Swedroe: Looking Under The Annuity Hood

September 17, 2014

Equity-indexed annuities aren’t horrible, but there are plenty of cheaper and effective alternatives for risk-averse investors.

One of the investment products I’m often asked to comment on is an equity-indexed annuity. Interest in them has been fueled not only by the desire of the people selling them to earn large commissions, but also by investors who are increasingly seeking protection from the kinds of losses experienced in the severe bear market caused by the financial crisis of 2008.

Financial author Nassim Nicholas Taleb labeled such crises “black swans.” In finance, a black swan refers to a large-impact, but rare and hard-to-predict, event beyond the realm of normal expectations. The term comes from the once-widely held belief that all swans are white.

As a result, “black swan” became a metaphor for something that couldn’t exist. The 17th-century discovery of genuine black swans in Australia led to a change in the term’s usage. It came to connote the actual occurrence of an event that had been perceived to be impossible. The terrorist attacks on Sept. 11, 2001, are an example of a black swan, as is the stock market crash of Oct. 19, 1987, when the Dow fell 23 percent in one day.

Stock Returns Exhibit Fat Tails

Researchers have known for about 50 years that stock market returns aren’t normally distributed. Instead, they exhibit what are called “fat tails.” Investors and financial advisors alike have been searching for products that can cost-effectively manage the risks of extreme negative movements in the market, such as is the case with black swans.

Various forms of “principal protection” programs have been developed to address investor concern about fat-tail risk. Among the more popular, at least among commissioned-based advisors and salespeople, are equity-indexed annuities, or EIAs.

Most EIAs address the needs of risk-averse investors by providing a safety net. Nearly 96 percent of them possess reset (or ratchet) features that allow the holder to lock in positive returns each annual or biannual period.

This feature eliminates the negative effects of a black swan event. Of course, this feature comes at a price in the form of higher costs and reduced upside potential. Helped by two severe bear markets of the first decade of the new century, EIA sales increased from just $3 billion in 1997 to $30 billion in 2009.

The question for investors is: “Are EIAs cost-effective alternatives?”

 

 

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