of Financial Services in King of Prussia, Penn.

Surrender charges often decline over time as well, so the older the annuity the smaller the hurdle.

Careful analysis should determine whether swapping for a new annuity is cost-effective. “For lifetime income [annuities], look at the amount of lifetime income the current contract provides versus how much lifetime income could be provided by moving the contract value, net of surrender charges, to a new annuity with a higher payout rate,” said Wade Pfau, Dallas-based co-founder of RISA (Retirement Income Style Awareness) and author of Retirement Planning Guidebook, in an email. “If the new guaranteed income is greater, it might be worth doing.”

Beware Market Value Adjustments
But with annuities, nothing is ever quite so simple. “Even if you have a no- or low-surrender-fee annuity, there could still be a market value adjustment,” said David Blanchett, Lexington, Ky.-based head of retirement research at PGIM, the investment management group of Prudential.

When you buy an annuity, he explained, the insurance company that issued it invests the lion’s share of your premium in bonds. Today, with higher interest rates, those older bonds are devalued. Therefore, if you surrender your old annuity now, it might trade in for less than when you bought it.

“You should expect to get less than you put in,” he said.

A Potential Opportunity
Nevertheless, the exchange still might pay off.

“Much like a decision whether or not to refinance a mortgage, it comes down to the cost to exit the old versus the time to realize the advantages of the new,” said Frank O’Connor, vice president of research at the Insured Retirement Institute in Washington, D.C.

But American College’s Finke notes that salespeople are encouraged to help clients evaluate the benefit of comparison shopping. “Commission-compensated agents are incentivized to recommend switching to more attractively priced products,” he said.

Record Sales—From New Buyers
So far, however, most clients don’t seem to be upgrading their annuities.

“As rates have increased, we’ve seen protected accumulation and income solutions like annuities provide increased value relative to other financial products, which has attracted new customers,” said Scott Gaul, head of individual retirement at Prudential Financial in Newark, N.J.

Higher interest rates have driven record-breaking annuity sales, according to data tracker Limra. But most of that has come from new buyers, not trade-ins.

“We have looked at this extensively, and we do not see signals of significant exchange activity in the market,” said Todd Giesing, assistant vice president and head of Limra Annuity Research in Windsor, Conn.