2002 - Financial Counselors Will Make A Lot Of Money
It will be a wonderful year for purveyors of insurance products. The last two years have made consumers aware that high returns mean higher risk, and that even the best plans to achieve life’s goals may be interrupted. There is a desire for safety and reasonable growth, but bank rates are the lowest they’ve been in decades. Into this environment, financial counselors bring forth…

This is the most profitable sales environment the insurance industry has seen in years, and it will only improve as the year progresses. Short term interest rates have plummeted while long term rates have only dipped. This means money market and CD rates are very low and fixed annuity rates remain competitive. Interest rates will begin trending up in the second quarter, narrowing the difference between offerings of banks and insurers, but insurers will continue to have a yield advantage though out the year.

After two years of declines, is there anyone that doesn’t believe the stock market will end 2002 higher than where it began? Fixed index annuities capitalize on this new bull market with the realistic possibility of double digit yields in this, the first palindromic year of the new century. And if “anyone” is right, index annuities still protect principal from market loss.

In spite of stock options and a new SUV in the garage, consumers now know they can die. Whether the vehicle is term, universal, whole, indexed or variable, only life insurance creates an immediate estate for use by the survivors.

The 2001 Tax Act gives additional bounty. On January 1st the sales potential of a book of IRA customers increased 50% to 75%. Contribution limits on all qualified plans have increased and plan participant funds may be rolled-over from plan to plan with abandon. In addition, increased flexibility and contribution limits on educational savings plans will create a new cottage industry of “education planners” as future education account balances rival today’s IRA totals.

Financial counselors should be scheduling first quarter seminars on Millennium IRAs, and contacting schools and churches on holding educational planning sessions. Clients should be informed of the benefits of consolidating qualified funds in a single account. Banks should be picketed by bearers holding signs showing fixed annuity rates. Carpe Annus.

Index Annuities In A 7% Index World   Top
In the December 10, 2001 issue of Fortune Warren Buffett was interviewed and asked for his outlook on the stock market. As always, Mr. Buffett’s comments and analysis were insightful and well reasoned. However, what made me sit up in my chair were his closing remarks where he said that the American public should expect equity returns over the next decade or two of perhaps 7% - including dividends.

My first thought was that if Mr. Buffett was right, index annuities were dead as a viable instrument. If you’re expecting an average 7% annual return from the overall market — and an index by definition attempts to reflect the entire market — and this return includes dividends, then your index return without dividends would be in the range of, maybe, 5.5% to 6% a year. Currently, index annuity rates, after the effects of averaging, caps or spreads, reflect, at best, 60% of actual index movement. So, my initial calculations assumed that a Warren Buffett market would result in average index annuity returns of 3% to 3.5% in an arena that could still produce 5% traditional fixed annuity yields.

Environments of less than double digit annual stock market returns lasting for long periods of time, are much more common than one might realize after seeing the wild bull market of the ‘90s. Although the S&P 500 Index produced an average 15.22% a year return in the last decade, compounded ten-year period returns never exceeded 10% in the years from 1955 through 1986. In fact, if you look at ten-year periods starting in 1960 and look at the entire decade (1960-1969, 1961-1970…1969-1978), the best ten-year period averaged a return of 6.46%.

But then it occurred to me, these average returns include the effects of negative years when the market goes down, and index annuities using annual or biannual reset structures treat negative years as zeros (although you won’t usually earn interest if the index goes down, the previous credited interest is protected). The question this posed was “What happens when you swap the annual losses of an equity index investment for the no-less-than-zero element of index annuities?”

If you look at the calendar year returns of the S&P 500 from 1951 through 2001, the average annual return is 9.49%, without dividends. If you substitute zeros for any negative years, and then calculate the average anew, the return increases to 12.60% for the fifty-year period.

I went back and plugged in zeros and redid my ten-year period math. The average annual returns for the new ten year periods — in which down years were replaced with zero returns — increased from 1% to as much as 7%. In fact, the best ten-year period return of the ‘60s s previously mentioned went from 6.46% to 9.28% when zeros were inserted.

What does this mean? If Mr. Buffett is correct about a 7% world including dividends, which becomes a 5.5% to 6% index return world without dividends, an annual reset index annuity structure substituting zeros in down years means that over longer periods of time the average returns upon which the index annuity crediting is based would be 2% to 3% higher than the pure index values.

Unlike a stock market investment, the index annuity doesn’t lose ground when the index drops, so if a stock market index would average 5.5% to 6% over time, the index annuity method would show an average return of 7.5% to 9% and base crediting on that number. The bottom line is even in a 7% stock return-with-dividends world the no-loss aspect of the index annuity crediting structure more than offsets the lack of reinvested dividends.

Okay. The good news is even if the stock market averages 7% returns over the next 20 years, the crediting element of annual reset index annuities should base interest calculations on index gains averaging better than 8%. The bad news is even at 8% gross annual gains, if effective index annuity participation rates are still at 60%, we’re still only talking 4.8% index annuity returns in a 5% traditional fixed annuity scenario. However, a Warren Buffett stock market would lower the costs of providing the equity index linked interest.

In recent years, option prices have been higher than the historical average because market volatility has been very high. Using the Option Volatility (VIX) Index as an example, the VIX ended 2001 with volatility values in the mid twenties. For much of the year VIX values were closer to thirty or higher because the market was extremely volatile.

This volatility caused participation rates and caps to go down, and yield spreads to go up, because the price of options rose. Ever since index annuities were introduced they’ve existed in a market with high volatility, because the stock market has been nuts for the last few years — either very bullish or very bearish.

A Warren Buffett stock market would be, well, boring. There just wouldn’t be a lot of volatility and sellers of options would have less fear of extreme moves. Volatility could drop to levels not seen since the ‘80s, thus lowering option prices.

In a Warren Buffett market, option prices could drop so much that we could be looking at annual reset point-to-point designs with participation rates of 100% and 15% caps, or 120% with 12% caps. Annual reset models using daily or monthly averaging could honestly show 140% participation rates, or have positive yield spreads adding 3% to 4% on top of the actual index gain. Imagine telling an index annuity owner “The index only went up 5%, so you made 8% this year”. What this all could mean, is a 7% stock market environment could readily produce index annuity returns which would be 40% to 50% higher than traditional fixed annuity returns or returns from bank instruments. I don’t know whether Mr. Buffett’s forecast will come true. The stock market could well put forth another score of years that resemble the previous twenty, or muddle along as the Omaha sage predicts. However, in either scenario fixed index annuities should do the job they were designed for — providing the potential for paying higher interest rates than one would receive from other savings instruments without subjecting the principal to market risk.

Index Participation Rate Indicator   Top
The two major components affecting the degree in which an index annuity participates in the movements of an equity index are the prices of options derived from the index and the yield on the portfolio used to provide the minimum guaranteed return. In general, if interest rates on bonds increase, then fewer bonds are needed to maintain the guaranteed rate, leaving more money available to buy the options which provide the potential excess interest and thus increase the annuity’s participation in the index. If option prices drop, the insurer can buy more options, and thereby increase the annuity’s participation.

Although a combination of bonds and options are usually used with an index annuity, there are carriers that have used portfolio replication methods utilizing stocks and other instruments, rather than buying options, and other carriers may supplement or replace bonds with mortgages, real estate, stocks, or other vehicles. Regardless of these variations, the driving forces behind index annuity rates are the general interest rate environment and the cost and volatility of the stock market.

Even though all index annuities use the same basic building blocks, with over 30 crediting methods in use it is difficult to determine if one annuity’s long term index participation reflects overall market changes, and direct comparisons are difficult. I thought it might be useful to develop a standard indicator of index participation that could be used to help see whether specific index annuities were, in fact, changing their rates to reflect markets costs and yields, and whether these product rate changes reflected the degree of change in the overall market.

The Index Participation Rate Indicator (IPRI) attempts to reflect changes in the portfolio yield of an insurance company combined with changes in the cost of index options. A higher indicator value reflects a more favorable environment for index annuities and thus, increased annuity participation should be observed. A falling indicator value should mean that product participation rates are declining as well.

