by Thomas Oliphint MassMutual San Antonio, TX and
J. Scott Dunn, CLU MassMutual Hartford, CT
Have you or someone in your agency:
- Lost an existing annuity case via a Section 1035 exchange to another annuity that offers an extra credit payment?
- Had a client ask why he or she is paying over 200 basis points in variable annuity fees while his neighbor is paying less than 100 basis points with an annuity purchased directly from a mutual fund company?
- Lost a sale because a competitor’s product offers a guaranteed minimum income benefit while none of the annuities in your portfolio offers this feature?
If we asked for a show of hands, we suspect that the overwhelming majority of readers would have an arm stretched toward the sky.
As the annuity business continues to evolve, companies are developing new bells, whistles, and products to distinguish themselves from their competitors. With these developments, it is harder to determine which products properly align with you and your clients’ best interest.
Regardless of the number of bells and whistles a product has, it must pass a litmus test on core features before the agent should consider offering it to prospects. Does the product have:
- Reasonable fees and loads?
- Appropriate investment choices?
- Suitable features that fit the prospect’s needs?
- The backing of a strong, highly-rated company?
Consider shopping for a car. A two-door convertible sports car with leather seats may be desirable, but not if the person needs to drive a family of four. And a family vehicle on a poor chasis is still a bad vehicle regardless of its compact disk player and cupholders.
Similarly, extra features do not make an annuity the right choice for the agent’s prospect if the product doesn’t meet their needs – or if it’s a poorly designed product to begin with.
Extra-credit annuities, now offered by more than 10 companies, are among the hottest annuity products on the market. These VAs credit investors’ payments with an additional payment, generally ranging from 3% to 5%, and often are used for Section 1035 exchanges. We know people who have been mesmerized by another planner saying, "Your current annuity has a 2% surrender charge. Move it to my annuity and we’ll pay you a 4% bonus, which covers your surrender charge plus crediting an extra 2% to your account."
The adage "If something sounds too good to be true, it probably is" applies to many extra-credit products. There are differences among the various extra-credit products, however, most of them come with high M+E (mortality and expense, plus administration) charges and investment management fees, high surrender charges, and limited standard death benefits. Six of the top 40 selling VAs are extra-credit products. An examination of these six products shows:
A Real Example
- M+Es range from 140 to 155 basis points (bps)
- The average investment fee (the arithmetic average of all of their variable subaccounts) runs from 77 to 120 bps.
- The total average expense for the contracts (M+E plus average investment fee) ranges from 217 to 260 bps. The average of the six contracts is 240 bps, well above the industry average of 210 bps for all VAs.
- The standard death benefit for five of the six contracts is the greater of a) the current account value or b) all of the premiums paid in. Many other VAs offer a standard enhanced death benefit that increases every year or is reset after a certain number of years. Four of the six extra-credit products offer these enhanced death benefits for an additional fee.
- All six contracts have surrender charges that are longer and steeper than most VAs. For example, the lowest surrender charge in the fourth year is 7%, 6% in the fifth year, and 3.5% in the seventh year – all of which are much higher than the average VA.
The higher fees associated with the extra-credit products can erode the benefits of the extra-credit payments over time. Here’s an example.
Another broker approached our 61-year-old client to move her annuity, valued at $105,000, into an extra-credit annuity. The broker told her she would receive a "bonus" of slightly over $4,000 to exchange the annuity, which would nearly cover the $4,200 surrender charge that would be levied against her account.
On the surface, this appeared to be an even switch for the client. After scratching the surface, however, the new product did not look as shiny. The fees on the extra-credit product were 30 basis points higher than her current product. These fees would shave approximately $25,000 off her account value after 20 years and more than $80,000 after 30 years (assuming a steady 10% growth per year before fees).
Liquidity was also an issue, as she would start a new surrender charge when she purchased the replacement annuity. With her current annuity, she would be free of any surrender charge after three more contract years; the extra credit annuity imposed a 7% sales charge for the first four contract years, 6% in the fifth year, 5% in the sixth year, and 4% in the seventh year.
While the extra-credit product offered a wider range of investment options, the client was satisfied with the options in our contract and was happy with the performance. In addition, the extra-credit product did not offer a better standard death benefit than the one she currently had, and a company with lower ratings offered it.
We are not saying extra-credit products are never appropriate. But the agent must weigh carefully all of the product’s costs and features when comparing them to others. The higher fees associated with the extra-credit products compared with many other VAs will offset the bonus payment over time. And if the product is being used as a Section 1035 exchange vehicle for contracts still subject to surrender charges, the performance will suffer further as the bonus is partially or fully offset by the surrender charge.
