EIA Post Mortem    7/00        Return to Library Index
EIAs were introduced in early 1995. By the end of 1996 there were two dozen active carriers. By the end of 1997 there were 43 insurance companies offering index annuities. Today, 44 companies offer 117 different index annuities; there are 170 EIA product variations if you include current offerings with bonus rates and multiple indices.

If you simply look at the number of companies in the market it appears that there has been little recent change. However, over the past three years eighteen players have left the field with only one returning. The second quarter of this year marked the first time in over a year that at least one carrier didn’t withdraw from the market. Each quarter the Advantage Equity Index Sales & Market Report examines the new entrants and departures of the index world. The list of departed carriers is as follows:

Players That Have Left The Field
Aid Association For Lutherans
ALLIED Life
Citicorp Insurance
Community National
Country Life
Delta Life
General Life
Guarantee Life
Massachusetts General
The Midland
Modern Woodmen
Pekin Life
Provident Life & Accident
Security-Connecticut
Transamerica Life
United Life & Annuity
Unity Mutual

Players That Have Left & Returned
SAFECO

Insurers exited the stage for a variety of reasons. We’ve attempted to determine the main reason or reasons why we believe a carrier left the market. In general, departures can be grouped into certain categories.

Change In Company Focus
Some companies simply wanted to change strategies. Provident Life & Accident decided to concentrate on non-annuity product lines. I’m not sure why Citicorp Insurance withdrew from the index market, however a change in focus may have been a reason.

Conseco decided to move Massachusetts General’s annuity functions to an annuity targeted carrier. Transamerica Life’s EIA was killed although Transamerica Occidental retained their index annuity. Transamerica Life then took a new tack by releasing their SelectMark Annuity, a “non-index” nontraditional annuity.

Company Acquired
ALLIED Life, Community National, Delta Life, Guarantee Life, Security-Connecticut and United Life & Annuity all withdrew from the index market due to their acquisition by other carriers.

Less Than Receptive Regulators
Unity Mutual had a nicely designed index annuity. Unity Mutual is regulated by the State of New York. This concludes my prepared remarks.

Pricing Concerns
SAFECO marketed a consumer friendly EIA that gave the insurer very little flexibility if financial markets changed. The markets changed; the product was pulled. SAFECO’s new EIA gives the company the flexibility to cope with changing markets.

Never Achieved Critical Mass
At the end of 1999 the top ten EIA carriers accounted for over 78% of annual sales - just like in 1998 and 1997. It can be difficult to bulk up in the index market and compete. EIA sales for Aid Association for Lutherans, Country Life, General Life, The Midland, Modern Woodmen, and Pekin Life simply never grew big enough.

The EIA landscape will continue to change. Eleven carriers are on track to generate less than $10 million in index annuity sales this year; seven of those could do less than $5 million. So far this year only eighteen carriers have a market share greater than one percent. This doesn’t mean that the market is closed to new competitors. Three of today’s top ten EIA sellers were either bit players or not even in the market a year ago.

Because the EIA market is open to innovations and is at the initial stages of the growth curve for every player that leaves the field another will take its place. Both players and product menus will evolve creating a more diverse, and hopefully, better market for all.

EIA Performance Benchmarks    8/00       Return to Library Index
Absolute numbers without a point of reference are meaningless as a way to judge how well one is doing. Suppose you were told that Investment A returned 20% and Investment B returned 2%. If you had only that information you might assume that Investment A was better. However, what if vehicles similar to Investment A returned 30% for the selected period and Investment B’s competitors all lost money for their period. You might conclude that Investment B was better because its performance relative to its peers was better.

We evaluate financial alternatives based on their historic returns. We attempt to categorize and sort different investments using certain risk assumptions, degree of liquidity, length of holding period or expected maturity and other factors. We then attempt to compare the performance of these categorized investments with each other, and against the performance of a generally agreed upon benchmark with similar attributes.

Index Annuities are fixed annuities. They differ from traditional annuities in that the crediting of excess interest is based on the movements of an external index. Although the ultimate return is often linked to the movements of an equity index, index annuities protect the principal and credited earnings from market risk, so it should be appropriate to compare index annuity returns with other long term savings vehicles.

Benchmarks For Measuring Annual Reset EIAs Performance 
Are CDs & Traditional Fixed Annuities

Annual reset methodologies credit interest each contract year and offer safety from market risk. The worst you could ever earn in a given year - even if the market plunged, would be zero. These index annuities feature stable principal and changeable rates. I propose that appropriate benchmarks for judging annual reset index annuity performance would be other vehicles with similar characteristics – traditional fixed annuities and certificates of deposit. For this exercise I chose CD returns as the benchmark against which annual reset index annuity performance would be judged.

From 3/97 through 6/00 I examined every twelve month period and determined the Mean annual return for all of the index annuities using an annual crediting method that applied a cap on the maximum return credited, and the Mean return for all index annuities that used monthly averaging of monthly values to determine annual returns.

I compared the actual returns of these different index annuities with certificates of deposit rates [Source: Federal Reserve Board six month CD Rates]. The CD rates were used as a base line - the certificate of deposit rates were always equal to 1.00. Index annuity returns were calculated as a percentage of this base line.

