You’ve heard the “F” word thrown around a lot recently, and often, it is clearly not appropriate. I’m talking about the word “fiduciary” of course.
The financial industry has a few different standards that apply to the sales and management of assets, from “suitable” all the way to fiduciary. Fiduciary is a standard by which people who invest and manage money are supposed to operate. It’s simple: Operate in the “best interest” of the owner of the assets. Recently, a trend has developed: using “fiduciary” as part of the marketing message in collateral, ads, infomercials and seminars. I’ve often been mildly amused at the innovative and creative tactics that are used in the financial industry, and in this commentary, I’m focused specifically on Fixed-Indexed Annuities (FIAs), most often being sold to older investors.
The rules for marketing and selling FIA contracts are different, and generally a bit more lenient, than the rules for selling registered securities because insurance agents are regulated by individual state insurance bureaus, whereas securities sales fall under the purview of FINRA. Somewhere along the way, a new model of delivering “financial advice” took a turn for the worst and produced an environment where purveyors of FIA contracts either dropped or never attained a securities license and instead took the easier path of holding only an insurance license and taking an exam to become an “investment advisor representative” IAR.
The IAR title mandates that the individual operate under the fiduciary standard, which by itself, is good. RIAs are also prohibited from earning any commissions. Here is the twist: Annuity sales agents who are also investment advisor representatives have begun to advertise their services as being offered by a “fiduciary,” when in fact, that statement was only partially true. If an agent holds an IAR and an insurance license, only investments that fall under the IAR license will have the fiduciary standard applied to them. However, fixed indexed annuities are not covered by the IAR license. The agent can only be considered a fiduciary with respect to those assets being managed under their IAR license.
This is where a potential conflict can arise. When an agent acts as both an IAR and an annuity agent, the implication, or what I think is more of a lie by omission, is that the agent is somehow operating entirely as a fiduciary, when in fact nothing could be further from the truth. The incentive to sell FIAs is high. Fixed indexed annuities can pay a huge commission, sometimes as high as 10% of the premium. To put into financial terms, if you invest $100,000 into that contract, the agent immediately earns $10,000; for a $1,000,000 investment, the agent earns $100,000 in commission. To be fair, most commissions today range from 5-7%.
Any transaction that involves a commission cannot fall under the fiduciary standard. This, to me, is a massive red flag. Either the agent is being guided by some “training academy” and simply doesn’t know they are being misleading, or more likely, they know exactly what they are doing and are trying to skirt the rules and create a false image of their true obligations. It’s either bad, or really bad.
There is nothing wrong with an agent earning a commission to help their client invest their money as long as both parties to the transaction benefit and the process is transparent so the client knows and understands exactly how it works and what reasonable expectations of performance could be. In my experience, as an advisor who has been operating for over 30 years, I have seen hundreds, maybe even thousands, of cases where I am approached by a client who needs help because they own a complex, underperforming annuity contract they don’t understand. Even though the annuity contract is not performing as expected, they are not able to exit the contract because it is cost prohibitive to do so. It’s heartbreaking and frustrating to hear.
To help people avoid finding themselves in a position where they are stuck with something they don’t want and can’t get rid of, I strive to provide you with information so that you can make informed, prudent decisions about your money. I also want to make sure you recognize when your needs are not a top priority. Let’s start with Fixed Indexed Annuities.
UNDERSTANDING THE FIXED-INDEX ANNUITY
Prodigious producers of FIA contracts, both individual agents and their supporting sponsors called financial marketing organizations (FMOs), have gotten pretty clever in their core focus of selling more FIAs. To be clear, selling FIA contracts in high volumes is quite profitable.
You need to understand what an FIA is designed to do versus what agents often imply that it can do. It is a fixed income alternative, meaning that it is built to provide a very conservative investor a choice beyond a CD, fixed annuity, government bond or some other investment that has safety of principle. As interest rates have steadily fallen over the last decade, yields on traditional fixed income products have become anemic. An indexed annuity offers a fixed principle investment that provides an interest component that is tied to the movement of a particular stock index, such as the S&P 500, NASDAQ, etc.