IPRI uses the arithmetic average yield of Moody’s Seasoned Corporate Bond Yield Aaa, Moody’s Seasoned Corporate Bond Yield Baa, and 10 Year Treasury Constant Maturity Rate. The monthly yields are an average of monthly business days. Data on all of these vehicles are available at the Federal Reserve.

The resultant average yield of the three bond vehicles is multiplied by a factor of 10. From this yield variable the average monthly value of the Volatility Option Index (VIX) of the CBOE is subtracted. The remaining product is the IPRI value for that specific month.

As an example, if the average monthly yield for the three bond instruments were 7%, 8%, 6% and the VIX monthly average value was 25, IPRI would be calculated as follows: The average yield of 7% [(7%+8%+6%)/3] is multiplied by 10 to produce a yield variable of 70, then the VIX value of 25 is deducted, leaving an IPRI value of 45.

I applied this formula to the period from 1995 to the close of 2001 — the product lifetime of index annuities. The formula says that participation rates should have been at their highest levels in 1995 and 1996, would have fallen dramatically around September 1998 and taken approximately nine months to recover. Participation rates then should have modestly risen, until beginning to decline in 2001, with a big shock in early autumn and some recovery by December. And index annuity products generally did react as IPRI said they would.

I then compared IPRI to the actual participation rate of an index annuity with a seven year surrender period using a term end point crediting method. I looked at the actual average product rate for the term end point index annuity, and the indicated IPRI values, from December 1996 through December 2001.

Although the results are similar they are far from perfectly correlated. The index annuity line tends to be less volatile, and lags, the IPRI line. The biggest disconnect occurs at the end of the period where IPRI indicates participation rates should be rising, and yet, the index annuity rate remains static (As I was completing this article I received notice that the carrier was increasing their participation rate at the end of the week).

IPRI may also be used to examine index annuities using asset fee or yield spread methodologies; however, since yield spread structures perform opposite of the way participation rates work, with rising spreads indicating a worsening index market, I have used an inverse variable created by subtracting the actual yield spread from a value of 10. In this manner, a “better” (lower) yield spread goes up on my chart and a worse (higher) spread goes down.

I compared IPRI with the yield spread of a monthly averaged annuity with a nine year surrender period for the last two years. (The actual yield spread is deducted from ten, and the resultant variable in shown. The result shows a tighter correlation between actual and indicated rates. As in the previous example, actual rate changes tend to follow indicated rates. And, as also shown in the previous example, both carriers demonstrate a tendency to hold rates steadier, in both rising and falling markets, than implied values would suggest.

I have conducted numerous comparisons of IPRI with different index annuities and feel the indicator does reflect the overall effects of portfolio interest rates and option prices on index annuity rates. My conclusion is that a rising IPRI value reflects a more favorable index annuity environment whereby participation rate increases, or yield spread decreases, would be warranted, and that a falling IPRI value would indicate the reverse. However, the magnitude of the rise or fall in IPRI does not directly correspond to the degree of change in the index annuity rate.

IPRI may help identify index pricing models that don’t reflect reality: If an index annuity is lowering rates when IPRI indicates more favorable conditions exist for index annuity pricing, other questions may need to be asked. Or, if a carrier raises rates when IPRI says they should be falling, perhaps the carrier is spending tomorrow’s dollars today.

The IPRI values may be compared with index annuities using participation rates and yield spreads, whether index values are averaged or not. But I am still working on a meaningful way to compare crediting methods that use caps. In the meantime, I will continue to test IPRI against actual index annuity performance.

Complexity Requires Building Realistic Expectations   Top
Moody’s Investors Service published a Special Comment report in November of last year titled Equity Index Annuities: Complexity Personified. The report is a fair representation of the potentials and concerns associated with an insurer’s decision to offer index products. One of the concerns addressed is that index products may be more vulnerable to market conduct issues because “complex products [are] more difficult for distributors to explain and contractholders to comprehend”.

Fixed index annuities are based on a simple concept — the annuity owner may earn excess interest, above the guaranteed minimum interest rate, based on the performance of an equity index. However, there are times when the formula used to determine crediting of this excess interest is rather involved and may be difficult to easily explain to a consumer. Let me show you what I mean.

The following is the Einstein Theory of Relativity upon which modern physics have evolved:

This, on the other hand, is a part of the formula used to determine one year’s interest crediting in a currently available index annuity:

Here is another index annuity crediting formula from a different index annuity: {(xn1+xn2…+xny)/Σxn}/S *0.9 = M M - G = D D * P = B B + G = F

Although both annuities may well produce respectable future returns, if returns falter I wouldn’t like to try to explain these formulas to a jury, excuse me, a client.

Not all index annuity crediting methods are this involved. One product on the market with a term end point structure could be shown as (E/S)-1 * P = I wherein Ending index value divided by Starting index value, minus one, and multiplied by the Participation rate gives you the Interest credited. The formula for an annual point-to-point annuity with a Cap is about as simple: (E/S)-1 * P = I = C.

However, the simplicity or complexity of the crediting formula doesn’t really matter if the index annuity concept has been adequately explained and the annuity buyer has reasonable expectations as to the interest to be earned.

“This is a fixed index annuity. Because it is a fixed annuity it provides minimum guaranteed interest earnings. Because the annuity is linked to an index, excess interest may be earned. What will your return be? I don’t know, because it depends on the how the equity index performs and how much of the performance we are able to capture. Some years will be good and some years could be zero, but the objective of the fixed index annuity is to offer the potential to earn more interest than you’d receive from a fixed interest annuity.”

I don’t understand exactly how a Cisco router works but I can still surf the Internet, and I couldn’t rebuild a jet engine to save my soul but I still fly in planes. Complexity is not a problem if you communicate the reasons why an index annuity is a solution and create realistic expectations. Index annuities can be complex, but that doesn’t mean they aren’t the correct answer for many financial questions.

NASD Web Page Skew(er)s FIAs  2/02   Top  
On 16 January the NASD web site unveiled a new consumer feature called “New Financial Products”. The first new financial product article is titled Equity-Indexed Annuities - A Complex Choice.  www.nasdr.com/02_products_01.htm

The NASD’s portrait of index annuities presents all of the possibly negative aspects of the savings vehicles with a faint attempt at balance. It isn’t that the words used in the portrayal are inaccurate, but little attempt is made to provide full and fair disclosure of the complete picture.

While I am sure that NASD is not trying to imply to consumers that index annuities are somehow a security attempting to evade regulatory oversight, and simply forgets to mention that there are only two registered index annuities in a market of 190 fixed index annuities, it would have been more accurate to say that because virtually every index annuity is a fixed annuity and not a security, the fixed index annuities are regulated by state insurance departments, and not the NASD.

The article does mention the guaranteed minimum return aspect of index annuities, but concludes “While it is not a common occurrence that a life insurance company is unable to meet its obligations, it happens”. Again, perhaps the NASD could mention every state has an insurance guarantee fund, or alternatively, the lack of any guaranteed safeguards with security products.

Fixed-Index Annuities Are Not Securities Because of Minimum Guarantees
Principal Protection from Market Loss
Marketed as Long-Term Savings Vehicles

NASD does mention how a few different crediting methods work, but again, omits or minimizes positive aspects of the story. For example, it says “Averaging may reduce the amount of index-linked interest you earn”, without saying averaging could also result in a higher value. And the article says “Since you’re not earning dividends, you won’t earn as much as if you invested directly in the market”, but the NASD fails to mention the commissions, fees, and potential losses of a direct market investment.

And to the question “Is it possible to lose money in an EIA?” the somewhat puzzling answer from the NASD is “Yes. Many insurance companies only guarantee that you’ll receive 90% of the premiums you paid, plus at least 3% interest. Therefore, if you don’t receive any index-linked interest, you could lose money on your investment.”

It’s not a secret that NASD does not like index annuities. NASD receives fees from security transactions and not one dime from fixed annuity sales. To enhance their revenues, NASD asked the SEC to say that index annuities were, in fact, securities, but the SEC declined to do so.