In other words, if the CD rate was 6% and the Mean monthly averaged return of the EIA for the same period was 9%, the monthly averaged return was listed as 150% of the CD’s return. Here’s what I found.

The vast majority of the time the annual reset index annuities produced higher returns than CDs. If you had purchased an index annuity using monthly averaging every month since the Spring of 1997 your return was 189% of the CD’s return. If you had purchased all of the annual reset with cap products every month your return averaged 185% of the CD’s return.

There were a few periods that generated a lower return. However, over 82% of the time the monthly averaged structures beat CDs and capped products won 92% of the time. The only contracts witnessing a back-to-back period of poor performance were contract years from April of 1998 to April of 1999 and from April of 1999 to April 2000. But, if that annuity had been originally purchased three years ago in April 1997 it still generated an average annual return over the entire three year period of 8.76% even after including the poor years.

For the most part, the period has been one with a rising stock market. However, the index annuity returns include times when participation rates were 65% and caps were as low as 9%. Even during the volatility of the first six months of this year index annuity returns in general remained competitive with CDs and traditional fixed annuities.

Index annuity returns, especially ones using an annual reset style of crediting, should not be compared with equity investments because EIAs offer a much greater degree of protection against loss. Index annuities are a long term savings vehicle and their performance should be compared to other savings instruments.

I’m not entirely convinced that six month CD rates are the perfect frame of reference and I will try to find an unbiased reference point as a basis for comparison. However, regardless of the benchmark, index annuities continue to generate competitive returns.

Other Indices    8/00        Return to Library Index
If you look back a year or so all of the EIA carriers, save one, used only the Standard & Poor’s 500 index as the basis for crediting excess interest. Today, there are ten companies that offer annuities using a variety of indices. The additional indexes I’ve identified are:

Why Use Different Indices?
You might select an alternative index because you believe that a particular market segment will perform better than others. Or, you might add additional indices to help balance your annuity’s return.

Thank Goodness For Caps    8/00        Return to Library Index
Of the dozen indexed annuities recently introduced to the market almost all of them place a ceiling, or have the right to put a ceiling, on potential returns. These caps limit the maximum interest that could be credited to an index annuity. This may raise a concern that the annuity buyer is missing out on potential gains. However, a cap on interest may help the annuity produce higher earnings.

Equity index annuities usually buy options on the index to create the potential for excess interest beyond the minimum guarantee. The sellers of the options have to pay off at whatever the market level is when the option matures, so the sellers bear the risk of a rising market. If the market only goes up a little, or if their exposure to market gains is limited, the sellers pay out less money. If they sell an option without an upward limit the sellers demand significantly more dollars for the option because they have substantially more risk. If the insurance companies have to pay more for options they can’t buy as many, so the participation rate they credit is lower.

Putting a cap on the potential increase in the value of the option means that the sellers have less risk, so a lower price is charged. Lower option prices means that the insurance company can buy more options and offer a higher participation rate.

A cap allows the insurance company to buy more options resulting in a higher participation rate. The higher rate means that the annuity buyer could receive more interest in those market years that don’t produce stratospheric gains.

So, placing a cap on potential gains means the participation rate should be higher for the capped product than for the annuity without a cap. If index gains are modest the capped version will credit more interest. Which annuity will credit more? It depends on the relative rates and how often the interest ceiling is actually exceeded.

A participation rate for an index annuity with an absolute (no averaging) crediting structure and no cap is 55%. You can find other EIAs with absolute structures offering higher participation rates, but they will have caps. One annuity offers a 100% rate, but will credit a maximum return of 11% for the coming year. Another annuity has a higher cap of The absolute EIA without a cap has a rate of 55%. Another EIA has a 100% rate, but an 11% cap. What this means is that in any year when the index growth exceeds 20% the non-cap annuity will produce a higher return. We determine this point by dividing the cap (11%) by the non-cap rate (55%). Conversely, whenever the index gains less than 20% the EIA with a cap will have the higher return.

If we look at index movements over the last fifty years we find that index gains exceeded 20% in 16 of those years. In other words, 68% of the time the capped method posted a higher annual return than the non-cap method.

So which is best? If you plug in these rates and caps into the last fifty years and figure out the average hypothetical return for the three methods over all of these years the average returns are virtually identical!

Any crediting structure can produce the highest return in a given market and our studies show that all crediting structures have delivered very respectable returns overall. Whether an index annuity with a cap on the return will result in more interest credited than one without a cap depends on the movements of the index, the ceiling on the interest credited and the relative participation rates of both products.

An Innovative Index Annuity That’s Simple    9/00        Return to Library Index
As index annuities evolved they usually became more complex. Interest crediting formulas added limits or based results on multiple index values. Fixed accounts and other equity indices were introduced. Product innovations were evolutionary instead of revolutionary as carriers attempted to accessorize the basic design.

A result of all of this was that products became a little more confusing. People were unsure of exactly how the index annuity worked and the returns they would earn. In general, these innovations improved the product and were based on changes in the financial markets or listening to market needs. But, even the greatest inventions may not get used if people don’t have a basic understanding of how they work.

I have said an index annuity is a very simple financial concept made complicated by the insurance company. I’ve been concerned that if we make the product too complex we risk driving away the cautious saver for whom the vehicle was designed. However, a revolutionary index annuity has been introduced that does away with the complexity.

