Bank customers are running away from fixed annuities as interest rates, which were more than two percentage points above one-year certificate of deposit rates in 1994, have dropped below CD rates.

Few bankers understand that insurance industry pricing practices tend to create this situation on a relatively predictable basis.

Banks often sell fixed annuities as a substitute for CDs though they are structurally dissimilar in many ways.

For example, CDs are guaranteed by the Federal Deposit Insurance Co., while fixed annuities are guaranteed by an insurance company. CDs carry a fixed price for their entire term, while fixed-annuity prices are adjusted annually.

And while earnings on CDs are taxable when paid, annuity earnings are tax-deferred until they are paid out.

In the minds of customers, annuity characteristics such as a weaker guarantee, less certain pricing, and higher, less flexible early withdrawal penalties do not offset the income tax deferral benefit.

As a result, demand for fixed annuities starts to dry up when the interest rates on fixed annuities drop to within one percentage point of one-year CD rates.

If a one-point spread is "normal," the actual spread would vary about one point above or below this level over time.

But the actual spread is unstable because:

We are comparing duration-dissimilar instruments, so the shape of the yield curve affects the spread.

Some insurance carriers use an average-rate approach to set their fixed-annuity interest rates.

While a one-year CD is frequently used as the interest rate benchmark for a fixed annuity, this match is probably not appropriate. One year CDs respond quickly to market changes, clearly moving with one-year Treasury rates.

Pricing on booked annuities varies annually but is not correlated to one-year market pricing.

Because the duration of the typical fixed annuity is probably in the five-year range, interest rates should tend to move more like a five-year Treasury.

While the five-year match is better than the one-year match, variations are still substantial because a fixed annuity is not as immediately responsive to market interest rate shifts.

This duration mismatch makes the spread vulnerable to the shape of the yield curve-narrower when the curve is flat as it is now.

Comparing the fixed annuity with the five-year CD gives a more consistent and logical pattern.

However, because banks do not sell a large volume of five-year CDs, the pricing at this longer term can be erratic at some banks.

This also means that viewing annuities as a one-year CD substitute is an overly simplistic view.

Another factor that drives the spread between fixed-annuity and CD rates is the way annuity prices are set by some insurance companies.

While practices vary from insurer to insurer, many carriers mix a "cocktail" of marginal rates and current portfolio rates, creating a blended rate they quote a new customer.

It is unknown how many carriers use this approach, but several of the large fixed-annuity players price this way.

While there is no logical reason to add a portfolio rate component to the cocktail-a new annuity has no connection to those already on the books- the practice tends to produce some exciting highs and some nasty lows.

As interest rates rise, portfolio rates tend to lag at a lower level than marginal rates, squeezing the margin versus CDs. As rates move down, the reverse occurs, making annuities more attractive to investors.

Rates bottomed out about two years ago and have drifted up since then, further compressing the fixed annuity-to-CD spread.

If the shape of the yield curve changes and carriers continue to use cocktail pricing methods, bankers will have periodic opportunities to promote alternative products to their customers.

In periods when rates are moving up and the yield curve is flat, which is the current situation, CDs are a relatively better buy. When interest rates fall and the yield curve is steep, fixed annuities will be a better buy.

This might be a good time for banks to review their product portfolio to be sure their offerings are complementary to traditional bank offerings.

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