Jeremy Alexander is Founder and President of Beacon Research, the industry’s leading source for comprehensive fixed annuity research. In this interview Alexander and I explore a number of issues of current interest to annuity industry participants. I ask him to explain why the annuity industry is facing its current negative marketing environment, and to comment on the changes he sees as necessary for the industry to reach its full potential in Boomer retirement security. As you’ll read, Alexander doesn’t fear new entrants that may try to take away annuity industry market share. Rather, he sees new opportunities for insurers in having their core competencies integrated into solutions which feature multiple product types.
Macchia: Jeremy, you are the founder and President of Beacon Research. Would you begin by describing your work?
Alexander: Certainly. We provide transparency into the fixed annuity market. We track fixed annuity products across all states, and all variations. We also track sales of those products in all channels. So we provide market intelligence to most of the leading fixed annuity providers which use our web–based tools for pricing, product creation and marketing. We also provide sales desk personnel with tools that allow the analysis of competitive products and give accurate answers to their sales force. And, we produce a front-end for distributors so that their producers can scan their product set to figure out which product is the most appropriate for a given client.
Macchia: You talked about the provision of transparency into the world of fixed annuities. That said, some fixed annuity products, including some that command a large share of sales, are relatively opaque. Are you able to make opaque products transparent?
Alexander: Yes, to the extent that a carrier provides their information to us. They will typically give us all of their source documents to their products; that would be contracts, brochures, state availability and rate information. And they would agree to keep us up to date on any changes that might occur to any of those variables. So once the source documents are provided to us we extract the data in a standardized format and put it into our system. At the point you have, essentially, full transparency into the product. So, yes, that’s what we do.
Macchia: It occurs to me that you have something of a unique perspective on the fixed annuity business. You live it day-to-day, you’re aware of the latest trends and developments, product development initiatives, product performance, etc. I’m curious as to your view on the long-term outlook for the health of the industry. You are certainly aware that fixed annuities have attracted no shortage of criticism by both regulators and the press over sales practices and contract designs. What do you think about when you imagine the future of the business?
Alexander: That’s a good question. Because we track sales of these products as well, we’ve been noticing something very interesting in the last year to two. And that is that typically we were able to benchmark sales by channel, by product type, and various independent indexes like rates, spreads, CD rates, even the S&P 500.
What’s been happening in the last year to two is that we’ve been seeing increased sales in the face of what would appear to be poor economic environments. So, in low rate environments, in strong stock market environments, we’ve been seeing sales that we have difficulty explaining in any other way other than the oncoming retirement income revolution. What we believe is that the fixed annuity side is truly the cornerstone of the retirement income market at this point, especially if you take a look at immediate annuities, for example. There’s no variable immediate sales, but there seems to be a continuing increase in fixed immediate sales. So, we think that there’s a very positive outlook over the next five to ten years in the fixed market. And frankly, to some extent, we believe the current regulatory scrutiny is positive to the market.
Macchia: Positive in the sense of ferreting out bad practices in order to set the stage for greater growth, tomorrow?
Alexander: Absolutely.
Macchia: When you say that, given hostile market dynamics, that you’re surprised by the level of sales you see, is that across all types of fixed annuities? Or is it indexed annuities, or something else? What type or types of product subset are you referencing?
Alexander: Well, they all compete with each other so we see expansions and contractions in book versus MVA versus Indexed versus immediates. So it’s not a straight line in each product type. I see the expansion in the overall sales. For example, we saw rates hit 5% in the 3rd quarter of last year and that created an explosion in sales of the MVA products. That was to the detriment of book value products. You could consider all of these as separate markets that compete for dollars in different economic environments. I see the overall expansion in the market in the consolidated numbers.
Macchia: I’m curious to get your views about the business of indexed annuities in the period post NTM 05-50. What have you observed up until now, and what you foresee going forward?