Index annuities will remain as insurance, and not security products, as long as they are presented as long-term savings vehicles. Fixed-index (a better description than equity-index) annuities offer minimum guarantees, protect principal from stock market loss, and credit interest each year. Even though the NASD article calls index annuities “investments” a half dozen times, they are fixed insurance savings instruments, and not securities.

Index Annuities - Selling Shoes In India* 3/02  Top

How financial counselors utilize fixed annuities is dependent upon how they were trained. There are annuity specialists that target “safe money” and market fixed annuities as replacements for CDs and other annuities. There are stockbrokers that will grudgingly sell fixed annuities to clients whom won’t accept the risk of a variable annuity. There are life insurance agents that might sell a fixed annuity if they uncover a cache of cash when doing a prospective insured’s needs analysis, or as a complement to fund premiums for a life insurance policy.

Indexed annuities are fixed annuities and 2001 was the seventh consecutive year of increased index annuity sales, but index annuity sales represented only 4% of total deferred annuity sales (which includes both traditional fixed and variable annuity production). This low percentage supports our research showing that fewer than 7% of the total agents selling fixed annuities have ever sold an index annuity.

Why has over 90% of the agent market not sold index annuities? Part of the reason is that index products are perceived as too complicated. Another significant factor is a lack of training and education, with the agents ultimately avoiding products they don’t understand. Another reason I have heard from agents, to explain why they aren’t selling index annuities, is that “index annuities are all hype and no substance”. Since perception often dictates action, the industry needs to show skeptics the strong actual returns posted by index annuities, and demonstrate the long-term viability of the product, for sales to reach the next level.

Index annuities have made the deepest inroad with annuity specialists. These agents recognized the possibilities of index annuities — both the potential returns and attractive commissions — and mostly through the efforts of these agents index annuity sales were near $6 billion last year. However, two major agent markets have ignored the index annuity phenomena. Our research shows that stockbrokers consistently represent less than 1% of index annuity sales. Furthermore, my talks with dedicated life insurance agents show, in some cases, an actual hostility to index annuities.

To increase index annuity sales with stockbrokers and life insurance agents, companies need to change the agent prejudices imbedded by training and experience. To be successful, carriers must change the agent’s perceptions of not only where an index annuity fits in the financial world, but the agent’s view of the financial world itself.

FIAs as Cash
The Wall Street universe consists of stocks and bonds; cash is where your money sits until you buy some more stocks or bonds. Stockbroker types sometimes use fixed rate annuities as a cash alternative, and fixed index annuities with shorter surrender periods may also be used in the cash bucket of a portfolio. Both Keyport Life and Lafayette Life have enjoyed some success with bank markets, and to a lesser extent wirehouse stockbrokers, with their shorter surrender period index annuities.

Stockbrokers could be trained, and index carriers could greatly expand their market, with index annuities offering one, two and three year surrender periods. These shorter term FIAs would be offered to bank brokerages and wirehouses as cash alternatives, with initial and renewal commissions roughly in line with mutual fund trailing commissions. The natural concern for insurers are mass surrenders at the end of a year. Although my own anecdotal experience is that a significant portion of this business should stay on the books, there is too little data to determine what the retention rate of one year FIAs would be.

FIAs as Bonds
Bonds are used as a portfolio’s zigs to the stock markets’ zags, and are usually offered as the lower risk complement to equities. However, bonds can be extremely volatile and bear bond markets can occur in tandem with bear stock markets.

Stockbrokers could be taught to position index annuities as the bond alternative in a portfolio. Even though the index annuity would mirror the movements of the index, the annuity’s protection of principal and credited interest from market loss could result in higher returns than bonds.

The chart shows calendar year stock index returns over the last 50 years. To reflect index annuity methodology, any negative years have been replaced with zeros. In addition, the chart shows only 60% of any actual positive gain. Even at 60% participation, the annual return over the last 50 years averages 7.5%. A strong argument can be made that an index annuity model could outperform bonds, especially in a low interest rate environment.

FIAs for Nervous Investors
The third use of index annuities by stockbrokers would be for those people that would like to be in the stock market, but simply do not have the temperament. There are people that just can’t emotionally handle loss and need protection of principal.

Stockbrokers began offering index annuities to nervous investors when the annuities were first introduced, but quit selling them as participation rates fell and the stock market looked like it would never go down. Today, stockbrokers need to be reacquainted with index annuities and shown that saving the client from a 30% loss may offset a lower participation rate.

FIAs as Registered Protection
One doesn’t need an index annuity to combine protection of principal with potential gains. An individual could buy a zero coupon bond and a Leap option, and produce a similar end, or an investor desiring tax deferral could select bond and equity sub-accounts in a variable annuity. However, an index annuity does offer economies of scale (the per dollar transaction costs are less when you buy 100 options instead of 1) and convenient packaging. Insurers could develop index annuities with a very narrow focus and register these as securities.

For example, registered index annuities could look like unit investment trusts with an index option married to a portfolio of bonds with specified short-term maturity dates. Or, we could have the XYZ Stock index annuity that combines a specific stock option with the annuity contract’s minimum guarantee. Both vehicles would protect principal if the option lost value and benefit if the option rose. Stockbrokers would sell these index annuities because they look and feel like securities.

FIAs for Insurance Agents
Many life insurance agents have been battling the world for twenty years selling fixed rate instruments, as equity investments ate their lunch from a return standpoint. In reality — and it doesn’t matter who does the math — over time equity instruments do outperform fixed rate vehicles; however, it would be difficult for some life insurance agents to admit this.

Clients owning only fixed rate products weren’t eviscerated by the millennium bear market, but it also means they missed out on significantly higher overall returns. Index annuities can be presented as a middle ground and should be presented to life insurance agents as “how the stock market would work if it were run by an insurance company”.

A life insurance agent consistently offering only fixed rate annuities and non-variable life insurance may have a “fixed good - stocks bad” mindset, mentally overstating the effects of bad stock market years and underestimating the power of good years on final results. The insurer needs to show how index products minimize bad year returns and eliminate market risk to principal. The index products need both fixed and indexed elements, so that the agent can dip just their toe into the index side of the market. Eventually, as interest is credited from both fixed and indexed sides and results compared, more of the account dollars will be moved to the index bucket.

The other part of the story is changing the agent’s long held beliefs on stock versus fixed returns. The chart on the next page uses the IPRI Composite Bond Index and shows annual yields on a portfolio of corporate and government bonds over the last fifty years (it could be viewed as a rough representation of the returns earned on an insurer’s investment portfolio).

While the ‘70’s and ‘80s had average bond yields of 8.8% and 11.3%, the ‘60s averaged a 5.4% annual yield and today’s bonds are at 6.7%. The average yield for the bond index is 7.3% over the last 50 years. Contrast this 7.3% return, representing 100% participation in the bond index, with the previously mentioned 7.5% average return representing only 60% of the positive stock index performance. Agents can be taught that the insurer’s index approach to equities can produce higher returns than a net fixed rate.

Stockbrokers and life insurance agents represent a huge market. Stockbrokers need to be taught that a financial universe of stocks & index annuities may be a better fit in the new century than the old millennium’s stocks & bonds mentality. Insurance agents need to understand that the protection and interest potential features of fixed index products could outperform fixed rate products. For both groups, new products and new educational approaches will be needed.

FIA Algebra  Top
Whenever I start to feel a little smug and think that I might actually know something about anything — which happens with less frequency as I get older — I’ll run across an article on physics and realize I know absolutely nothing about everything (Did you know a proton weighs 1,836 times more than an electron and nobody knows why!) However, there is a surefire way to at least appear smarter in front of others, and receive oohs and aahs from mere mortals, and that is to use some algebra in everyday life.

Where M is the fund or variable annuity account movement for a period, from which you subtract E, representing fees and expenses, and the resulting number is R, or the return. So, if a mutual fund moved up 10%(M) by the end of a period, and the management fee was 2%(E) then the return is 8%(R).

You could use a similar formula to compute an index annuity return. Index annuities don’t have fees in the same way that mutual funds and variable annuities do, but you could say that the E in the equation represents the yield spread in an index annuity. So, if an index moved up 10%(M), and the yield spread was 2%(E), you could show a return of 8%(R) for the index annuity as well.

