The Indexed Annuity Illustration With a 9% Cap
An agent presents a fixed indexed annuity to a 63-year-old client using an illustration showing a 9% annual cap, a 0% floor, and a participation rate of 100%. The illustration projects account values using the maximum historical index return each year and shows a 20-year value of $480,000 on a $200,000 premium. The product also has a 1.25% annual rider fee, a 10-year surrender schedule starting at 8%, and a 3% premium bonus vesting over 10 years. The agent tells the client "you can't lose money and you'll likely average 9% a year." The illustration does not show a renewal-rate scenario, and the agent does not disclose that caps and participation rates can change.
1. Identify the misleading elements of the illustration and the statements, and explain why each is problematic.
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Misleading elements:
- Using maximum historical returns each year. An illustration that assumes the best index return every year is not a reasonable projection; it ignores down and flat years. Index credits are capped, so the client cannot capture full index gains, and a 0% floor means flat years produce no credit while fees still apply.
- "You can't lose money." The 0% floor protects against index losses, but the client can still lose value through surrender charges, MVA, rider fees, and admin fees - and can lose purchasing power to inflation. The statement overstates the guarantee.
- "Likely average 9% a year." The 9% is a cap, not an expected return. With a cap, participation rate, and 0% floor, the realistic credited rate is lower and variable. Promising a likely 9% average is a misrepresentation of expected performance.
- No renewal-rate scenario. Caps and participation rates are not guaranteed and can be reset at renewal. An illustration that omits a lower renewal-rate scenario hides a material risk.
- Bonus vesting over 10 years combined with an 8% 10-year surrender schedule means early exit forfeits bonus and incurs charges - not disclosed in the illustration.
These are sales-practice and illustration violations: illustrations must be balanced, disclose non-guaranteed elements, and not imply guaranteed or likely returns that the contract cannot support.
2. Recompute a more realistic view: if the index returns 12%, 0%, and -15% in three years, what does the client actually receive under a 9% cap, 0% floor, 100% participation, and a 1.25% annual fee?
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Apply the cap and floor to the index return, then subtract fees:
- Year 1: index +12%. Capped at 9% → credit 9%. Less 1.25% fee → net +7.75%.
- Year 2: index 0%. Credit 0% (floor is 0%, no negative). Less 1.25% fee → net −1.25%.
- Year 3: index −15%. Floor at 0% → credit 0%. Less 1.25% fee → net −1.25%.
On $200,000:
- Year 1: $200,000 × 1.0775 = $215,500
- Year 2: $215,500 × 0.9875 = $212,806
- Year 3: $212,806 × 0.9875 = $210,146
So over three years the client gains about $10,146 (≈5.1% total, ~1.7%/year) - far below the "9% a year" claim, and in flat/down years the account declines due to fees despite the 0% floor. This shows why the max-historical illustration is misleading and why fees must be modeled.
3. What should a compliant illustration and disclosure package include, and what supervisory action is warranted?
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Compliant illustration/disclosure should include:
- A balanced range of scenarios, including flat and negative index years, not maximum historical returns.
- Clear disclosure that caps, participation rates, and bonuses are non-guaranteed and can change at renewal, with a renewal-rate scenario shown.
- The 0% floor explained accurately: it protects against index losses but not against fees, surrender charges, MVA, or inflation.
- All fees shown (rider 1.25%, admin, surrender schedule, MVA), and the bonus vesting/recapture terms.
- A statement that the 9% cap is a ceiling, not an expected return.
- The surrender schedule and liquidity terms.
Supervisory action: The illustration and the "can't lose / likely 9%" statements are non-compliant. The supervisor should reject the illustration, require a corrected balanced version, remediate the client (correct the misimpression in writing), review the agent's other indexed-annuity illustrations for the same pattern, and document the correction. The sale should not proceed on the misleading materials.