There are at least three scandalous aspects to the index annuity racket. First up is the commissions, of as much as 9%. Incentives matter, of course, and when financial products carry these enormous commissions, the people selling them will never have their clients’ best interest at heart.
That problem is exacerbated by the fact that not only don’t the salespeople have any fiduciary duty to their clients, they don’t even have to have securities licenses. Index annuities are technically an insurance product, which means that you can sell them with nothing but an insurance license — even if FINRA has torn up your securities license. That’s no mere theoretical problem: more than a third of all brokers of insurance annuities in Florida and Massachusetts have had their securities licenses revoked.
Gibbs explains how this egregious loophole survived Dodd-Frank. It’s exactly what you thought:
When details of last year’s massive financial reform bill were being hammered out, Democratic Sen. Tom Harkin slipped in an amendment affirming that index annuities are not securities — and therefore are out of the SEC’s reach. Harkin is from Iowa, home of five big index annuity sellers.
Gibbs singles out one company, Pinnacle Investment Advisers, which persuaded elderly investors to surrender old annuities, paying $208,000 in surrender fees in the process, and for its troubles earned both $126,000 in commissions and a lawsuit from Illinois’s securities division. But it turns out that the only reason that the securities division has standing to bring the suit is because Pinnacle was a registered investment adviser. If it was just an insurance broker, it would be out of their reach.
And on top of all that, index annuities are very bad at their main job, which is being annuities. To back up a bit: in old-fashioned defined-benefit pension plans, there was always a significant insurance component. The pensioners who needed the most money — the ones who lived the longest — would receive the most money. Meanwhile, those who didn’t need as much — people who died relatively young — would effectively subsidize the longer-lived. That’s a great idea: living people need money much more than dead people do.
Nowadays, however, with the move to defined-contribution pensions, all that has gone out the window. You have a certain amount of money, and it needs to last you the rest of your life, but you have no idea how long that life will actually be.
Annuities are the obvious way of solving this problem. You hand over a lump sum, and an insurance company promises to pay you an income so long as you’re alive. If you die early, you lose out (but don’t need the money any more); if you live long, you win, and do need the money.
The problem is that many annuities, and pretty much all index annuities, are sold as investment products:
Insurers say that index annuities are meant to be held over the long term. However, in the wake of complaints like Passanisi’s, they have added provisions to most new index annuities that allow you to take out up to 100% of your money penalty-free if you are diagnosed with a terminal illness or enter a nursing home.
This, of course, does a great job of undercutting the main reason why annuities ever make sense. The reason for me to buy an annuity is that I want to be subsidized by the short-lived if I turn out to be one of the long-lived. What I don’t want is for the short-lived to be able to get their money back in full, because then my subsidy goes away, and there’s no point in buying an annuity at all.
At the end of her piece, Gibbs manages to replicate an index annuity at much lower cost and with much more upside. Put 85% of your money into FDIC-insured bank CDs, and 15% into a low-cost S&P 500 index fund. Then, when you retire and are ready to start getting that lifelong income, buy a plain-vanilla immediate annuity designed to cover all or most of your basic living expenses; the rest should be kept invested according to your risk appetite.
What Gibbs doesn’t do is raise any hope that the Consumer Financial Protection Bureau or anybody else will start regulating and cracking down on the index annuity racket. Insurance regulators are reasonably good at regulating the sale of genuine insurance products. But index annuities are not insurance products, they’re financial investments. And they should be regulated as such, by a federal regulator.