And it doesn’t take much imagination to change the formula so that it works with index annuities using a Participation rate, rather than a yield spread: M x P = R would do the trick. So, if the index moved up 10% (M) and the participation rate was 80% (P), then the index annuity return is 8% (R).

Now we get to the ooh and aah part of the lesson. The mutual fund and variable equation look like this

M - E = R

But the index annuity formulas are conditional equations. A conditional equation means the variable value depends on the value substituted. 

Let’s say the mutual fund or variable annuity actually goes down, say, 20%. The formula would show [-20% - 2% = -22%] or a loss of 22%. Indeed, the minimum value in a fund or variable annuity for R is -100%, representing a total loss of all principal.

On the other hand, let’s say an index annuity with a 2% yield spread is linked to an index posting a 20% decline. Due to the conditional value the formula would show [-20% - 2% = 0].

What if the index annuity had an 80% participation rate and the index dropped 20%? The formula would show [-20% x 80% = 0]. The minimum value for an index annuity R is 0.

Think about the ramifications of If R<0 Then R=0. In an interest crediting period the worst that can happen is you don’t lose any money. Take this a step further. Since R can never be less than zero, this means that returns credited in previous periods can’t be lost either.

Since R can never be negative, index annuities don’t lose ground and won’t give back credited interest. In fact, because all index annuities are fixed annuities with minimum guaranteed returns, R will ultimately be greater than zero, so the worst the index annuity can produce is a positive return, and that’s a very favorable condition indeed. This is one algebra lesson that should be shared.

Announcing The Best Index Annuity Company of 2002  Top  
We are a nation obsessed with superlatives. Everyone wants to be able to claim they are the highest, the newest, the most improved or the greatest, even though the actual difference between first and second place — or third, fourth or fifth for that matter — is usually small.

The same desires hold true in the index annuity market. However, it’s difficult for companies to claim top status in an arena in which better or best is often only a matter of opinion and conjecture. Therefore, I have developed the ultimate (notice the superlative) list whereby every index annuity carrier may claim they are the best. And the winners are…

Allstate - Best hands

American Equity - Best use of the word “Plus” in product names

Americo - Best carrier to know if you need Kansas City Chief or University of Texas tickets

Americom Life - Best insurance carrier ending in “com” that isn’t a telephone company

AmerUS Group - Best corporate group if you’re trying to score Big 12 tickets

BMA - Best headquarters from which to fly a kite

Clarica - Best index annuity carrier, owned by a Canadian company, headquartered in a town with an average January temperature below freezing

Conseco - Best visitor parking

Great American - Best index annuity carrier in an Ohio city beginning with the letter “C” that isn’t Cleveland or Columbus

ING USG - Best corporate use of the letter “G”

Jefferson-Pilot - Best company named for a flying dead president

Keyport - Best Red Sox fans (worst Yankees fans)

Lafayette Life - Best use of the name “Marquis”

Lincoln Benefit - Best carrier named for a dead president with a beard

LSW - Best carrier to know if you need to unload some Dallas Cowboy tickets

Midland National Life - Best carrier employees to go on a fishing trip with

National Western - Best index carrier with a 22 character web site address

Northern Life - Best carrier with a service center located in Minot

Oxford Life - Best annuity carrier named for a shoe

Standard Life of Indiana - Best office cube layout

SunAmerica - Best carrier named Sun that isn’t Canadian

Union Central - Best geographically correct corporate name when the country had 31 states

Western United - Best carrier above the 47th Parallel not located near a Sound

Top

Index Annuities Top Record Sales Quarter With Record Year    
Fourth quarter index annuity sales were over $2 billion, resulting in a record-breaking $6.5 billion in 2001 equity index sales. Sales for the fourth quarter of 2001 were a record $2021 million compared with sales of $1258 million for the fourth quarter of 2000. Fourth quarter index sales were up 27% when compared with third quarter index sales and up 61% when compared with the same period one year ago. Sales for 2001 were 20% higher than 2000. The top selling index carriers were:

4th Quarter Index Annuity Sales			2001 Index Annuity Sales
Allianz	$ 433,962,000		Allianz	$1,330,128,000
Midland National	385,500,000		Midland National	1,164,600,000
American Equity	300,022,621		American Equity	899,734,597
AmerUS Group	153,249,528		AmerUS Group	481,771,905
North American	110,800,000		Jackson National	402,276,941
Jackson National	108,873,046		Conseco	335,348,824
Keyport Life	84,176,000		ING USG Annuity	235,433,154
Conseco	75,935,419		Keyport Life	229,858,000
ING USG Annuity	54,024,469		North American	217,100,000
Lafayette Life	49,960,217		Fidelity & Guaranty	203,856,257

More index annuities were purchased in the last three quarters of 2001 than were sold in 1995, 1996 and 1997 combined. In fact, the top five carriers out-produced the total for all 48 carriers selling index annuities in 1998.

The record sales occurred as the number of players contracted. Delta Life, GPM Life and Life Investors left the index annuity market. There are now 37 carriers offering index annuities. This is the lowest number of providers since the spring of 1997. Insurance agents continue to represent 19 out of every 20 index annuities sold. Banks and broker/dealers continue to avoid the market, although indications are that will change in the current year.

Market Composition 03/01 45 Equity Index Annuity Companies 134 Products By Surrender Period & Methodology 137 Products Plus Bonus Rates, Cap/No Cap Option 194 Products Plus Other Indices 2/02 37 Equity Index Annuity Companies 142 Products By Surrender Period & Methodology 148 Products Plus Bonus Rates, Cap/No Cap Option 197 Products Plus Other Indices

Annual reset structures and crediting structures using averaging continue to dominate the market. Products using some degree of averaging dropped from over 90% of sales to 83% of sales; annual reset designs represent over 92% of total sales. Products with surrender periods of ten years or longer account for four out of five sales; the weighted surrender period based on product sold is 11.9 years. Index annuities with agent commissions of 9% or more represent 82% of index sales.

 

Low Opportunity Costs Another Reason For FIAs     Top 
In Economics or Finance 101 you are told that an Opportunity Cost is the theoretical cost of forgoing a profitable alternative. One example of this is selecting a certificate of deposit with a stated rate instead of a fixed index annuity with an unknown return. If the index annuity returns more than the CD the cost is the opportunity lost by not selecting the annuity; if the index annuity is selected, but pays less, the cost is the difference between the CD yield and the annuity.

A couple of years ago certificates of deposit were yielding nearly 7%, some traditional fixed annuity rates were even higher, and the S&P 500 index was near its all-time high. Although index annuities have credited double digit interest rates, there can also be years of zero, or near zero, returns. Two years ago the opportunity cost of selecting the potential returns of an index annuity over the stated returns of a certificate of deposit or traditional fixed annuity was high.

Today, the opportunity cost of selecting the index annuity over these other saving vehicles is much less. The average one-year CD yield is under 2.5%. This means that even if the index annuity credits zero, the cost of selecting the index annuity opportunity is under 2.5% — a very low cost by historical standards. Longer term CDs and traditional fixed annuities offer returns of 4% to 5%, but you need to compare these returns with the potential index annuity returns to determine the true cost.

Based on today’s values, if the S&P 500 index closed at a level of around 1200 a year from now most index annuities would be up, or actually credit, 6% interest. Now, 6% interest is not an earth shattering return but it’s still double the current return of CDs and at least a percent higher than most traditional fixed annuities.

If the index gets back to around 1300 in one year most index annuities would credit 10%, and the index would still be over 200 points below its previous high. If the index takes two years to get to 1400 most index annuities would credit 16% to 18% while fixed annuities were crediting 9% to 10% for the same time frame. In fact, if the index takes 5 years to regain previous ground and simply returns to its previous high, you’re still looking at index annuity annual returns that are double those of any CD or most traditional fixed annuities.

The bottom line is the theoretical cost of selecting an index annuity, instead of a CD or traditional fixed annuity, is 2% to 5%. The cost of choosing a CD or fixed rate annuity, rather than a fixed index annuity, is 6%, 10% or even more. Which opportunity would you select?