Conseco Simple Index Annuity credits 10% to the contract in every year that the index doesn’t go down. That’s it! No talk of participation rates, caps, yield spreads, assets fees, smoothing, European or Asian strategies, Ouija boards or Tarot cards.

The Conseco Simple Index Annuity guarantees the rate for a five year term at which time a new rate is declared. At the end of five years the customer may renew or walk away without surrender charges. If the index level is the same or higher at the end of the contract year than it was at the beginning the annuity credits the guaranteed rate which is currently 10%. If the index finishes the year lower the contract credits zero, but no previous credited interest is loss.

It’s 10% each year. If the index was flat or up every year for five years the contract would have a total return of 50%. If the index was down in two of those five years the total return would be 30%.

Interest is credited on the initial premium only and does not compound. If the index was flat or up for each of five contract years the total return would be 50%, but this is calculated as simple interest (see sidebar).

I looked at all of the five year periods over the last fifty years and applied the Simple Annuity’s current rate: The Simple Annuity’s hypothetical Median return was the highest of all five year index annuities that guarantee their rate for the term.  The Simple Annuity’s worst return was four times greater than its guaranteed minimum return. For 30% of the five year periods over the last fifty years the S&P 500 would have produced a lower return than 98% of the Simple periods. Certificates of Deposit were five times as likely to produce a return under 5.39% than the Simple Annuity over the last forty years.

The Conseco Simple Index Annuity is a simple savings vehicle that should, based on history, provide higher returns over time than other traditional savings vehicles.

Information is from sources believed accurate. The Advantage Group neither endorses nor recommends any financial product.

Compound vs. Simple Interest    9/00       Return to Library Index
Suppose you had $1 and someone gave you a choice between earning 10% calculated as simple interest or 9% calculated as compound interest. Which one do you choose? It depends on how long you’re going to leave your money at work.

At the end of one year the simple interest method would add a dime to your initial dollar and you’d have $1.10. The compound interest method would add nine cents and you’d wind up with $1.09. If you’re only looking at one period there’s no difference between simple and compound interest.

If you went out two years, the simple method would add another dime to your $1.10 giving you a balance of $1.20. Simple interest means that interest is only earned on the original principal.

Compound interest works a little differently. Compound interest multiples the previous balance - in this case $1.09, by the interest rate (9%), and adds the numbers together to determine a new value.

So, $1.09 multiplied by 9% produces not 9 cents but 9.81 cents. This is added to the previous balance (1.09 + .0981) to produce a second year total of $1.1881. A short hand way to figure the results of compounding is to put a one in front of the interest rate ($1.0 x 1.09 = $1.09).

At the end of five years the simple method would have produced a total of $1.50
($1+ 0.1+ 0.1+ 0.1+ 0.1+ 0.1).

But, the compound method generated $1.54
($1 x 1.09 x 1.09 x 1.09 x 1.09 x 1.09).

If you’re only looking at a few periods there isn’t a lot of difference between the effects of simple and compound interest. However, the benefits of compound interest become proportionately greater with each passing period.

Second Quarter EIA Sales Dip    9/00        Return to Library Index
Sales for the second quarter of 2000 were $1425 million compared with sales of $1348 million for the second quarter of 1999. Second quarter index sales were down 5.02% when compared with the $1500 million total of the previous quarter. Sales for the first six months of the year were $2948 million, up 23% when compared with $2401 million reported for the first half of 1999. Index life sales were $16,872,452 for the second quarter; a 17% increase over the previous quarter.

I believe the main factor in flat index annuity sales are very competitive traditional fixed annuity sales. Fixed annuity rates were at a high point in the cycle as annual declared rate products offered first year interest rates of 8% or higher. Multiple year guaranteed rate annuities were locking in effective yields as high as 7% for periods of five to ten years. Several companies told me that their multiple year annuities set sales records.

Risk, Forecasting & Models (9/00)       Return to Library Index
Index annuity carriers are faced with certain problems in forecasting volatility and market conditions to determine participation rates. Any predictions of future market performance involve using historical data and then extrapolating this data through techniques like linear regression. This is the basis for modern portfolio theory.

If you examine past annual returns of, say, the S&P 500 you can determine how often these returns occurred. You find that the S&P 500, like most general market indexes, produces a large number of low returns, a large number of high returns and relatively few returns in the middle. When you graph the frequency of these returns your picture looks like an inverted bell curve. By using this history you attempt to determine the probability of these returns occurring in the future and develop appropriate hedging strategies.

As an example, based on the last fifty years there have only been two times when the S&P 500 index lost more than 15% in any given calendar year. So, over 96% of the time the index has posted a better return than a 15% loss. In the last fifty years there have only been two time periods where the index posted better than a 35% gain. So, over 96% of the time the index produced a return under 35% a year.

In you look at all of the returns and basically subtract these low probability areas you find that index returns were between a negative 15% and under 35% in over 92% of past years. On a probability basis, you would then develop a general hedging strategy that took into account these parameters.

However, while historical data is helpful the past doesn’t exactly repeat in the future. And, from a probability standpoint, just because you have the first 33 numbers of the roulette wheel covered by bets doesn’t mean the next turn of the wheel won’t come up 34 or 35. Portfolio theory to a large part ignores the possibility of extreme events which can devastate expectations.