Alexander: My first guess about the result of 05-50 was that there was going to be a tremendous shift of sales from the independent channel over to the broker-dealer channel given that a good number of these individual insurance producers are series 6 and, or, series 7 licensed . My guess was that we were going to see movement of these products over to the broker-dealer side.
We have not seen any numbers in our sales studies that indicate that this shift is occurring. Now, part of that is simply because, you know, even if a broker-dealer does do business in the EIA space often times they’re utilizing an IMO to do that business, so some of those sales are just coming out as IMO sales even though they should be broker-dealer sales. But I think that what has actually happened based upon discussions I’ve had with clients is that a polarization has occurred in the industry in that the registered reps seem to have shifted back to the variable annuity sales, and your traditional producers are shifting over to fixed annuity sales.
We don’t think that it is necessarily 05-50 that’s created some of this downturn. There’s an indirect effect of 05-50. Now we’ve got reps selling variables instead of indexed products now, but there’s also another dynamic going on. When someone makes a calculation about where they’re going to invest they typically do sort of a risk/return calculation, My no risk or low risk option, here, is the fixed annuity earning me 5%. If I’m going to take the risk of putting my money into equities or a variable sib-account, well, I need an 8% or 9% return. Well, with rates where they are, especially with an inverted yield curve, there’s downward pressure on crediting in equity-indexed products. So when you tale a look at some of these products today you see fairly low caps; the risk/return tradeoff right now is, alright, I can earn 5% with no or low risk, but I can only earn 7% because that indexed annuity has a cap set at 7%. So, if I’m going to take the risk to put my money into something that is equity related, I’m going to go to VAs. If I like the low risk option I’m going to go to fixed. So I think that in today’s market the indexed product is being squeezed from both ends.
Macchia: We’ve seen the variable annuity product morph into what progressively looks more like a fixed annuity in terms of the various guarantees available including the guaranteed income riders. Do you think this plays into the calculus?
Alexander: Yes, absolutely. And this has always happened. You can actually see the opposite effect happening as well, which is we’re starting to see fixed products, both traditional and indexed, coming in with what has traditionally been variable annuity benefits like guaranteed living benefits and death benefits and withdrawal benefits. Certainly, the variable annuity market now has fixed sub-accounts to compete with the fixed side of the world, but interestingly, it seems as though from the numbers we’ve been seeing from VARDS, that new flow has been steadily declining as well.
So although we see a tremendous amount of sales on the variable side, we’re not seeing much new money come into that market. From what I understand, only 60% of the money flowing into variable annuities is going into equity sub-accounts. The remainder is going into the fixed bucket, so I often say if you add up the fixed components of variable sales to true fixed sales you have a larger overall fixed market than the true equity subaccount portion of the variable annuity market.
Macchia: I’ve likely made some industry executives’ heads spin- probably in disbelief- over my prediction that indexed sales could achieve a four-fold increase and reach $100 Billion within five years. I based this projection on a couple of assumptions. One is that it is inevitable that indexed products will become more transparent, the communications strategies around them will become more effective, and the product’s quite substantial inherent value proposition will become better appreciated not only by consumers, but also by advisors, most of which have shunned the product up until now.
This sales prediction is not made without context. Specifically, the needs of Boomer retirees, specially in terms of their entry into what the Retirement Income Industry Association refers to as the Transition Management Phase, and the need Boomers have to place principal guarantees under accumulated retirement assets while also maintaining the potential for upside interest growth. A consumer-oriented indexed annuity, it seems to me, matches-up nicely with this financial need. I’m wondering if you buy into my logic or, if not, if you may have any comments on it?
Alexander: Well, I think that the particular sales number you mention is open to debate. But I also think that what needs to happen in order for your prediction to come true is that the true value proposition needs to be uncovered. I say that because right now no one really knows how these products are actually performing. Are they actually providing a better return over time than a plain old fixed annuity? We don’t know.