All information is for illustrative purposes. S&P index-linked products are not sponsored, endorsed, sold or promoted by Standard & Poor’s and no representation is made regarding the advisability of purchasing these products.

Interest Crediting Concepts     Top 
I once said index annuities are a simple concept made complicated by insurance companies. Although the comment was meant mostly in jest, I decided it would be interesting to see how many concepts would have to be broached to explain the crediting methodology of a particular index annuity. I started with a general opening statement.

“This index annuity has a minimum guaranteed (or stated) interest rate of X% with the potential for excess interest based on the movements of an external index.”

My opening statement assumes that the prospective annuity owner understands how a fixed annuity works and would use the way a traditional fixed annuity credits interest as a frame of reference.

I then wrote down all of the possible variations in crediting methods I could think of, assigned each variation a letter, and placed a letter beside each index annuity that used the specific variation.

The maximum number of variations are listed, even if a simpler version is available. For example, if a product has both a cap and no-cap version I listed the cap as a variation, but if you only present the no-cap style you would have one less concept to explain. The number of concepts is based on current rates. The following is the listing of index annuity crediting concepts, and then a ranking by product of the number of concepts that need to be communicated, from fewest to most.

Index Crediting Variations
A	Minimum or stated interest is not calculated and credited each year
B	Participates in less (or more) than 100% of index movement (includes base)
C	Deducts a yield spread or asset fee
D	The maximum interest that can be earned is x% (cap)
E	Participation rate and/or spread and/or cap can be changed each year (or biennially)
F	Any gain is not fully credited until the end of the term (except death)
G	Annual index movement is based on daily or monthly averaged values
H	The minimum guaranteed interest rate is based on less than 100% of premium
I	End point of term is based on highest anniversary value
J	Index values for some part or all of the final year of the term are averaged
K	Must be annuitized to receive full index value
L	Annual interest is not compounded
M	Start point of term is based on lowest anniversary value
N	Deducts a spread from annualized term yield and recalculates interest
O	Averages all monthly values during term and uses highest anniversary as end point
P	Deducts an administrative fee
Q	Participation rate and/or spread and/or cap can be changed after five years
R	Gain is converted to annualized rate and a portion is deducted based on the result of multiplying the respective base rate by the participation rate
S	70% of account receives index-linked interest, 30% receives fixed rate
T	Participates in x% of index gain up to level y%, then participates in z%

 

2 Concepts
Conseco SIMPLE H, L	Lafayette Marquis Flex D, E
3 Concepts
Allianz IDEAL Index B, K, Q	Clarica 7-Year Averaging Annual Reset A, G, H
Jackson National ELI A, B, F	Western United Horizon II A, H, S
4 Concepts
AmeriBest ReliaLink A, F, H, J	AmeriBest ReliaLink One A, C, E, H
American Equity Freedom Plus A, D, E, G	American Equity Premier Plus A, B, E, G
American Equity Ultimate A, B, E, G	Americo EquiFlex A, B, C, E
Americo FlexIndex A, B, D, E	Clarica 7-Year Annual Reset A, B, E, H
Clarica 10-Year Annual Reset A, B, E, H	ING USG Advantage A, F, J, T
ING USG GenOne Pro A, C, E, H	ING USG GenFlex A, C, E, H
Jackson National Elite 500 A, B, F, J	Lincoln Benefit Savers Index II A, B, G, H
Midland National Legacy A, F, J, N	Oxford Life Affluence A, D, E, G
SunAmerica IndexAmerica A, B, F, J
5 Concepts
Allianz BonusDex A, D, G, K, Q	Allianz FlexDex A, D, G, H, Q
Allianz Powerhouse A, D, G, K, Q	Allstate Elite Index Annuity A, B, D, E, H
AmeriBest AmeriGrand A, B, E, G, H	American Equity El Toro Bravo A, B, E, G, H
American Equity Future Plus A, C, D, E, G	American Equity New Millennium Pl A, C, D, E, G
American Equity Performance A, C, D, E, G	Americom Allegiance A, C, D, E, H
BMA Index Master (All) A, D, E, G, H	Clarica 10-Year Aver Annual Reset A, B, E, G, H
Conseco Classic, SPDA, FPDA A, B, E, G, H	Conseco Choice, Option A, C, E, G, H
Farmers New World Index A, B, F, H, J	Fidelity & Guaranty Power Select A, D, E, G, H
Fidelity & Guaranty (Others) A, C, E, G, H	Glenbrook Secure Index A, B, D, E, H
Great American EquiLink A, B, F, H, J	Great American Choice, Choice Plus A, B, E, G, H
Great American MultiLink 4 A, B, F, J, R	ING USG Generation Pro A, F, H, J, N
ING USG Heritage A, F, H, J, N	ING USG Regency A, B, E, G, H
Jackson National Elite 90 A, B, F, H, J	Jefferson-Pilot (All) A, C, E, G, H
Keyport KeyIndex MultiPoint A, B, F, H, O	Lincoln Benefit Savers Index A, B, D, E, H
LSW Secure Plus Select A, B, E, G, H	LSW (Others) A, B, D, E, H
Midland National Direct, Bonus A, C, E, G, H	Midland National APP A, C, D, E, H
Monumental Future Enhancer A, E, G, H, L	National Western (All) A, C, E, G, H
North American II, III Bonus A,B, G or D, E, H	North American Market Choice LT A, F, H, J, T
Northern Life FutureLink v1.0 A, B, D, E, H	Standard (IN) Equity Mser, TwinDex A, B, E, G, H
Standard (IN) 5 Star A, D, E, G, H	Standard (IN) (Others) A, C, E, G, H
Transamerica Transdex 500 A, B, F, H, I	Union Central FlexIndex A, B, D, E, H
Woodmen Growth 500 A, B, F, H, J
6 Concepts
Allianz SelectDex A, B, D, E, G, H	American Life Select Edge, Plus A, C, D, E, G, H
Americo Great Index A, B, C, E, H, P
7 Concepts
Americo FlexPlus A, B, C, D, E, G, H

The average index annuity required five interest crediting concepts to be communicated to the potential buyer after the opening statement. The fewest number of additional concepts needed were two. Lafayette Life Marquis Flex, after the general statement, would only require “The maximum interest that can be earned is x% (reflecting the cap), and the rate or cap can change each year”. Conseco SIMPLE substitutes one concept for another in the opening statement This index annuity has a stated interest rate of X% (if the index doesn’t go down replaces the potential for excess interest based on the movements of an external index) and finishes with “annual interest is not compounded and the minimum guaranteed return is x%”. The greatest number of additional concepts needed to illustrate how interest is credited was seven for the Americo FlexPlus.

Simply because one annuity’s crediting method requires more explanation than another doesn’t mean it is worse. As an example, the addition of a term high point (high water mark) variation to a term point-to-point structure lowers the owner’s risk of future market volatility harming returns. Or, the addition of a cap may reduce or eliminate the need for a yield spread and improve returns under certain market conditions.

Complexity is not a bad thing. My stereo system is much more complicated than the crystal radio I built as a boy, but the stereo does so much more. However, index annuities are perceived by many agents as being too complex. To attract the 90% of the agents that aren’t selling index annuities, the industry perhaps needs to work on developing products with fewer required concepts to entice these agents to at least listen to the music.

 Why The Rams Threw The Super Bowl     Top    
The most accurate investment forecasting tool is the NFL Super Bowl Indicator. Simply put, the indicator says if the NFC, or former NFC, team wins the Super Bowl the stock market will finish the year higher than where it began. If the AFC team wins the Super Bowl, the stock market will end the year lower.

In the 31 years from the Super Bowl’s inception in 1967, through 1997, the Super Bowl Indicator correctly predicted the direction of the stock market 74% of the time. The Super Bowl Indicator accuracy rating was double that of stock market analysts and almost four times more accurate than economist forecasts.