If you look at the twelve month period ending 3/31/98 the S&P 500 was up 45%. If you had only hedged the first 35% of gains you’d be exposed to losses. Conversely, over a six week period during the Summer of 1998 the index fell 21%. Again, if you didn’t hedge for this extreme event the result would be unanticipated losses. Extraordinary events are not truly covered by portfolio theory and it’s the main reason that hedge funds lost millions two years ago.

There are new methods being developed to address coping with the effects of extraordinary events and the concept of risk itself. Professor Mandelbrot of Yale University says that these variations in financial prices may be accounted for by mutifractal geometry.

A fractal is a geometric shape that relies on the concept of self similarity. The multifractal model shrinks the time scale and introduces generators that are interpolated along a straight trend line. The multifractal generators are compressed along the time scale to show the effects of volatility. The result is a financial model on steroids that attempts to predict the direction of a market by rapidly analyzing trading activity. It is hoped that this technique can do a better job of predicting extraordinary events.

Risk budgeting is a process whereby you determine the risk of various investments, decide how much risk you are willing to take, and then allocate that risk. What it does is take away somewhat from merely seeing whether you beat a benchmark’s return, into grading performance on whether your return was commensurate with the risk involved in getting that return.

Even our benchmarks are under siege. Treasury Secretary Lawrence Summers predicted all treasury debt would be gone by 2013. What does this mean for those using treasury instruments as benchmarks?

One effect of the diminishing government bond pool is that users of bonds will need to use investments with greater credit risk. If greater credit risk translates into greater returns then bond investors, like insurance companies, would realize higher portfolio returns in the future. However, greater credit risk also means during times of economic downturns defaults will be more frequent which could harm investors.

It also means that using historic bond and bond index data as a basis for future decisions may be irrelevant. If the past is no longer there, what do you put in the model?

Even though the next decade will be a new world in which many of our previous predicting tools may not function, I’m optimistic that risk modeling and forecasting will become much better, and while periods of extreme volatility will still occur new risk techniques will help soften the blows.

Customer Suitability Issues    10/00        Return to Library Index
In past talks about sales practices I used to say that the concept of suitability was foreign to the insurance business. Suitability was a security industry concept; insurance companies talked about market conduct. This has changed.

Fourteen states now have suitability regulations that pertain to the selling of insurance and the NAIC approved a white paper on suitability in June. NAIC is now working on a model regulation that, at least initially, uses the NASD approach to insurance sales.

The industry’s first reaction is... Whoa! They point out that insurance companies have a very different relationship with their agents when compared with a broker/dealer. Some companies, State Farm comes to mind, have a more or less career relationship with their agents which might lend itself to an NASD supervisory styled framework. However, many companies are basically product manufacturers, leaving training and supervision to others. Requiring these insurers to determine customer suitability would be tantamount to making mutual funds decide which investors should be permitted to buy their products.

In addition, security firms work mainly with one regulatory entity. Insurance companies have to fight their way through 51 fiefdoms. Regulators will need to recognize the uniqueness of the insurance industry delivery systems in developing suitability guidelines.

Lo, and Volatility Begat Volatility    10/00        Return to Library Index
Last year was a volatile year. The S&P 500 index rose over 14% in the first six months of 1999, fell almost 9% by the dog days of Summer, rallied again, fell back, and rose at the end producing a 19.53% gain for the calendar year. 2000 is making last’s peaks and valleys look like a dead man’s EKG.

The S&P 500 index value on 1 September was 1520.77, a whopping 3.5% increase from where it began the year. The high point was reached on 24 March when the index was at 1527.46; the nadir was on 24 February at a level of 1333.36.

The index has been above 1500 for 21 days and below 1400 for 30 days. In all, the index has closed higher than the previous day 51% of the time and closed lower 48% of the time. The longest string of steadily increasing index values was achieved 8 August when the S&P 500 rose for the seventh day in a row.

All this data shows a bronco busting market ride where “day in” and not “time in” determines the short term winners and losers.

You and your spouse invested in the index on 18 May last year, but one of your checks was delayed in the mail by one day. In May of this year the one with an 18th anniversary gained 7.79%; the one with the 19th date earned 4.67%. From 4/7/99 to 4/7/00 the index rose 14.28%. But, if you use 4/14 as your end points your gain is 2.12%.

Averaging the monthly values exaggerates the volatility. If you’d purchased a monthly averaged version of the index on 17 July last year your 2000 anniversary date produced a return of zip. However, if you’d waited until you came back from vacation on 8/4/99 to buy, your 8/4/00 gain was 8.56%.

Depending upon the annual reset index annuity you purchased, your average return for anniversaries occurring through 1 September ranged from 3.79% to 7.44%. But again, if last year you picked the best day each month to buy an index annuity your average gain would have been 9.06%. If you chose the worst date each month you’d have earned a mean return of 2.41%.

This disparity in returns is resulting in some interesting conversations with agents. I’ve heard 2000 returns from the same product praised and vilified depending upon the day the agent made the sale. If today’s index annuity returns are upsetting to some people it may be time for a reality check.

