Top story: Why annuity charges and interest are flip sides of the same coin

"When you finish a sales presentation for a fixed deferred annuity, the client meeting isn't over," says John Olsen, a certified financial planner and principal of Olsen Financial Group, Kirkwood, Mo. "You need to make sure the prospect understands what you've proposed by saying, 'now explain it all back to me.' If the individual can't do that, then you haven't done your job." These words to the wise, Olsen says, are especially important for the producer to bear in mind when describing two items on the annuity account balance sheet that can have a big impact on how much money the annuity investor ultimately receives. Those two items are charges imposed and interest earned. Absent an adequate discussion of these points, clients can be blindsided when the contract later doesn't perform as expected — prompting them to bolt to another carrier. Applicable charges and interest rates are actually flip sides of the same coin, according to annuity experts. They explain that each is used by the issuing insurer to recoup client acquisition costs: mortality, interest and administrative expenses, plus the commission paid to the selling agent. The fees may include a front-end sales charge assessed at the time of the transaction or a surrender charge (or market value adjustment) imposed upon the surrender of the contract or a withdrawal exceeding the "free withdrawal" amount. Insurers also recover costs by maintaining a "spread" between the crediting rate paid to the insured/investor and a higher rate the insurer earns on the funds invested. Most annuity contracts no longer carry a front-end sales charge, having shifted to a "back-end" surrender charge to cover the agent's commission. This, sources say, is because of the unpopularity of up-front charges among consumers. The surrender charge typically declines each year until the contract period ends (e.g., 10% of the contract value during the first year, 9% in year 2, 8% in year 3, and so on). As to the interest rate spread, experts say this information is often difficult (if not impossible) to obtain, because insurance companies generally don't release to the public information about their portfolio returns. But for producers, imparting this information is not necessary to clinch the sale. What clients do need to know is the interest they can expect to receive once the ink is dry on the signed contract, say experts. Enter the guaranteed interest rate: the minimum interest crediting rate that will be paid to the annuity each period, regardless of market conditions. Additionally, all fixed deferred annuities pay a current, non-guaranteed interest rate that may be higher, but not lower, than the guaranteed rate. Insurers determine the non-guaranteed rate using either a "portfolio" or "pocket of money" (or "new money") method. Under the first, the insurer applies the same crediting rate to all in-force contracts, regardless of the contract's inception date. The pocket of money method, by contrast, credits a certain rate to a particular block of business, such as contracts issued in the last year. Which of the two methods is better? That depends on market conditions. "The portfolio method tends to give better crediting rates in a rising interest rate environment," says Olsen. "In a decreasing interest rate environment, you'd like to have the pocket of money approach. Over the long haul, the two methods should average out." Many companies also provide a "bonus" interest rate to encourage prospects to buy. Typically, the bonus exceeds the current market rate and is credited to deposits during initial years of the contract. But the bonus comes at a price, often in terms of a higher surrender charge and/or a lower current crediting rate, caution financial professionals, some of whom advise steering clear of them. "Once the client sees what they're getting [after the bonus period expires], they're not going to return your calls and they won't give referrals," points out Ed Meakim, a certified financial planner and principal, The MacNamee Group, West Chester, Pa. "Selling a pie in the sky rate may be fine for making a one-time sale, but it's not a viable strategy for building a loyal clientele." Colin Johnson, a director of communications at Symetra Financial, Bellevue, Wash., agrees, adding: "One thing to watch out for is the interest rate bait-and-switch, wherein the client buys into a contract offering a high initial rate that, come annual reset time, defaults to the lowest contract minimum rate. You don't want the client to feel like the carrier is playing rate roulette. Producers need to look for providers that really are committed to transparency and consistency at renewal time." One way to do that, he adds, is to review the interest rate renewal history of the carrier in question. Excepting any guarantees noted in the contract with respect to the minimum crediting rate and/or a rate stipulated for a guaranteed period, the interest paid on a contract is at the discretion of the manufacturer. A common result: the interest rate is ratcheted down during the annual "reset."

That needn't be to the detriment of the annuity holder in all cases. Some fixed deferred annuities, sources say, offer an escape hatch in the form of a "bail out" rate. Should the renewal interest be credited below a specified rate, the client can exit the contract during a certain period without paying surrender charges. But an early exit could also result, depending on the contract, in the loss of any bonus interest that hasn't yet vested. Surrendering the annuity prior to the end of the contract period or upon a partial withdrawal can also lead to a market value adjustment, depending on contract design. More often than not, the upshot is a reduced surrender (or withdrawal) value. The reason: Fixed annuity investors tend to withdraw funds when interest rates are rising to buy into higher yields offered on new contracts. But when rates are rising, the insurer's investments backing the annuities (typically bonds, in the case of fixed deferred contracts) are declining, given that bond prices vary inversely with interest rates. The MVA is thus imposed to compensate the insurer for losses in these situations. How much of all this needs to be explained to clients and prospects? Sources say that essential information about charges and interest–the amounts/rates to be expected, when and how applied during the life of the contact and their potential impact–should be conveyed during presentations. But experts counsel against going into technical detail that might only serve to confuse prospects and result in a lost sale. "The advisor's job is to select the best product for the client," says Olsen. "If that product happens to use the pocket of money approach, then certainly the client needs to understand that the interest credited during initial contributions will be different than for subsequent contributions. But I'm not sure that a theoretical discussion about different crediting methods would be productive." Adds Lew Nason, founder of Insurance Pro Shop, Dallas, Ga.: "If the advisor is doing his due diligence, then the client will buy based on the advisor recommendation. The advisor shouldn't have to detail the inner workings of the product any more than a car sales rep should have to explain how a new car engine works."