However, things begin to change. In 1998 an AFC team, the Denver Broncos, won the Super Bowl and yet the stock market rose over 26%. In 1999 the same AFC team won again, and yet the market rose almost 20%. In 2000 the indicator was again confounded because even though an NFC team won the Super Bowl — America’s team the St. Louis Rams — the stock market defied history and went down.

In 2001 the Baltimore Ravens, an AFC team, won and the market declined. This would appear to confirm the indicator was working again; however, the Ravens ancestry was that of the Cleveland Browns, a team that was once an NFC team. So in fact, the indicator was once again inaccurate as a former NFC team won the Super Bowl and yet the market still declined. It began apparent to economists and bookies around the world that something was wrong with the universe, and there was.

In 1997 Comet Hale-Bopp became visible to the people of Earth. What wasn’t known then was that the Comet, on its trip out of our Solar System, collided with an asteroid near Neptune while a Sagittarius moon was waxing. The resultant explosion caused a fissure in the galaxy time line throwing the universe upside down.

The Hale-Bopp Bang Effect, as it is now called, explains why the Asian financial crisis occurred in 1998, why the Super Bowl failed to predict the stock market outcome for the last four years, and why investors thought Pets.com was a viable business model. But, worse was yet to come

Leading economists determined that unless the fissure in the galaxy time line was closed a global depression would result. They concluded that the only way to heal the fissure was to cause a break in one of the basic universal truths, hoping the resultant negative energy from this break would close the galactic tear. As everyone knows, the three universal truths are the sun rises in the east, the earth revolves around the sun, and the Rams will beat the Patriots. Since nothing could be done about the first two, an international delegation of world leaders headed to St. Louis in January.

The delegation met with the Rams and told the team that the future of the planet was on their shoulders. The only way for harmony to be returned to the universe was for the Rams to lose the Super Bowl. America’s team the St. Louis Rams, in the spirit of giving and charity that exemplifies these giants of the gridiron, unanimously decided to throw the game for the economic welfare of the world.

We all know the outcome. The Rams gave away the Super Bowl (although they had to work very hard to let the Patriots win). And on that fateful Sunday evening when the game was over a wave of sorrow and negative vibes emanated from this planet with the force of a thousand hydrogen bombs pounding the cosmic fissure closed and righting the universe once again.

The results are already being felt. Economists are saying that the recession is over and the recovery is on its way. Indeed, both Montreal and Minnesota will even enjoy a season of baseball that was once in doubt. And Boston has something to be proud of for the first time in 84 years. But you know the real story. So, the next time you see a Rams player on the street give him a thumb’s up or an “attaboy”. Although winning the Super Bowl is laudable it takes a real hero to save the universe.

Index Annuities Are For Real    Top
In March 1997 the Advantage Index Card premiered. The eight page monthly issue was designed as a  companion to the Index Annuities Report, containing summaries of product features and hypothetical performance. Today, the Index Card has 24 pages listing the top selling 85 index annuities.

Both the Report and Card contain hypothetical returns calculated by applying the current rates, spreads and caps to terms of the last 50 years. Although hypothetical testing is far from perfect, the lack of actual returns in the early days of index annuities precluded other methods of analysis.

However, index annuities have now been around for over seven years and there is a steadily growing number of index annuities with actual credited returns. I am attempting to build a database of actual product returns and the number of carriers providing this data to me is also increasing.

There were eight carriers in business at the beginning of 1997 that are still around with the same or similar products today. Five of those carriers provided verifiable information on the actual interest they credited to policy’s issued on or near January 2,1997 for the last five years. Their results appear in this issue.

Their story shows that index annuities, even during a time of extreme stock market trial, can not only be competitive with other vehicles, but provide higher returns. The potential of index annuities as viable savings instruments are for real.

5 Year Index Annuity Returns     Top
Let’s pretend it’s New Years Day 1997 and you are five years away from retirement. You need to decide where to place your money for the next five years. Here’s what you’re seeing:

Both the S&P 500 and Dow Jones industrial average have risen over 50% in the last two years and could keep going up. But the investment oracle in the newspaper says that every time the index has increased this much in two years, the third year is always down, and even Alan Greenspan, with the Dow closing over 6000, has questioned whether irrational exuberance has inflated stock prices.

Your stockbroker is suggesting bond mutual funds. Although bond rates dropped in 1995 rates soared in 1996. Your broker says that bonds are less volatile than equities, and bonds are better than equity vehicles if you’re near retirement.

Your financial advisor has suggested a mix of equity and bond mutual funds for diversity and protection against risk. The advisor has devised three allocation strategies using differing percentages of stock and bond funds with different degrees of risk.

Your banker says you can never go wrong with FDIC insured certificates of deposit and states that rates are on an upswing. Who knows, you might even see those double digit bank rates of yore.

Your agent has proffered the idea of something new called an index annuity. The agent says that the index annuity doesn’t benefit from reinvested dividends, nor do you fully participate in any gains (in fact there might even be a cap on how much you can earn), and if you pull out early you might not even get all your money back because of surrender charges. But, the index annuity is designed to pay somewhere between what an equity and a bond might, and if you hold it long enough you’re guaranteed to at least get back what you put in, plus a little bit of interest. What do you choose?

These Are Actual Returns For The Last 5 Years

Since their inception in 1995 index annuities have been building a track record, and there are now a handful of companies that can demonstrate actual interest crediting for at least five years with the same products that they offer today. Five of those carriers shared the results of their annuities with five year track records.

One of the common performance benchmarks used by the investment world are annualized 5 year returns. We have compared the returns of these index annuities with other financial vehicles for the five year period from January 2, 1997 to January 2, 2002. If the exact dates were unavailable the nearest dates were used and the difference noted. The results do not reflect any sales or surrender charges. To be very clear I’ll again say these are actual, not hypothetical, returns. Which decision would have been best in 1997? The story continues.

Index Annuities Beat Up Bond Funds & Banks    Top
Index annuities are designed to provide the potential for interest earnings above those of other savings instruments. For the five year period ending at the start of 2002, the actual annualized five year results provided by these index annuities were each more than 2% above those produced by certificates of deposit and the average bond fund for the same period. Of the 626 bond mutual funds with five year track records each of these index annuities bested at least 622 of them. Of the 1990 distinct stock and bond funds with five year track records each of these index annuities stood atop 1210 of them. Another way of saying this is that all of these index annuities:

Outperformed the average Bond Fund & CD by at least 40%
Had Higher Returns Than 61% of All Mutual Funds
Blew the Socks Off 99% of Bond Mutual Funds

The following chart compares the five year annualized return of the index annuities with a variety of different fixed rate alternatives. The index annuities had higher returns than all of them.

These index annuities did just what they were supposed to do, and not only managed to hold their own against more traditional fixed rate products like CDs and bonds, but significantly outperform them. Is this meant to imply that index annuities might be an alternative to bond mutual funds? No, I’m stating that index annuities are a very competitive alternative to bond funds and provide far greater protection from loss.

Source for Mutual Fund Data: Kiplinger’s Mutual Fund 2002; Standard & Poor’s Fund Services. Assumes dividends and capital gains distributions are reinvested, does not include sales and redemption fees. Oldest share class of fund listed. Period is 1/2/97 - 1/2/02

Source for CD data: Federal Reserve Board. Period is 1/2/97 - 1/2/02.  Source for index annuity data are the carriers and does not include possible surrender charges. LSW Period is 12/21/96 - 12/21/01

High Point (Water Mark) Term Cages The Bear     Top
If there ever was a period that showcased the potential of the high point term (high water mark) design, that time was the millennium bear market. A high point term crediting method uses the highest anniversary value of the index during the term as the end point. The S&P 500 finished 2000 at a lower level than the previous year and 2001 ended at a lower level than 2000. So, a high point term designed index annuity, with a term ending in 2001, went back to 1999 to write the conclusion of its story.

On January 2, 1997 the S&P 500 index closed at 737.01 and the five year term Keyport KeyIndex Annuity offered a 78% participation rate. Five years later on January 2, 2002 the S&P 500 closed at 1154.67. However, the KeyIndex used the higher anniversary value of 1469.25 from two years before.

