Early Annuities: A Simple Start

In the early 1980s, annuities were extremely simple. Typically, a company would purchase rated securities such as T-bills, or the like, at the respective interest rate at the time, let's say 5% for example, although it was much higher back then.

They would determine how much it would cost them to issue the contracts, the benefits of the contracts, market the contract, and then how much profit they wanted to make. Let's say all of that total is 1/2 of 1% per year.

The company would then offer an interest rate of 4^1/2% to the public and sell as many as they could. That was considered the traditional fixed annuity.

At that time, you could generally assume that the current offered rate of the company would remain the same throughout the contract surrender, even though it was not guaranteed to do so. If you needed it to be guaranteed, multiple year guaranteed annuities or MYGAs were available.

Then, something interesting happened.

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Changing Landscape: The Fixed Indexed Annuity Emerges

In the late 1980s, a company called Keystone pioneered something called the fixed indexed annuity. This seemed very suspect to me. It claimed to pay upside potential of the stock market but not to lose money when the market fell.

I remember my father joking about a local farmer who was being paid not to farm land by a program. He called my father and asked him how that was working out. He said that they did so well not farming 100 acres the first year, that they tried not farming 200 acres the second year. But it was a case of growing too big too fast, and they lost their shirts. Then he cracked a smile, indicating that it was all a joke.

I kept thinking that upside potential of the stock market without downside sounded fishy. So, I actually visited with the pioneers personally, people at Lincoln, National, and Keystone. I explained my father's company philosophy of never recommending anything that we did not purchase ourselves. At that time, you could make 10% of the stock market upside, but if the market fell, you would lose nothing.

I requested the sales marketing manager sign an informal agreement stating that there was no stock market risk in the contract and sheepishly deposited $10,000. It did return 10% for the majority of the five years I was in the contract, to my surprise. But what was more interesting was that when the market fell, I lost nothing. I was a believer.

What happened? How did they do that? Here's how.

It was a twist on the traditional fixed annuity. Quite simply, they took the same interest rate the client was to receive in the first place and gave the client an option of allowing the company to buy a call option on a market index with that same money. Brilliant.

You don't need to know a lot about options to understand that they either function or not. This made perfect sense to me. That's how, if the markets go up, the insurance company has an option to exercise which provides the return on the annuity. The insurance company is being reimbursed by the options market. They also explained to me how their annuity does not lose money when the market falls because the money was never in the market. The only amount placed at risk by the insurance company was the interest rate the annuity was going to receive in that year. So, after these discussions I clearly understood how a fixed indexed annuity could have the upside potential associated with the market, without all of the downside market risk.

Many variations of annuities have come and gone over the years. Structured annuities and variable annuities are attempts to limit market risks by utilizing certain contractual provisions. However, our family does not believe in taking risks and making them safer through contractual provisions. This does not mean that we are against risk. We simply have risk money in equities managed by fiduciaries who credit annuity commissions earned against our fiduciary asset management fees. As we do not pay these annuity commissions out-of-pocket, our risk management by the fiduciary management team typically has low or no cost. They also handle our annuity recommendations using our scientific tools. It makes perfect sense to us to take a certain portion of your money and try to increase returns, which can reasonably be expected from it.

Historical backtesting on any calculation method is possible and can be used.

Structured annuities may limit some market risk, but they are still risk vehicles. The same is true for variable annuities. Although we do not play in that environment at all with Averill money in the Averill family portfolio, we can still assist you and help guide you through the process if you choose to purchase these types of annuity products.

At Cap Averill II & Associates, we did not see the upside potential as being available to us at lower cost, or with a higher propensity, or lower risk. But we know that the vast majority of people who seek annuities are seeking stability of some sort, and we are also among those people.

The fixed index annuity has gone through several incarnations. New crediting or allocation methods have been developed over the past few decades, all of which have been tried, tested, and either accepted or rejected by our agents and equipment. Each of them has their own thrills of victory and agony of defeat.

It was only in 2014, almost 30 years after the inception of the product, that we advocated for certain types of allocations that would put us and our management team in the position of literally eviscerating the Date Lottery issue, which has plagued owners of fixed indexed annuities from the outset. Our management style of the right index options is proprietary and will be shared only with our clients.

The current environment and propensities for available allocation methods to perform more efficiently and at higher levels with very low levels of possible disappointment, if managed properly, have never been better than they are now, in our view. This has not always been the case. We found 2012 and 2020 during the coronavirus to be typically horrible times to purchase annuities because the rates on the products purchased by insurance companies to back their annuities were so low.

Candidly, there's not much to discuss in a fixed annuity. It is essentially the interest rate the insurance company can get at the time, minus their spread of how much it costs them to put the product on the books, plus their desired profit. This ultimately equals the amount they can pay the client. The rest of the specifics are included in the contract.