An insurance company or mutual fund company sells direct-marketed annuities directly to consumers. These contracts have lower total costs as a result of low M+E charges.
Lower prices are usually appealing to consumers, but people usually get what they pay for. A look at the top 10 selling direct-marketed annuities shows their average total expense is 124 basis points, 86 basis points lower than the average VA (according to VARDS Profilers – Third Quarter 1999). When comparing these products to a product in the agent’s portfolio, however, the key is whether the other VA offers additional features or options to justify the added expense. A further look at the top 10 direct-marketed annuities also shows:
- Only one of the 10 offers a standard death benefit beyond the return of premium or account value.
- The average number of variable subaccounts within these VAs is 14, which is less than the number of subaccounts offered by most other top selling annuities.
- The equity funds in the three lowest-cost direct-marketed products averaged a 21.47% return in 1992, well below the average return of 29.24% return for all VA equity funds in 1993.
These three contracts rely heavily on index funds and do not cover the same range of investment categories as do many other variable annuities. This is not a blanket statement that direct marketed products generally underperform other VAs. Rather, in general the performance of a VA equals investment returns minus fees, and the aggregate number is what is important.
Product features common in many VAs do not appear in all direct-marketed annuities, including dollar-cost-averaging plans, asset allocation and rebalancing programs, and terminal illness benefits.
Finally, and perhaps most important, a direct-marketed annuity buyer often does not receive valuable service from an investment professional like the agent. Non-direct-marketed annuities cost more mainly because of commissions, but those commissions pay for the valuable and effective counsel and services we agents provide. Is the client properly diversified in the right subaccounts? How does the annuity fit with the client’s financial objectives? Should the client annuitize or take systematic withdrawals?
Living benefit options provide additional guarantees to the policy owner. These benefits include:
- Guaranteed minimum income benefit: This guarantees, upon annuitization, that the person’s monthly income will not fall below a certain amount.
- Guaranteed minimum accumulation benefit: This guarantees the account value will not be below a floor level after a set number of years.
- Long-term care coverage: This provides a monthly income if the insured is confined to a long-term care facility.
These benefits are certainly viable and attractive options for some customers, but there are cautions. First, as with extra-credit products, the options are only as good as the underlying product, and an inferior product with a living benefit still is an inferior product.
Second, there generally is an additional fee for these options that limits the account’s growth potential. As we showed in the example highlighting the effect of higher fees in an extra-credit product, an extra 25 or 30 bps can limit the client’s growth potential by tens of thousands of dollars over the contract’s life. Is this expense worth it? For some, yes, but the agent and the prospect need to weigh the benefits against the additional cost.
Third, a negative regarding guaranteed minimum income benefits is that the person must annuitize and usually must take a fixed annuitization. While the monthly payment is guaranteed, the amount over the years may not be as high as it could be with variable annuitization. This could harm the client financially during inflationary periods. We often wonder how many clients who opt for a fixed payout stream from their annuity fully understand the advantages and disadvantages of this option.
As we mentioned, it is imperative that the agent confirm that the underlying annuity product is appropriate for the prospect before considering the options. Are the fees and loads appropriate for the situation? For instance, a no-surrender-charge product may be appropriate for an older prospect but not for a younger prospect because of tax considerations. Are the fees in line with the death benefit and other product features? Is the M+E lower than other products but are the subaccount fees higher? Does the product offer a breadth of investment choices so the person may properly diversify investments?
Behind every annuity product is an insurance company. Many experts believe the company’s strength is important in the variable annuity market for several reasons. A strong insurer:
- Is more likely still to be around to fulfill long-term needs of clients and of sales representatives.
- Can better invest in technology and additional product features.
- Is more likely to work with money managers who comport with the strategy, goals, and objectives of the issuer itself. That leads to strong, reliable partnerships with firms that have substance and proven track records.
For clients and prospects, the issues seemed so simple at first: hot new products that seem to offer more. But after you lift the hood on these products and look at all the issues, you may be able to offer prospects what they really need: a solution to their specific needs. Ensuring that your clients have the right products and services is – and always will be – the best deal for both of you.
Printed in Life Insurance Selling for March 2000.
Last Updated: 12/15/2002 10:51:00 AM
- VARDS Total Reference, Third Quarter 1999 Sales & Asset; Morningstar Variable Annuity Performance Report, December 1999.
- VARDS Profilers, Third Quarter 1999; VARDS Total Reference, December 31, 1999, Monthly Performance: Morningstar Variable Annuity Performance Report, January 2000.