A $10,000 premium placed in this KeyIndex contract grew to $17,750 for an annualized return of 12.16%! When compared to mutual funds with 5 year track records, the KeyIndex Annuity’s actual return was:

Higher than 75% of all equity mutual funds

                                Higher than 86% of all mutual funds

Higher than 100% of all bond funds

                                         More than Double the Return of CDs

Back in 1997 Keyport began meeting some resistance when the participation rate dropped to 78%. Some agents told me that index annuities just didn’t make sense when the participation rates were this low and it was better to pick direct investments.

I thought it would be fun to compare the KeyIndex return with other vehicles and determine how much of the index annuity return these other vehicles effectively represented. If the 12.16% KeyIndex return represents 100%, then the effective participation rate for these vehicles is:

If Index Annuity Returns Represents	100%, Then
Small Company Value	91%
S&P 500 w/dividends	88%
Average U.S. Stock Fund	75%
Large Company Value	74%
Large Company Growth	68%
Small Company Growth	61%
Average Taxable Bond Fund	46%
Certificates of Deposit	46%
International Stocks	21%

Or, to flip this around, the KeyIndex participated in 114% of the average S&P 500 index fund (including dividends) return, 134% of the average stock mutual fund’s return, or 218% of the average taxable bond fund’s return.

An argument could be made that the last five years weren’t a “normal” period. In the first three years, from 1997 through 1999, the S&P 500 roughly doubled and then spent the next two years enduring the worst bear market in a generation. In addition, overall interest rates during the period fell and rose and fell again. However, I don’t believe there’s such thing as a normal market. Savers are always faced with uncertainty and risks. Index annuities eliminate the risk of losing principal due to market declines and provide the certainty of at least receiving a minimum return.

In this issue we’ve examined the performance of four index annuities. Is the performance of these five annuities representative of how all index annuities would have performed for the period? No. Annuities with different methodologies would have different results and differences in renewal rate philosophies would have tremendous effects on ultimate returns.

At the beginning of 1997 index annuities had barely been around two years and there were few index annuities posting actual returns, but every new day increases the visible track record of a growing number of index annuities. As time passes some index annuities will generate even higher returns and some will credit lower interest than these annuities did in the past, but index annuities are proving themselves as viable savings instruments.

 

 

 

 

 

 

Some Truths I Think I Know    Top

John and Mary live in St. Louis. If it takes John’s car one half tank of gas to commute back and forth to work each week, and it takes Mary’s car one full tank of gas to commute to work each week, which car gets better gas mileage?

I asked a number of people this question and several answered that John’s car gets better mileage. However, this ignores the possibility that John’s car may have a 25 gallon gas tank while Mary’s car has a 10 gallon tank. Or, that John’s office is three miles from his house while Mary commutes from St. Louis to Detroit and back every day. Or, that John turns his car off while going down hills and coasts until the car stops before restarting it — a possible irritant for motorists following John on the turnpike, while Mary travels at 80 miles per hour with the air conditioning on, the tires under inflated, and towing a boat.

Attempting to compare the performance of different vehicles, without knowing and being able to adjust for all of the different variables involved, often results in wrong conclusions. And yet many people try to determine how different index annuities will perform solely based on a comparison of participation rates or other interest crediting mechanisms. The problem is unless the crediting structures of the index annuities are identical, any attempt to select the best performing annuity based on respective rates or caps or spreads will be flawed. This is not only because the various methods produce different answers when applied to the same set of index values, but also that the composition of any given set of index variables is made up of totally random numbers that cannot be predicted. Furthermore, in most cases, the respective rates or caps or spreads of the different crediting methods applied to these random, independent, index numbers can be arbitrarily changed by the carrier.

So, besides the primary difficulty of predicting how stock market indexes will move in the future, index annuities use crediting structures that not only produce different answers when given the same set of index values, but for the most part these crediting structures operate without the direct correlation or causality that would produce consistent answers if index values change, and for the most part insurers can arbitrarily modify the degree to which the crediting structures reflect the index value change.

The most common question I get from consumers and agents is “Which index annuity is best?” The preceding paragraphs show the difficulty I have in answering that question. However, based on countless hours spent examining different index annuity crediting methods, different stock market scenarios, and tens of thousands of calculations, I have found out a few truths that I think I know, until proved otherwise.

If the stock market of the ‘80s or ‘90s repeats, index annuities could produce very respectable returns.
The last twenty years were a wonderful time for the market. At current rates, index annuities would produce average annual returns ranging from 7% to 12%. In general, term end point structures (measuring index movement from a starting point to an end point several years away) would produce the highest returns.

An annual reset (ratchet) treats negative years as zeros, which offsets the reinvested dividend benefit of direct equity investments.
A point often used to try to disparage index annuities is that index funds, or returns of similar investments, include the effects of reinvested dividends while index annuities do not. However, index annuities with annual reset structures treat negative index years as years with zero gain and do not give up credited interest based on previous gains. Over the last fifty years, the index annuity zero gain approach increases the return of an average index year by 2.5%, essentially offsetting the benefit produced by the reinvested dividends of index funds.

If the stock market of the ‘60s or ‘70s repeats, index annuities could produce poor returns.
An average stock market year between 1961 and 1981 returned less than 5%. Even if you substitute zeros for losses, at current rates and spreads the average index annuity year would credit 3% to 4% interest. The best performing structure in this period is an annual point-to-point with cap method; the average return was a little better than 5% a year. If index rates and spreads were improved 30% to 40% from today’s levels, and a ‘60s and ‘70s style market repeated, then index annuities would be competitive with fixed rate vehicles.

If you wait long enough, it doesn’t matter what day of the year you buy a term end point index annuity, but annual reset structures make the date you buy a little more important.
If you look at fifty years worth of index data, the annual return difference between buying a term end point structure on what turns out to be the best day of the year is less than a half percent better than if you somehow had picked the worst day of the year.

However, annual reset structures purchased in the last half of the year hypothetically perform a bit better if markets represent the ‘60s and ‘70s, but if markets look like the ’70s and 80s the middle of the year is the best time to buy for annual point-to-point structures and the last half of the year for averaging structures.

If everything is equal, monthly averaging produces a slightly higher return than daily averaging.
On average, an annual return using the average of twelve monthly index values as an end point will be 107% of the annual return determined by using the daily average of a year’s index value as an end point. Or conversely, a daily averaging return will be 93% of a monthly averaging return if other variables are identical. In others words, if a daily averaging return is 5% the monthly averaging return would be 5.35%.

The two key phrases are “slightly higher” and “variables are identical”. The difference between returns in the previous paragraph is only 35 basis points. And if the monthly averaging had a 2% spread and the daily averaging showed a 1.5% spread, then daily averaging would credit more interest. Or, if the daily averaging model had a higher participation rate the results could be different, or if one had a net cap of 15% and the other had a gross cap of 17%, the results would also vary.

Index annuity renewal rates are the biggest performance variable.
Index annuity renewal rates are dependent upon the general level of interest rates — because bond yields determine how much of the premium dollar is needed to provide the minimum guaranteed return; the price of options — because cheaper options enable you to participate in more of the index movement whilst expensive options do the opposite; and the final decision of the insurer — because interest rates and option prices don’t set renewal rates, people do.

I had hoped to find some kind of broad relationship between different crediting methods, whereby I could say that if index annuity A had a rate of x then index annuity B would need a rate of y to produce the same returns. I did find that certain correlations between methods did exist, but only under certain market conditions. For example, if you knew markets were going to rise, an annual point-to-point with a cap of x would produce the same return as a monthly averaged method with a spread of y. But if markets zig-zagged instead of rising, the correlation fell apart. Instead, I found a few very limited relationships that worked in all market scenarios.

What all of this means is that a tenet I discovered a few years ago still holds true, and that is the integrity of the insurer is far more important than the crediting method in receiving the highest index annuity return.

