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  • A Rational Look at a Much Maligned Product

    November 27, 2011 by Bob Seawright, Madison Avenue Securities

    Fixed index annuities have generated a great deal of criticism, but it seems that they succeed in the objectives for which they were designed.

    Few products within the financial services industry have received as much consistent criticism as fixed index annuities. An FIA is a type of deferred fixed annuity that earns interest or provides benefits that are linked to an external reference or index, most commonly the S&P 500. The insurer underwriting the FIA generally funds its contracts using bonds and call options on the referenced index.  FINRA — which does not regulate FIAs but wants to — said in an Investor Alert that FIAs “are anything but easy to understand” and compared them unfavorably to 401(k) plans. And, with numbing consistency, the financial press routinely recycles round after round of criticism of this product.

    For example, in an article earlier this year,  Money called FIAs a “safety trap” and alleged that they have “pervasive problems.” One major problem the magazine claimed is poor performance: “A typical index annuity would have lagged an investment portfolio with equivalent risk — 85 percent one-month Treasury bills, 15 percent U.S. large-cap stocks — by nearly two percentage points annually, on average, over the past 44 years.” This claim is based upon the research of Prof. William Reichenstein of Baylor University, who has also been a plaintiffs’ expert witness in lawsuits attacking FIAs.

    Forbes called FIA sales a “protection racket” and claimed that “whatever your station in life, indexed annuities are in all likelihood a lousy investment.” The biggest complaint seems to have been that FIA performance doesn’t match index performance and does not include dividends, even though it should be obvious that principal protection comes at a cost.Forbes even claims that “some 99 percent of the time indexed annuities underperform a simple portfolio that’s 60 percent in zero-coupon Treasurys and 40 percent in a low-cost S&P 500 index fund,” citing a prominent plaintiffs’ consultant who seems to have made a pretty good living attacking FIAs. Last year Kiplinger’s advised consumers to avoid FIAs citing “skimpy returns” despite “big promises.”

    Businessweek has attacked FIAs too. Oddly, the primary “victim” cited in the piece is said to have earned, after having taken a 15 percent early surrender charge, “about 3 percent a year” as compared to the S&P 500, which “returned 6.3 percent including dividends in the same period.” Since the article says this victim held the FIA for about five years, it appears that its performance was essentially equivalent to that of the S&P 500 without principal risk. That hardly sounds like the returns of someone who was victimized. Since this alleged victim cashed out of her FIA in 2008, apparently for the higher potential returns of market exposure, I wonder what a performance comparison would have looked like a year later.

    Despite the routine criticisms from the financial press claiming extremely lengthy terms and huge surrender penalties, most FIAs have now been retrofitted with shorter surrender periods and lower commissions. Broker-dealers commonly enforce a “10-10 rule” on FIAs whereby surrender periods cannot exceed 10 years and surrender charges cannot exceed 10 percent. Even the major wirehouse firms are now interested in them and some, such as Bank of America Merrill Lynch and Morgan Stanley Smith Barney, have already begun offering them.

    Moreover, The Journal of Financial Planning (JFP) published a research study entitled “Real-World Index Annuity Returns” earlier this year that, for the first time, examined actual FIA returns. This study suggests that these poor FIA performance claims are not all they have been made out to be: “If your future included all of the 141 five-year periods from April 1995 through 2009, and you had purchased any of these real-world index annuities month after month, these actual index annuity results bested the S&P 500 alone over 67 percent of the time, and bested the 50/50 mix of one-year Treasury bills and the S&P 500 79 percent of the time.”

    Rather than relying upon questionable hypothesized crediting rate formulae, constant participation rates and caps, and unrealistic simulations of stock market and interest rate behavior, this study examined actual FIA returns. The research relied upon by Money andForbes received especially stinging criticism: “The flaw in these studies is that they do not take into account the real-world effect of changes in interest rate environments and the market volatility’s effect on the cost of providing the index participation. …Clearly the reach of the conclusions is limited by the unrealistic assumptions underlying the annuity modeled.”

    Accordingly, “some index annuities have produced returns that are competitive with other asset classes, such as equities and equity/T-bill combinations. Although FIAs are not designed to be direct competitors of index investing (rather for safety of principal with returns linked to upside market performance), our findings on FIA returns contrast with assertions in other studies — based on no actual return data — that the structure of FIAs necessarily relegates them to being inferior or unsuitable products.”

    When I referenced the research with respect to “real-world” FIA returns noted above to a FINRA regulator, I was told that the study had to have been paid for by an insurance company and that any citation of it would require a disclaimer to that effect. That response tells you pretty much all you need to know about FINRA’s view of FIAs. However, I have received outraged written confirmations from the study’s authors denying any request for or receipt of sponsorship for their work. In fact, they turned down overtures of industry sponsorship.

    That is not to say that all questions about FIAs have been answered. The “real-world” study has some serious shortcomings, most notably the paucity and potentially biased nature of the data and the inability of other researchers to analyze it. FIA performance was also measured in a particularly difficult period for the market, when principal protection should be especially valuable.

    In a follow-up piece in JFP entitled “Can Annuities Offer Competitive Returns?,” Prof. Reichenstein expanded upon his criticisms of FIAs. His primary argument is that because of their design, FIAs cannot add value to offset their embedded costs. He comes to this conclusion not based upon data and testing, but upon a conceptual proof using the “arithmetic of equilibrium accounting” and the work of William Sharpe contrasting active and passive management. However, my review of scores of actual FIA contracts suggests otherwise. I suspect the flaw in his logic is that the leverage provided by the options FIA carriers use to provide interest undercuts Sharpe’s argument on costs.

    Fixed income annuities are designed to provide principal protection with annual returns roughly 1-2 percent better than traditional fixed annuities. Based upon those standards, FIAs appear to have succeeded. Indeed, according to a predecessor “real-world” study, FIA returns have averaged well over 5 percent per annum in a variety of market conditions since their inception. As the Wharton School’s Prof. David Babbel, one of the study authors, noted, “for most levels of risk aversion, [FIAs] have dominated the alternatives.” Indeed, “FIAs outperformed the alternatives over the lifetime of their existence (since 1995) for every year that they have been issued.”

    More research is clearly needed with respect to FIAs. Additional transparency and the broad release of performance data by FIA carriers would surely facilitate that work. However, FIAs seem to have far more promise for those with serious risk aversion than has been allowed by their critics to this point.

    Bob Seawright is chief investment and information officer for Madison Avenue Securities in San Diego and a frequent writer on financial planning and related matters. He was educated at Duke University, where he received his J.D. in 1981. He holds securities and insurance licenses as well as a number of industry designations.

     

    Originally Posted at AdvisorOne on December 1, 2011 by Bob Seawright, Madison Avenue Securities.

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