5 Reasons to Question the Recent Indexed Annuity Article in Bloomberg

An article on indexed annuities appeared in Bloomberg yesterday (click here to read).

The article is substantive and comes from a credible source.  It is provides a good explanation of why surrender fees need to be a front-and-center consideration for any consumer considering the purchase of an annuity.

Upon further reflection, though, I realized that much of the article is essentially a more polished version of the same old saw on annuities, and here are 5 reasons why:

1) Indexed Annuities are too Complex

You mean to tell me that people understand variable annuities, life insurance, how their mortgage works, their health insurance policy, how their car runs, how their television works, the Electoral College?  The list goes on and on.  Few people have in-depth understanding of how anything works.  This is one of the reasons why we rely on a market economy where people specialize and where I can avoid having to build and understand my own automobile.  If full understanding were the bar to ownership of anything nothing would happen in our society and I would be walking everywhere.

2) Lack of Transparency

The article leads one to believe that the lack of transparency is a result of some sort of intentional obfuscation.  Not sure that this is at all the case.  Indexed annuity contracts and prospectuses do exist, and much of the information is in the public domain.  The reality is that no one bothers to read them.  However, this fact is not unique to the annuity industry.  Did you read the prospectus for your most recent mutual fund purchase, mortgage contract or life insurance contract?  How about the user agreements for your preferred email provider or PC operating system?

3) Sales Commissions

The reality is that the incentives driving much of our financial system are conflicted.  Want to trade a bond?  The bid-ask spread is good for the broker but bad for you.  Your mutual fund management fee is directly at your expense and so are any additional advisory fees.  Frequent trading of securities is bad for the customer but good for the croupier.  Sales commissions provide financial advisors with a financial incentive to do the time consuming and expensive work associated with finding customers and selling products.  I think one of the reasons sales commissions get so much airtime is because the concept is comparatively straightforward and easy to understand.  Regarding incentive trips to Disney World, how does one begin to compare the societal harm of this incentive relative to the incentives provided to our nation’s banks to make highly leveraged “heads I win, tails you lose” bets with a taxpayer safety net?   

4) Inadequate Regulation

Are securities regulators really more capable of managing the indexed annuity industry than departments of insurance?  It would seem that this argument has lost a bit of its luster after what has taken place over the past several years?  Name the most recent Madoff or Stanford that came to us via the insurance industry.  Does the insurance industry subject consumers to binding arbitration via a panel comprised of participants largely from that same industry?  Why would federal oversight be more rigorous than state-level regulation?    

5) Derivatives and Limited Upside

Not sure I completely understood the derivatives reference in the article.  It seems related to product complexity and the overall toxicity of indexed annuities.  If the use or existence of derivatives in a product or service makes it unsuitable for public consumption, then prepare to forgo your mortgage, many of your groceries, your life insurance policy, your airline tickets, your heating bill…

With respect to the capped or limited upside of indexed annuities, how on earth could a product that provides a floor or downside protection also provide full upside?  The upside and downside features of indexed annuities are created through hedging programs, and hedging is expensive.  Call your broker to see how expensive this type of hedge would be.  In my opinion, one of the points in favor of indexed annuities is that they enable the delivery of sophisticated hedging programs on a mass scale.  Retail consumers simply would not have access to similar derivative positions without the use of a product that can deliver standardized hedging programs at scale.

On the plus side, the Bloomberg article does a good job of highlighting an important point.  Namely, if you are considering the purchase of an indexed annuity, be aware that:

• Buying an annuity means your money could be locked-up for awhile.
• You need to know how long this period is, and it varies from product-to-product and contract-to-contract.
• It will likely cost you money (surrender fees) to make an early withdrawal.
• Don’t put money into an annuity unless you do not need access to it during the surrender period.  You need to have adequate liquidity and reserves for expenses that will arise--especially unplanned expenses.