Rainbow Method
Altho new to the index annuity arena the Rainbow concept itself is not new. It has been used for many years in the investment world, and I wrote about this securities option strategy, as well as several others, three years ago. It is an option basket whose best-performing indices are weighted more heavily than those that perform less well. It is always a "look-back" because the money is allocated based on the ranking of the performance after the period is over. Currently six carriers offer rainbow allocation crediting methods, but not all allocation methods are rainbows. For example, Allianz Endurance and ING Envoy products also credit interest based on the blended performance of multiple indices, but the specific index allocation is fixed at the beginning of each year so they are not rainbow methods. 

Do rainbow methods run a better horserace? 

The Rainbow marketing appeal has been expressed by saying that the annuitybuyer gets to bet on the race after it has been run and that most of the bet will be put down on the horses that “win or place.” To determine whether the different rainbow allocations may be a better horserace I have run calculations going back to 1991 using April 2008 rates to produce hypothetical returns for both rainbow and S&P 500 only crediting methods. I attempted to compare rainbow methods with S&P 500 only methods within the same or similar carrier products. Because index annuities are used, any years with negative returns were replaced with zeros.

A problem with most rainbow indices is short history. With the exception of DJIA and S&P 500 the other indices generally have been around less than 25 years, and I am unsure whether this provides enough track record to be meaningful. Three of the four carriers include the EuroStoxx 50 in their mix and this index has only been around for 6 years, with almost all of its history occurring in a bull market. However, I discovered that a composite index made up of half German DAX and half French CAC 40 values had a 0.99 correlation with the EuroStroxx 50 since its inception. In others words, a 50/50 mix of the DAX and CAC has essentially mimicked the EuroStoxx 50, therefore I have used my composite index as a proxy for the EuroStoxx 50 prior to July 2003. 

I examined rainbow products from AIG, Aviva, National Western and North American Company. Rainbow products are also offered by American Investors and Midland National, but these were basically the same as the respective Aviva and North American ones. I picked products without bonuses and with surrender periods of 10 years or less. These examples apply current rates to 195 past rolling 12 month periods. The past does not predict the future and all of these rates could change wildly in years to come, so the returns should not be viewed as real numbers or investment advice. Finally, no index sponsors or endorses any index product.

Comments
If the S&P 500 is having a rotten year a rainbow method probably will not produce a great return; all stock markets tend to respond to news and changing economic conditions similarly. However, the rainbow method could offer higher returns than the S&P 500 alone in good times if pricing of the options was similar.  

The advantage of the rainbow method in having greatest participation in the top performing index is handicapped by a cap. Capping the rainbow method somewhat defeats the main attraction of using the method. However, if the option cost of the rainbow method permits higher caps than the S&P 500 alone might receive, then using the rainbow method would be justified.

In all hypothetical cases the Rainbow method produced higher average returns

The goal was to see which would have hypothetically performed better – the Rainbow method or the S&P 500 only methods. I discovered that in all cases the Rainbow method produced higher average returns, but there is insufficient data to deduce whether this is due to any inherent superiority of the rainbow method or simply an aberration in current option pricing. The rainbow method is a legitimate addition to index annuity methodology. I believe it provides the greatest potential interest when offered without a cap, even when offered at lower participation rates or higher spreads. However, if the rainbow method uses a cap, and the rainbow cap is higher than the cap for the S&P 500 alone, I would pick the rainbow method at a higher cap every time.      

Savings Bonds Are A Terrible Investment Now
Altho one might have purchased Savings Bonds in the past because they offered safety, tax deferral, minimum guarantees and usually rates that were at least competitive with banks, I would not buy one now. The new long-term rate on Series EE bonds is 1.4%. That's it, and the 1.4% is locked in and will not change. Series EE bonds still promise to return double your money in 20 years - an effective return of 3.5% - but if you take out your money early you would only earn 1.4%. In actual dollars this means if you put $5000 into a Series EE Bond today you would get back $10,000 in 20 years, BUT if you cashed in the annuity in 19 years and 364 days you would get back $6,602; this is equivalent to a 68% surrender charge!

Existing bonds have also taken a hit. Any Series EE bond purchased in the last 11 years is currently earning 2.74%.

I Bonds were attractive because they gave you a fixed rate of at least 1%, plus extra interest that was index-linked to the rate of inflation. But any I bonds purchased today do not have an interest rate floor. If inflation stays low I Bond returns could be much worse than other safe money places because the fixed rate is zero. Today, it does not make sense to buy U.S. Savings Bonds.

Copyright 2008 Jack Marrion, Advantage Compendium Ltd., St. Louis, MO (314) 434-6030. webmaster at indexannuity.org. All information is for illustrative purposes only,  does not provide investment or tax advice.  No index sponsors, promotes, or makes any representation regarding any index product. Information is from sources believed accurate but is not warranted. Advantage Compendium neither markets nor endorses any financial product.