Swedroe: Looking Under The Annuity Hood

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

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?”

Are EIAs Worth It?

Fortunately, we have a study on the subject to help us determine the answer to this question. The authors of a 2010 paper, “Real World Index Annuity Returns,” examined the real-world returns of 19 EIA providers and then compared them to the return of the S&P 500 Index. Following is a summary of their findings:

• Annuity returns have been competitive with alternative portfolios of stocks and bonds.
• Their design has limited the downside returns associated with declining markets.
• They have achieved respectable returns in more robust equity markets.
• Studies that have criticized these products are typically based on hypothesized crediting rate formulae, constant participation rates and caps, and unrealistic simulations of stock market and interest rate behavior. When actual policy data is used, the conclusions change.

The following table shows both S&P 500 and EIA returns for each period the authors studied.

The data do indeed support the authors’ conclusions. They did note, however, that one limitation of their data is its origin from carriers that chose to participate in the study. These carriers also chose the products for which they reported returns. This could have imparted some bias in the results. Further, the authors examined portfolios that combined the S&P 500 with one-year Treasurys and found similar results.

Parsing Returns

Before you jump to any conclusions, it’s important to remember that the time period of the study included the two worst bear markets in 40 years, and the worst bear market since the Great Depression. You should also note that, in the only period of the nine studied not spanning either of the two major bear markets (October 2002 to September 2007), EIAs underperformed the S&P by 7.3 percentage points. If EIAs have any value at all, it certainly should have shown up during a period like the one covered by this study.

The fact that they did relatively well compared to the S&P 500 during this particular time frame doesn’t necessarily make EIAs attractive vehicles over the long term. You should also examine how EIAs perform during longer time frames that include secular bull markets, such as the decades of the 1950s, 1960s, 1980s and 1990s.

The reason to include such periods is because you also need to consider how much upside EIAs fail to capture to determine if their downside protection in extreme and persistent bear markets is worth the lost gains.

Beyond EIAs

That said, you should consider another alternative that can provide protection against the risks of black swans.

In our book, “Reducing the Risk of Black Swans,” my colleague Kevin Grogan and I discuss an alternative strategy for reducing the risk of fat tails. In short, the strategy is to:

• Lower your allocation to the stock market.
• With the remaining stock holdings, increase your exposure to small and value stocks in the U.S., developed and emerging markets.
• Hold only the highest-quality fixed-income investments.

In summary, EIAs will continue to be popular because commissioned-driven advisors and insurance salespeople love them. What’s interesting is that I’ve never heard a fee-only, fiduciary advisor recommend one, though that doesn’t necessarily mean it has never happened.

The fact is that, after analyzing these products, there’s almost always a more efficient way to accomplish an investor’s objective of reducing the risk of large losses. If you’re a risk-averse investor looking to protect yourself against black swans, a more efficient way to do so is through the use of what can be referred to as a low-beta and high-“tilt” strategy.

The low beta portion of the strategy is an allocation low in equities and high in safe bonds. The high “tilt,” or allocation, portion of the strategy is to load on small and value stocks. This will certainly create a lot of tracking error.

Therefore, the returns of the stock portion of your portfolio typically won’t look anything like the returns of popular indices, such as the S&P 500 or the Dow Jones industrial average (DJIA). Historically, however, such a strategy has greatly reduced a portfolio’s risk while allowing investors to maintain the portfolio’s expected returns and retain a significant portion of the upside.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.