First, the last few years not withstanding, the market doesn’t go up in a straight line. A diversified portfolio of domestic securities has generated excellent returns over time. Stay the course.

Second, no one lost money in an index annuity. This is a no market risk to principal vehicle - the return fluctuates, not your premium. Over time, index annuities are designed to generate higher returns than other traditional savings vehicles.

Third, you may be set for next year. If the market recovers in 2001 you may have already established a low starting point upon which to calculate the gain. Volatility is a factor in all financial instruments, but as time passes it becomes less noticeable. Index annuities are a long term vehicle.

Regulators Don’t Like Bonus VAs    10/00        Return to Library Index
Since 1994 variable annuity sub-account assets have grown 44% faster than mutual fund assets and now total $847.9 billion. Variable annuity sales last year were roughly three times those of fixed annuities. Though the industry has taken some shots from financial writers over fees and tax treatment vis-a-vis mutual funds, even the most negative reporters acknowledge that VAs make sense in a lot of situations.

If you go online to the SEC web site (www.sec.gov) and head for the consumer oriented section entitled Protect Your Money you’ll find a subsection with the headline Avoid Trouble - Investor Alerts. On this page the SEC says that consumers should watch out for:

Identifying And Avoiding Bogus Bank Scams

Nigerian “Advance Fee” Fraud Schemes

Promissory Note Fraud & Scams

Avoiding Internet Investment Scams

Fraudulent Telemarketing

and

Variable Annuities

The regulators are taking an increasingly active posture in the variable annuity arena. Last year the NASD reminded members of their responsibilities in the sales of variable annuities with the release of NASD Notice to Members 99-35. The notice listed sixteen “suggestions” covering VA sales practices ranging from what a registered representative should discuss with the customer to establishing firm compliance systems that “red flag” a “particularly high rate of variable annuity replacements or rollovers”.

The notice devotes a complete section to the use of VAs in qualified plans, and makes a special point of stating that “the registered representative should disclose to the customer that the tax deferred accrual feature is provided by the tax-qualified retirement plan and that the tax deferral accrual feature of the variable annuity is unnecessary”.

Also last year, the SEC looked at the records of over fifty variable annuity carriers and said that 80% of those examined were cited for failure to follow security sales regulations. Roughly a quarter of those initially audited were subjected to further investigation.

In the Summer of 2000 SEC published a consumer Internet report Variable Annuities: What You Should Know. The eleven page guide does a pretty good job of describing what a variable annuity is, how they work, what the charges are, and questions you should ask. What I found interesting were the “Caution” bullets highlighted within. The Bullets contained suggestions like:

Caution: For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity...In addition, if you are investing in a variable annuity through [a] retirement plan you will get no additional tax advantages (their bold type, not mine) from the variable annuity.

Caution: If you are thinking about a 1035 exchange...you may be better off keeping the old annuity.

Caution: Variable annuities with bonus credits may carry a downside, however - higher expenses that can outweigh the benefit of the bonus credit offered.

Caution: If you already own a variable annuity and are thinking of exchanging it for a different annuity with a bonus feature, you should be careful...the schedule of surrender charges and other fees may be higher on the variable annuity with the bonus credit than they were on the annuity that you exchanged.

Part of the reason for the higher visibility from the regulators is the growth of the variable annuity market. Another reason for increased governmental action may be due to rapidly changing VA product features and a feeling among regulators that rules governing investor protection have not kept pace.

I am not attempting to determine the merits of any VA product benefit or applicable market. However, the regulators seem to be saying that there are a couple of areas with which they’re a little uncomfortable.

It would appear that if you use variable annuities inside qualified retirement plans that you’d better be able to justify their use on the basis of enhanced death benefit protection or lifetime income payment features. At the very least, you’ll need to show that the customer understood that the VA’s tax deferral feature wasn’t needed.

When it comes to bonus features, we may be able to read between the lines and get an idea of the direction the SEC is leaning. At the NAVA Conference in Washington on 5 June Paul Roye, Director, SEC Division of Investment Management, had this to say about bonus features “there’s no such thing as a free bonus...I would urge you not to wait for [us] to come knocking on your door with questions about bonus products. Ask yourself whether your products are designed...as a spur to inappropriate sales practices Increasing sales at the expense of those for whom these products are not suited will not be tolerated”. My take on the subtle signals telegraphed in Mr. Roye’s speech is THE SEC DOESN’T LIKE BONUS VA’s.

What should be done?

If you’re a broker/dealer the guidelines listed in NASD Notice to Members 99-35 should be followed.

Companies should establish compliance procedures that alert them of representatives with a high rate of VA contract replacement.

Complete and accurate disclosures detailing all fees and charges need to be presented to, and signed by, the customers.

Specific training and disclosures should be adopted for VA sales in qualified plans.

Companies need to examine their variable annuity bonus programs.

The reason for the growth in variable annuity sales is they have a proven track record and they fill a need for millions of investors. We need to share all of the relevant facts with the customer to avoid possible problems down the road.