The salient point is that while the interest is tied to the movement of the index, NONE of the money is actually invested in the stock market. The insurance company invests mostly in a portfolio of bonds; a relatively small portion of the investors’ money is used by the insurance company to purchase options on the chosen index; and the interest credited to the investors account will be determined, in part, by how well or poorly the chosen index performs.
If it does well, the options will produce some extra income and the investor’s overall yield will improve. If the chosen index produces a negative return, the options expire and are worthless. The owner of the annuity contract won’t lose principle, but the options didn’t improve the base return, which is mostly generated by the bonds in the insurance company’s general account. Overall, the return of the contract is usually driven by the interest the bonds generate. The options can have a meaningful impact, however, contribution to performance tends to be less significant to overall performance than the bond interest.
There are essentially four basic components that an investor’s money will go to once the insurance company receives the deposit. Broadly, the categories are bonds, options, commissions to the selling agent, and lastly, profits to the insurance company. You might be surprised to learn that in most cases, profits to the insurance company are the smallest category. FIA products are generally high volume, but lower margin, products for the insurance company, but they are immediately lucrative to the selling agent. Again, commissions will vary between carriers and specific contracts, but as a very general rule, the amount of the commission can loosely be estimated by the length of the surrender charge. The longer the surrender charge period, the higher the commission is likely to be. If the length of the surrender charge is somewhere between 5 and 7 years, the commission percent to the selling agent is often in that same range. In my opinion, there is almost never a great case for the length of the surrender charge to exceed 7 years.
What the FIA is NOT designed to do, is produce returns that are competitive to equity-based strategies such as mutual funds, managed stock portfolios, index funds or any other investment based primarily on the stock market. Expecting equity-like returns is like expecting the laws of physics to change.
We established that, generally, the largest component of potential returns generated by an FIA is the interest generated by the bond portfolio. It’s no secret that today interest rates are near historic lows, which means that the interest income generated by bonds will also be low. The lower the bond interest earnings are, the smaller the amount of money the insurance company has to buy options on a stock index, and thus, the options will have a lower potential impact on the overall interest credited to the FIA contract.
Like the laws of physics, these basic facts will never change. Commission structures have come down, modestly, but the fact is, FIAs are complex products that do not sell themselves, so there will always need to be a strong incentive plan to induce agents to move product for the insurance companies, so it seems unlikely that the compensation portion of the equation will change much. Insurance companies require profits to stay in business, so that component is unlikely to change either. The only variable components are interest rates and options returns. In a low-interest rate environment, expecting anything other than modest returns from an FIA is, again, like expecting the laws of physics to change.
As an added measure of protection against these periods of low interest rates, investors are often sold “income guarantee” riders to the FIA policies. In my opinion, adding any kind of an “income guarantee” rider to a FIA is usually pointless. The whole argument for an income rider on an FIA is based on the concept that highly volatile markets can produce periods of time where investments experience losses, and if you are taking withdrawals during times when your investments are also falling in value, the odds of your investment running out of money increase by quite a bit. FIA contracts do not produce losses, they simply may not generate any interest income for a period. With an added rider to the FIA, the investor is essentially paying the insurance company extra money to insure against a risk that essentially doesn’t exist. This makes no sense to me.
Ultimately, I perceive the rider concept as a way to alleviate the fear of running out of money in retirement – something that most people genuinely are concerned about. However, it’s a bit like buying insurance against the risk of being struck by lightning. Could a rider on a FIA add value? Sure, but the odds of an investor actually getting measurable value from an income rider on a FIA don’t seem much better to me.
In the end, I see the FIA contract as potentially useful for a very conservative investor who simply cannot come to terms with any kind of principle fluctuation, but wants a bit more interest than what traditional fixed income securities offer. Mostly, however, it has become the product of choice for insurance agents to take advantage of a fearful aging population for their own financial gain.