Total Return Annuities Can Be CD Alternative

By Jack L. Martin and Kathran J. Martin

Many people are asking about one of the hottest new fixed annuity products—the so-called "total return" fixed annuity—now available from at least five major annuity players.

This FA credits the client with the total return (including interest and capital gains) from the insurer’s general account investments, minus a fixed administrative fee.

To achieve its purposes, the policy uses what may be called a "hybrid technology." Specifically, it has the positive characteristics of a variable annuity, in that it links the clients' interest rates to the 'total return' of the insurer's general account assets. But it also retains the strengths of the traditional FA, in that it provides guarantees of principal and interest.

News of the product has spread like wildfire among agency groups, with many wanting to know if these products are real, how they work, and what their future might be. This article addresses the key elements.

The concept began taking root as early as six years ago. As indicated, its goal is to credit the client with the total return (including interest and capital gains) from the insurance company’s general account investments minus a fixed administrative fee. The structure differs from the traditional crediting method, because the returns are not limited to yield on the investments, but also include the capital gains. It also differs from the traditional approach by capping the insurer’s profits through the fixed administrative fees.

Some people are calling these new plans "bond index annuities." This label is probably misleading, however, since the clients' interest is not directly indexed to bonds.

These FAs promise returns similar to the returns from the Merrill Lynch Convertible Bond Index, Lehman Brothers Government/Corporate Bond Index, or the Merrill Lynch High Yield Bond Index. But there is no direct linkage to the index, as there is in an equity index annuity, which links the credited interest to the growth of a specific index.

This lack of direct linkage allows the products to generate both current interest and minimum guaranteed interest from the same assets. The insurer purchases no bond index options. It is the insurer's general account assets that back the guarantees, and the client's total return is derived from those assets.

The insurer may choose to segment its general account assets into categories—like investment grade, convertible, or high yield. But the approach that has offered the greatest appeal to state insurance regulators is to blend these bond categories.

In our view, since the products are FAs guaranteed by the general account assets of the insurer, they really are "total return" annuities. They guarantee the clients will receive the total return from the underlying assets. In addition, they guarantee that the maximum charge kept by the insurer from that total return is limited to an annual administrative charge of 2.5 percent to 3 percent.

(The best of these products, in our opinion, also guarantee that the underlying assets will match the strategy or investment objective, such as a long-term retirement strategy. This is a very important consideration since a company could manipulate the assets backing a total return annuity in a way that hurts client returns.)

How have they performed? Assuming the company only did as well as the Lehman Brothers' Government/Corporate Bond Index (and most companies can do better), the client would have netted 7.51 percent in 1997, and 7.24 percent in 1998. By contrast, the average single premium deferred annuity, 5.74 percent in 1997 and 5.25 percent in 1998, according to A.M. Best. That’s 180 to 200 basis points a year more for the client with the total return product—and no additional market risk. So it worked for the client.

This is a good point to add a cautionary note to producers: In selling these products, it’s important to guard against "over-promising" to the client—even though we’ve had excellent returns in recent years. If the client expects 6 percent to 8 percent a year and the product produces that, you will have satisfied clients. But if the "promise" is at 8 percent to 10 percent a year and the actual return is only 7 percent, the client will be disappointed—which often means you will lose the client, even though 7 percent is better than the average certificate of deposit rate and the average SPDA rates.

There are those who say that, with total return FAs, you don't know what you've really earned until you withdraw the money. This seems odd to us, since every day billions of dollars are invested into the stock and bond markets, and those millions of people know their profits and/or losses are never locked in until they sell. But the concern certainly is not a big obstacle to sales, especially since clients may make more with a total return FA than with many annual reset EIAs.

Jack L. Martin, CFP, and Kathran J. Martin, CFP, are co-founders of Annuity Financial Services, Inc., a Dallas national marketing organization. E-mail: info@annuityfinancial.com.