Here’s an illustration of why it’s so difficult to determine which is the best index annuity: Suppose three vehicles are trying to get from Kansas to California. The first vehicle is a tandem bicycle, and on level ground, with the two riders pedaling in turns, the bike will go 20 miles per hour. The second vehicle is a car with the cruise control locked in place so that the car goes 15 miles per hour at all times. The third vehicle is a wagon with a sail. The breezes blowing over the Kansas prairie fill the sail and produce a forward speed of 10 miles per hour

At the start, the bike has the best speed. But what if 40 mile per hour winds suddenly blew out of the east because of a storm front. The bike might gain a couple of miles per hour, thanks to the tailwind, but the sail wagon would gain the greatest benefit and fast pull into the lead. As the trio headed up the Colorado Rockies the bike’s pace would slow (unless they increased pedaling participation by having the second rider pedal), unless a strong wind averaged out the negative force of gravity against the sail wagon the wagon would also slow, and the car would keep going 15 miles per hour. As the travelers crested the final mountain range and headed towards the Pacific, a combination of gravity and pedaling might propel the bike to 50 miles per hour; ocean breezes might push back against the sail wagon causing a downhill speed of 30 miles per hour; and the car would continue to go 15 miles per hour.

Even though the three vehicles are on the same road, and subject to the same external forces, at any given time any vehicle could have the highest performance based on the how the vehicle’s design reacts to these forces. The original bike model has one rider pedaling at all times. But what happens if pedal participation can be increased when the road is fast so the effect is doubled? Or what if pedal participation is backed off when the speed increases? The sail wagon could travel at the highest speed, if gales were the order of the day, or be stuck motionless if the ground was flat and wind as calm. Meanwhile, the car’s progress is capped at a speed of 15 miles per hour and steadily progresses. Which vehicle would ultimately win the race? It’s impossible to determine.

A Fistful Of Annuities   Top
Fiery dawn rays streaked the iron red rock of the mesa as I rode over the crest and had my first look at the town of Real Vida. As I neared boot hill the words of the mayor’s telegram that I had received the day before returned to my mind, “COME TO REAL VIDA. FUTURE SHOCK GANG IS RUNNING WILD. SHERIFF HURT. DEPUTY IN HIDING. HURRY.”

I had just passed the general store when I heard “psst, psst”. Either my horse had sprung a leak or someone was trying to get my attention; it was the later. A man with a pale face and a ten gallon hat was hissing and beckoning me his way. I got down and walked over to him. It was the mayor.

“Marshall, I sure am glad you showed up,” said the mayor. “What seems to the trouble?” I asked.

The mayor began his story, “This has always been a quiet little town. People felt if they just lived their lives and did what the banker told them to do, then everything would be all right. Two days ago the Future Shock Gang rode into town and it all changed. Before you knew it all heck had broken loose. People’s piggybanks were stampeded, savings accounts were corralled, and our oldest dance hall girl, Ms. Ira, was forced out of retirement and put back to work.”

I’ve heard about this gang,” I replied, “if I remember correctly, the leader is a difficult hombre called Retirement Needs. His right hand man is Market Risk, and the other gang members are Inflation and Taxes. I’d like to talk to the banker and get his take on what I’m up against.”

The mayor sneered, “As soon as they showed up the banker lit out of here shouting ‘every asset for himself’. He was absolutely no good.”

“Bankers usually aren’t any good when facing up to Retirement Needs.” I went on, “I believe I met your sheriff, Vance Adams, once in Dodge City. What happened to him?”

“Our sheriff, everybody calls him V.A., was quick on the draw and was able to put Taxes away, so Taxes won’t be a problem anytime soon. And he wounded Inflation. But Market Risk got to V.A. and dropped him out of sight. As long as Market Risk is formidable, V.A.’s out of the fight.” continued the mayor.

“And the deputy?” I asked.

The mayor answered, “The deputy is the sheriff’s kid, Fran Adams, F.A. for short, F.A. was simply outgunned and is hiding in the stable waiting for you to arrive.”

“I guess I’d better go over and get the deputy, I could use the help,” said I.

The mayor asked, “What are you gonna use against the gang? A Winchester?”

“Nope.”

The Mayor continued, “You going to go in with your six shooters a blazing?

“Nope.”.

“Then you must be using a sawed off shotgun,” puzzled the mayor.

“Nope,” I Cooperishly replied.

Exasperatedly the mayor said, “Then what are you going to use to subdue the Future Shock Gang?”

“Fixed rate and fixed index annuities,” I concluded.

I moseyed over to the stable and spied the deputy hiding in the third stall back. I explained what needed to be done. The deputy took a big gulp and said that she was with me all the way. I wasn’t surprised by the deputy’s response; I’ve found that F.A.’s can always be counted on when you need them.

The deputy and I strode over to the saloon where the mayor said the gang was. As I pushed open the swinging doors I saw the gang seated in the center of the room. Market Risk had a pair of scissors and was cutting mutual fund statements to bits. Inflation was feeding a pile of dollar bills into the flame of a kerosene lamp and laughing every time another George turned to ashes. The leader, Retirement Needs, had the townspeople busy trying to build a retirement plan out of sand. But every time one wall of the retirement plan seemed to be complete, the others collapsed back to the ground, a sight that gave Retirement Needs great amusement.

The leader spotted us, “What are you here for?”

“A showdown,” I responded.

“I don’t see any pistols, where are your weapons?” the gang leader queried.

“We’re packing annuities,” I replied with steel in my voice.

“Annuities,” squeaked Market Risk, “We don’t need no stinking annuities!”

“Oh yeah,” says I, “Fixed rate and fixed index annuities protect principal from market risk.”

Market Risk yelled and grabbed his shoulder.

“And fixed rate and fixed index annuities preserve credited interest from market loss,” added the Deputy.

Market Risk screamed and put one hand on his leg.

“In addition, fixed annuities provide a guaranteed minimum return regardless of how the market performs,” the deputy and I said in unison.

Market Risk clutched his stomach like he’d been gut shot and rolled onto the floor – Market Risk was no more.

Inflation had already been beat up by Sheriff V.A. and it didn’t take much more to put it away. “Equity-linked vehicles,” I soliloquized, “typically outdistance inflation providing a real return that keeps up with the cost of living and preserves retirement assets.” Inflation sighed, “You got me,” and his eyes rolled back. Inflation was whipped.

Retirement Needs smirked, “I won’t be as easy to defeat. It’ll take more weapons that you’ve got.”

“The only weapon we need to face Retirement Needs is knowledge,” and with that the Deputy and I opened up the saddlebags I’d retrieved from my horse, and pulled out fixed rate and fixed index annuity sales materials, illustrations and product disclosures, which we gave to the townspeople. By using this annuity knowledge the townspeople were able to build a solid base for the retirement plan and keep their goals from crumbling.

Retirement Needs slinked out the door saying, “Curses, annuitized again. I may have met my match here but there are other towns that don’t know about annuities, I’m not finished yet.” And with that, the threat from the Future Shock gang was history in Real Vida.

“My champion,” breathed Ms. Ira as she batted her eyes, “Now I can go back to my well deserved retirement.”

“Aw shucks, Ma’am,” I modestly replied, “It was annuities that defeated Taxes, Inflation, Market Risk and faced up to Retirement Needs. I am only a Marshall in their service.”

I got back on my horse, tipped my hat to the townspeople, and slowly rode out of town. As I was almost out of earshot I heard the deputy ask the mayor “Who was that stranger that rode in here and saved the day?”

The mayor replied, “That was the agent with no name”. Yippee-Ki-A.

Outlook Is For Modestly Rising Rates    Top
Interest rates and option prices dictate the direction of index product participation rates. The movement of option prices, based on volatility, have been heading lower for the last six months. During the same period interest rates, if not spiking back up, have at least ended their downward motion.

If the relatively modest pace of the recovery continues, interest rates should trend upward moderately as the year progresses. Barring any particularly nasty energy surprises, index option prices should modestly decline a bit further in the months to come.

A rising Index Participation Rate Indicator (IPRI) means that interest rates and option prices permit carriers to offer higher participation rates, higher interest earning caps or lower yield spreads.

 

The direction of the current Advantage IPRI chart indicates that participation rates or caps could be raised, or yield spreads decreased, as the year progresses, but any improvements in rates, caps or spreads will be modest.

Top