EIA Targets    10/00       Return to Library Index

The $1.5 Trillion Sitting In Banks Earning Less Than 2%

The 40% Of Mutual Fund Owners That Have Never Seen The Market Go Down

The Temperamentally Unstable That Think A Bear Market Lasts Three Weeks Before Stocks Head Up Again

The 40 Million Graying Baby Boomers Who Don’t Have Time To Recover From The Next Bear Market

Crediting Methods of the Annuitus Indexia    11/00        Return to Library Index
The following is a list of the 42 different crediting methods used by insurance companies to determine how index movement translates into interest credited.

Index Annuity Crediting Methods
Term End Point
Term End Point Averages Final 12 Months
Term End Point Averages Final 6 Months
Term End Point Averages End Point And Value 6 Months Prior
Term End Point Averages Final 120 Market Days
Term End Point Averages Final 52 Weeks
Term End Point Averages Final 13 Weeks
Term High Point (High Water Mark)
Term High Point Yield Spread
Term Yield Spread Averages Final 12 Months
Term Low Point Averages Final 90 Days
Term Two Step Capped Averages Final 12 Months
Term High Point Annual
Term Average Annual High Points
Term Average Highest Anniversary
Term Annual Average w/o Interval Crediting
Partial Term End Point Averages Final Days Of Mid Term
Annual Reset Point-to-Point (Absolute)
Annual Reset Point-to-Point, Simple Interest
Annual Reset Point-to-Point w/ Gross Cap
Annual Reset Point-to-Point w/ Net Cap
Annual Reset Point-to-Point w/ Minimum Yearly Crediting
Annual Reset Point-to-Point w/ Yield Spread & Administration Fee
Annual Reset Average Month Values
Annual Reset Average Month Values w/ Cap & Partial Term Guarantee
Annual Reset Average Monthly Negative Values
Annual Reset Average Month Values w/ Yield Spread
Annual Reset Average Month Values w/ Yield Spread & Participation Rate
Annual Reset Average Month Values w/ Yield Spread & Gross Cap
Annual Reset Average Month Values w/ Yield Spread & Net Cap
Annual Reset Average Month Values Rebalanced Indexes
Annual Reset Average Month Values w/ Yield Spread & Premium Bonus
Annual Reset Average Daily Values
Annual Reset Average Daily Negative Values
Annual Reset Average Daily Values, Simple Interest
Annual Reset Average Daily Values w/Yield Spread
Annual Reset Average Daily Values w/Yield Spread & Premium Bonus
Annual Reset Simple Non-Negative Crediting
Annual Reset Fixed Rate w/ Equity Component
Biennial Reset Average Daily Values w/ Yield Spread
Biennial Reset Average Month Values w/ Yield Spread & Cap
Biennial Reset Point-to-Point w/ Yield Spread & Participation Rate

I believe in its simplest form there are really only two ways to measure index movement. You can measure the movement of an index over a period of one or maybe two years, or measure the movement over a longer period of time before you credit any gain.

You can graph the returns of index annuities by frequency of the distributions. There are several ways to do this, but for this example let’s simply see how often returns occur within certain ranges.

We could use the actual performance of index annuities. However, because the track record of index annuity returns corresponds with the greatest bull market of the century our graph may not reflect long term realities. Instead, I’m going to plug in different rates and different methodologies into the 42 ten year periods of the last fifty calendar years and see how often annual returns for these periods would have been less than 5% a year, between 5% and 8% a year, between 8% and 10% a year, and over 10% a year. I’m assuming we’ll earn at least a minimum guaranteed return of 1.92% a year (which is 90% of premium compounded at 3% for ten years).

Let’s use a term end point method that only measures gain once at the end of the period. We’re going to credit 90% of the total index gain for the full ten years. And, we’ll compare this with an annual point-to-point reset method that compounds 80% of any yearly gain up to a maximum of 14% interest in any given year (down years are treated as years with zero gain). When we plug the numbers from the two methods into the last fifty years we get the following chart. The frequency of the annual reset returns shows a small percentage of very low returns, a small percentage of very high returns, and a lot of returns in the middle. The term end point methods shows more very low returns, more very high returns, and fewer returns in the middle.

Why is there a difference in annual return distributions? Term end point designs and other methods that measure index movement over long periods of time (high water mark, term yield spread) tend to follow the actual performance of the index. An equity index often has a large number of years of very high returns and very low returns with relatively few returns in the middle.

All annual reset returns look more like a bell curve. Most annual reset annuities ignore years with negative returns. This limits the periods with very low index returns, but annual reset structures tend to have higher option costs than term end point structures which means the annual reset methods usually have a lower effective participation rate than term end point designs. This means annual reset structure don’t tend to produce extended periods of very high returns.

The slope or shape of the frequency of return lines depends upon the methodology and the rate applied. If the term end point had a rate of 70%, and the annual reset rate had slipped to 60%, the lines would shift to the left. If rates had increased the lines would shift to the right meaning higher returns.

However, annual reset structures whether they are point-to-point, averaged, capped and/or yield spread will produce a bell curve. Let’s look at the distribution curves of two annual reset structures using our previous parameters. The first annuity credits a 50% participation rate on yearly point-to-point index moves; the second credits 85% based on the monthly average values of the annual index. The chart shows almost identical frequencies of return distribution. While different crediting methods react differently over the short term, annual reset structures show similar distribution curves over the long term. In 1998 index annuities using averaging of index values posted the highest returns. This year the honors went to the lower cap-higher participation rate structures.