Very often people ask me to tell them what is the best indexed annuity out there and I say to them we have no idea. Until the industry puts the light under the dark box and says here’s what’s actually happening, then we’re going to continue to have market conduct issues, and I don’t think that pent-up demand is going to be unlocked.
For example, broker-dealers are drawing somewhat arbitrary lines in the sand over what products they are going to put on their shelf. Why is that? Why is there such an argument over what indexed strategy works best- the 300 different versions of these strategies out there? Why does a broker-dealer cut-off certain types of products- just out of hand say these are no good? The reason is, they don’t know. Until they really understand what has been the renewal history of these products, what is the strategy that the carrier has for renewing rates, and how have they treated clients over time, then broker-dealers and distributors and everyone else involved will continue to sell the sizzle instead of the steak.
In think that its’ purely conjecture that these things really perform in the way everyone says they do. In a perfect world if we had complete transparency- whether its plain old fixed annuities or indexed- we would see a huge release of pent-up demand in this industry, not only would people feel more comfortable selling them, but people would feel more comfortable buying them. And advisors who traditionally wouldn’t even touch these things, the RIAs, the professional planners who say they won’t even look at fixed annuities, for example, might begin to understand how they fit into a portfolio, because the transparency is there; they can be modeled, we can show them inside an asset allocation program. I think all of that revolves around transparency. Today the industry likes to sell around a Snoopy, or a red umbrella, and not based on the actual product.
Macchia: You’re agreeing with me because what you’re describing the sorts of structural changes upon which I condition my prediction. It reminds me of another issue I’d like your comments on, and that is something I have trouble with that seems to be taking root in the indexed annuity marketplace, and that’s this effort to try to make comparative decisions about various products based upon backcasting.
Alexander: Yes. This is one of my favorite subjects. Go on.
Macchia: I’d like to know what you think about backcasting. Will it be successful? What effect or effects stem from it? Do you approve if it, or not?
Alexander: No. I believe it’s misleading and mischaracterizes how the product actually works, and I’ll give a good example. If I were to take a product in today’s market and backcast it ten years, let’s assume today’s cap is 7.5%, and I say what this product would have realized if you invested ten years ago- using this 7.5% cap, well, this can contrast significantly with reality.
We’ve got a couple of players who’ve been around ten years, Sun Life Financial Keyport and Allstate’s Lincoln Benefit’s Savers Plus. Savers Plus came out in April of 1995. Had you invested $100,000 at that time, you would have begun with a 14% cap, and your $100,000 would have grown to $190,000+. Over the holding period rates declined. Well, most of the money in an indexed contract is invested in reserves. Therefore, over time Lincoln Benefit had to lower the product’s cap, because of interest rate conditions. So you saw a gradual decrease in the cap from 14% to 12% to 10%, down to the current level.
Well, if you took, say, an 8.5% cap- which is what I believed it was six months ago- and backcasted the same product over the same exact period using the same S&P numbers, it would turn into $163,000. So in this example, backcasting lowers the true return of that product over time. You’re basically saying this will be the market condition going backwards.
Secondly, and more importantly, you reward carriers that are mispricing. So if a carrier introduces a product today with a 10% cap, I know they can’t sustain that cap. But that product will show up as the best product in the backcasting model. To me, that’s lowballing. You actually reward mispricing when you have backcasting.
Here’s my best analogy: Jeremy Alexander starts a new mutual fund as of today. And because I don’t have a history, I’m going to publicly assert that my mutual fund would have realized a certain percentage gain if it had been invested over the previous ten year period. I don’t think that any regulator would allow me to show such a projection to a client, nor do I think that any OSJ at any broker-dealer would be happy to see any registered rep use that kind of methodology. In fact, I’d likely be barred from the industry and be hit with an SEC fine. And yet, this is exactly what’s happening with backcasting of indexed annuities. So yes, I’m 100% on the same page with you that backcasting is misleading, and frankly if there’s going to be anything that is disallowed over time it’s going to be that.
Macchia: Over 30 years of observing life insurance companies I’ve learned that it is certainly within the operating framework of some to introduce new products with artificially high or subsidized rates. What you’re saying is that applying the backcasting model gives such a company and its products unfair advantage, and almost by definition, a policyholder purchasing such contracts will have results which disappoint. Because the initial projections are unsustainable. Is that right?
Alexander: Exactly. And you touch on an interest subject which is expectations. When you read the complaints or the lawsuits that emerges from many of these market conduct issues you sit back and you say, Man, I can’t believe that it’s really as bad as this complaint states, or the annuity contract can’t be as bad as its being made out to be. But the point is that if you can’t set the correct expectations with the client you are going to have a problem. And that goes back to transparency.
Is the carrier, for example, offering an unsustainable cap? Well maybe… or maybe not. Maybe that carrier’s strategy is to be dynamic and move with market conditions over time, and therefore that cap seems to be higher than other caps. Or maybe I’m a carrier that is setting a policy to renew at a consistent cap, and therefore because I’m looking at my cost structure over time and I’m expecting that my benchmark average it will be “X”, and therefore I can’t come up with a higher cap. Once again, with transparency, we can start to get an idea as to what the carrier is trying to do and set the client’s expectations correctly. That’s what this is really all about, and that’s what will help lower market conduct liability. The only reason backcasting even exists is because a buyer can’t look at renewal rate histories.
Macchia: If I could somehow convey to you a magic wand, and by waving this magic wand you could effect any change or changes within the fixed annuity business which you saw fit, I mean instantly effect that change, what would the first two or three changes you’d want to accomplish?
Alexander: Good question. First, I would want the industry to disclose the renewal rate histories, whether they’re indexed or traditional products. Secondly, I’d like to see some sort of standardization of the suitability process across all lines and across all channels, not just the broker-dealer channel. This is essentially leveling the playing field so it’s not putting any distributor or carrier at a disadvantage.
Macchia: I have not been shy about criticizing the practices of some companies that have been overtly harmful to the industry as a whole. For instance, the development of annuity contracts with extraordinarily long surrender charge periods, or two-tier crediting methodologies, or excessive loading. And I’ve even named certain companies, citing them for their- let’s call it gimmickry- in contract design. Privately- for years- executives of competing annuity providers have complained to me about these very same practices, and they’ve been vocal (privately) in their criticism, and have stated we would never do anything like that, but neither these company executives, nor the industry associations, have ever publicly condemned these practices, or try to distance themselves from them, or sought to isolate and marginalize the companies which engage in them.
And I believe that the result of his inaction has been to place the fixed annuity business in its present precarious position. Would you agree with my analysis of this? And if you do, what do you think is likely to happen over the next couple of years?
Alexander: I absolutely agree. I hate to be a broken record about this but, once again, it goes back to transparency. Here’s an example. Let’s say I have a tremendously long timeframe to invest money, I’m 40 years old and I’m not going to need to access my money for 25 or 30 years. So, I’ve got a timeframe that might allow for a product with a seventeen year term. I want to know why I should buy a seventeen year product. You’ve got seventeen years to use my money. Presumably, you should be able to provide a better return to me that someone else who has my money for ten years. Prove it! If I could see a renewal rate history that makes me comfortable that this thing is going to give me 50 more basis points over time, then I have the tools I need to make a good decision.
Now it’s easy to criticize such products, and I believe that you have a very good point that they may not perform as well as some of the other, shorter term products- but I don’t know. In an opaque world you don’t know, so you end-up drawing arbitrary lines in the sand. I’m agreeing with you entirely.