Although the nominal or stated market participation varies from annuity to annuity the net effective participation in index movements is tightly grouped. This makes sense because everyone is buying their options and other financial instruments in the same general market.

Annual reset index annuity returns will not be identical over time for the same reasons that traditional fixed annuity returns differ from carrier to carrier and product to product. Products have different loads and different cost structures. Carriers have diverse ROE requirements or internal costs. Some investment teams will do a better job of managing their portfolios than others, and some actuaries will use more aggressive or less aggressive assumptions than their peers.

Since the basic return modeling for all of these different annual reset methodologies produces similar returns over time, I believe that the selection of the carrier is far more important than selection of a crediting style.

Integrity Not Methodology
Less than a third of the index annuities on the market guarantee that all of the crediting mechanisms will stay the same until the end of the surrender period; most of these are term end point structures or long term variations. Only a half dozen of the index annuities using annual reset methodologies lock in all of the moving parts.

The vast majority of annual or biennial reset index annuities may change either the participation rate and/or the yield spread and/or a cap on maximum credited gains at sometime during the surrender period and usually each year. Insurers need this flexibility because financial markets change. They need the ability to protect the company from financial loss. This flexibility also means that agents must select carriers whom they feel will treat their customers fairly when renewal time comes around.

In a generally rising market term end point index annuities should produce higher returns than annual reset designs. In a “middling” market the returns for both could be similar. In a bearish environment the annual reset structures should outperform. However, there are other criteria for choosing an index annuity. If your customer wants all of the moving parts fixed in place they’re more likely to find this in a term end point. If your customer needs to know that interest is credited each year they’ll want an annual reset.

All fixed annuities offer important benefits: protection of principal from market risk, tax-deferral of interest, minimum guarantees and an income you can’t outlive. Index annuities offer the potential for higher interest earnings than one might get from other savings vehicles. Find an index annuity with a crediting method you’re comfortable with underwritten by an insurer you can trust.

Realistic Expectations - Avoiding Future Problems (11/00)        Return to Library Index
Index annuities, even after you include current year results, are in general performing very well. The first high point (high water mark) term and term end point index annuities purchased are delivering compounded annual returns of fifteen to twenty percent. Annual reset structures have averaged first year returns over the last four years of nine to eleven percent. All in all, index annuities are doing what they are supposed to do. However, I’ve been hearing from some agents and consumers that all is not sweetness and light on the index annuity frontier.

3% Of What?
A common source of consumer complaints is not understanding how the minimum guarantee works. The consumers tell me that their agent said they would at least get 3% a year - why did I get 1.2% or Zero?

Well, I have to tell them in most cases that they’re not even earning 3% on the full premium. The minimum guarantee is on 87% of the premium or 82% of the premium or 90% of the premium. So, worst case is they’d make 1.92% a year or 1.46% a year or 0.85% a year.

Even when the 3% is calculated on 100% of the premium I have to tell them that - with the exception of only two carrier’s products - the 3% is not paid each year and would only be paid if their total return averaged less than 3% a year over the whole contract.

I Deserve 16%
I’ve received calls from consumers who were unhappy with their returns; they say they expected more. At first I thought that the reason for their faulty expectations was because the agent hadn’t made them realize the effects of a cap or how averaging affected values. In many cases the problem was inadequate education. However, in a disturbing number of instances the client simply expected more because this was an “equity” annuity. Everybody knows that people are getting rich with equities and No, I’ve haven’t read the business section of the newspaper all year, why?

Realistic Expectations
Index annuities have a wonderful story to tell, but you need to convey realistic expectations in your presentation.

The Great News Is They Can’t Lose Their Premium - It’s Not Earning A Lousy 3%

The sizzle behind the guarantee side is not the minimum return; it’s the protection of premium from market risk. “Mrs. Smith, even if the market steadily falls for the next ten years the worst you will get back is your premium”. That’s the story; not earning a measly 3% interest. A low guaranteed return is a positive, it means that more money is available to enhance the index side of the equation.

When you hear someone talking about equities what kind of returns do you suddenly think of? 12%? 20%? Higher? When your hear the words “fixed annuity” what are your return expectations? I would imagine much lower.

Index annuities are long term savings vehicles designed to provide an opportunity for returns higher than you would receive from traditional fixed annuities. In a macro view of the world if stocks are earning 10% to 12% and banks are paying 4% to 6%, index annuities would come in at 7% to 9%. However, if you talk about EQUITY index annuities this is what your client hears “Equity Returns...No Market Risk...Safety...20%...Go to Tahiti”. Instead, talk about fixed annuities linked to an index. Because then the client hears “Safety...Might Be Better Than The Bank...Sleep At Night”.

We will survive this tumultuous year and index annuity returns will go up. You can be a hero by creating realistic return expectations.

3rd Quarter EIA Sales Drop 13%    12/00        Return to Library Index
The Advantage Equity Index Sales & Market Report shows that third quarter index annuity sales were $1213 million; a 13.1% decline from the previous quarter. This compares with $1277 million reported for the third quarter of 1999. The primary reasons for the decline were very competitive fixed annuity rates coupled with an extremely volatile stock market.

The survey, completed in November, includes reports from carriers representing 98% of total index annuity production. Sales for the first nine months of 2000 totaled $4103 million; an 11% increase over last year. It appears that final 2000 sales totals will be flat when compared with the previous year.

The marketplace was very stable. No new carriers entered the market and very few products were introduced. North American has ceased marketing their index annuity and life products. The tally today is 44 index annuity companies offering 177 product variations using 42 different crediting methods.

Market Stress & Diversification    12/00        Return to Library Index
A key principle of portfolio theory says that market risk can be reduced if investment portfolios are sufficiently diversified. Academic studies have developed formulas that attempt to determine the correct portfolio mixture to optimize returns at the lowest level of risk. Their analysis looks at the correlation, or performance relationship, between different financial instruments and how they performed in the past. The goal is to put together a clump of investments that generates the greatest returns at the lowest risk over all periods.

A fundamental problem with the whole concept is that correlation does not mean causality and the past doesn’t exact repeat in the future. By that I mean if historically one investment has always gone down when the other goes up every time dividend yields reached “x” percent, there’s no guarantee that the same thing will happen the next time “x” is reached. Unfortunately, the market is not an actuarial table.

The ultimate flaw in the diversification tale is that it fails to protect portfolios during times of severe market stress. When the stock markets are trudging along this diversification may increase returns. However, diversification is often sold as a way to reduce losses if the market tanks.

October, 1987 was a particularly nasty month for the stock market. If you had owned the S&P 500 index at the start of October you were down 23.1% on All Saint’s Eve. During a period of severe market stress this common market benchmark plunged; how were other indices affected?

For the same period the Dow Jones Industrial Average dropped 24.5%. Well, the similar drop really isn’t surprising because the Dow is also a broad market indicator, but how were other sectors affected? In October the Nasdaq 100 fell 28.4%; the Russell 2000 plummeted 31.0% and even the London FTSE slid 26.3%. During this time of severe market stress all of these sectors were similarly affected. There were sectors that responded a little differently - the Tokyo Nikkei 225 only dropped 9.3%; the drop in precious metal stocks was also down less than the broad markets. However, if you had then determined that the stocks of Japan and gold shares were the place to put your money your returns for the next twelve years would have been abysmal.

For many brokers and investors 1987 is ancient history. An argument could be made that advances in portfolio theory make lessons of past declines less relevant. After all, weren’t the ‘90s a new paradigm in investing in which the old rules didn’t apply?

In July of 1998 the stock market was hit with several shocks. The first shock was a concern that growth in corporate earnings might have been slowing. This was followed by a banking crisis in Asia, a president on the verge of impeachment, and a Russian government that said “You want us to actually pay off on our bonds?” The resultant uncertainty caused the S&P 500 to drop 11.3% in the month of August. During the same period the Dow fell 11.3%, the London FTSE fell 11.4%, the NASDAQ 100 dropped 11.8%, the Tokyo Nikkei 225 slid 12.3%, and the Russell 2000 declined 17.5%.

In these periods of severe market stress the indices were almost perfectly correlated - they ALL went down. Stock diversification did not protect the portfolio from loss. I believe diversification can increase returns over the long haul, because history doesn’t repeat and diversification may mean we accidentally benefit from unforeseen growth in some neglected sector. I also believe that there is a better way to protect a portfolio from severe market downturns than buying more stocks. It’s called cash.

The American Heritage dictionary defines cash as ready money. I would extend my definition to say that cash has no market risk to principal and has defined liquidity. My definition of cash would exclude bonds. Although bonds in general are less volatile than stocks, an investor’s principal is subjected to undefined liquidity risk if the bonds are sold prior to maturity. However, my definition of cash would include certificates of deposit and many fixed annuities. Neither vehicle subjects principal to market risk and liquidity is generally available.

But, certificates of deposit have interest penalties that can eat into the principal and annuities have surrender charges that can do the same thing. True, but with the exception of market value adjustment products, the cost of liquidity is known. A CD buyer knows that the worst they could get back is 96 or 97 cents on the dollar; a typical fixed annuity buyer knows the worst they could receive is 87 or 90 or 92 cents for every dollar of premium. And, in both cases the buyers know if they hold their financial instrument long enough the interest buildup within the account will make them whole regardless of how the market performs.

Index annuities are fixed annuities. Although excess interest crediting is linked to the movement of an external equity index these annuities specify their liquidity costs and provide a minimum guaranteed return that at some point will make the investor whole. Because index annuities do not subject principal to market risk, have defined liquidity, and may provide higher returns than other fixed rate instruments, they are an excellent portfolio diversification tool.

A stock investor has only two choices if the market declines. He can sell and take his losses, or he can wait and hope the market quits falling and heads back up before he needs the money. An index annuity owner has the same choices, but with more positive outcomes and without the uncertainty. The annuity owner could cash in the annuity and receive a specified amount known in advance, or hold the annuity with the knowledge that a minimum interest guarantee will continue to increase the annuity’s value regardless of what the market does. These guarantees give the index annuity owner a great deal of power.

I am very optimistic about the future of the world’s stock markets. I also believe it will be a bumpy ride. Cash protects a portfolio from market risk. Index annuities protect principal from market risk and have the potential for higher returns.