I was a producer for ten years. When I was producer I was always in an uncomfortable position where it took me at least a couple of meetings to get clients to trust me. Why? Because I was an insurance guy. Well, I didn’t think that this was fair. And I couldn’t understand what I was considered inferior, say, to a stockbroker. But the bottom line was that an individual could come into Merrill Lynch, and a Merrill broker would say, Here’s what I recommend. And that person could go to their local library and check out S&P or Morningstar or Lipper, and they could say, Gee, that was a great recommendation. And the rep could say, We use this third party source and here’s how we came up with your analysis.
Well, as an insurance guy, I couldn’t do that. And I had clients who asked me would you sell this to your parents? And they’d look for me to flinch. Now that’s not the way to sell. That’s why the insurance industry has so many problems with how people perceive the industry. It’s simply that they can’t know that the recommendation is good. Until you have transparency you can’t have an efficient market. It’s bonds before Bloomberg. It’s mutual funds before Joe Mansueto. And until the industry solves this problem, it will always suffer from a poor perception.
Macchia: One of the goals I have with this Blog is to develop candid exploration of some of the inherent poor practices that the industry tends to observe so that a bright light can be shone-in and some reform may occur. This is because the industry needs to set itself up on a better footing so that it can realize the growth it will then deserve based upon its inherent competencies, benefits and advantages that perfectly align with the needs of millions and millions of soon-to-be retirees. Yet, there are many in the industry who continue to defend at all costs even the very worst practices that occur. And the failure to isolate and marginalize these worst practices publicly has brought significant harm to the entire industry. My question is, do you think this will change, or continue in the same manner that is has for a long time?
Alexander: Nothing in this industry changes quickly. I’ve been doing this (Beacon Research) for more than ten years now and it’s clear that it’s a very slow process for the industry to change. I do think that it will, however. I think that things are moving in the right direction in terms of our ability to collect data. I think that over time we will get carriers with best practices to provide the transparency we need. When that does happen it will begin to marginalize the other carriers or distributors which continue to do things that are not in the best interest of the client. I do think the industry will figure this out. I just won’t happen quickly.
If we’re looking for new flow- which everyone is talking about- and not just 1035 exchanges of fixed to fixed and fixed to variables and back again, then we’ve got to tackle this problem. I think the companies with best practices have a huge interest in doing so.
Macchia: On the institutional side, products are created that effectively match-up with the benefits of, say, an indexed annuity. And there’s a lot of talk of packaging structured products so that they can be brought into the consumer market, to deliver to the consumer via Wall Street what the insurance companies deliver to the consumer via Main Street. Have you thought about this and what it may mean? Is it a threat?
Alexander: Well first of all I don’t think it’s a threat. Every industry thinks they have THE solution to the retirement income problem. The mutual fund industry thinks it has THE solution. Every industry thinks it has THE solution. And the fact of the matter is there is no single solution; it’s a “best” solution for a client, and that is always a collection of different products working together to deliver long-term benefits.
I actually think it’s healthy. In fact, insurance companies have begun to provide risk components to non-insurance products. Could, for example, an insurance company provide a living benefit to a plain old mutual fund? Certainly it could. It could take the portion that is the risk and package it inside the mutual fund. Over time we will see combinations of products.
I’d be interested in seeing a pooling of these products to serve the client’s best interest instead of a mindset which says, My silo is best. This is something that could unlock pent-up demand. Everybody talks about the fact that we need this new product or that new product. Wrong! We already have all the products we need to create a strong retirement income portfolio. We have longevity insurance, we have immediate annuities, we have living benefits, we have mutual funds, and we’ve got bonds and stocks. All of those things in combination could and will provide a secure retirement for individuals. This isn’t to say I’m against innovation. But the industry needs to think more about how they fit into the picture instead of his they are the picture.
Macchia: I agree with you and that‘s a terrific insight. Is there anything else you’d like to address that we’ve missed?
Alexander: No, I can’t think of anything.
Macchia: Thank you, Jeremy, I really enjoyed it.
Alexander: Me too.
©Copyright 2007 David A. Macchia. All rights reserved.
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