Real World Index Annuity Returns
From: Wharton Financial Institutions Center
Abstract
• We offer the first empirical exploration of fixed indexed annuity returns based upon actual contracts that were sold and actual interest that was credited.
• Annuity returns have been competitive with alternative portfolios of stocks and bonds.
• Their design has limited the downside returns associated with declining markets.
• They have achieved respectable returns in more robust equity markets.
• Studies that have criticized FIAs are typically based on hypothesized crediting rate formulae, constant participation rates and caps, and unrealistic simulations of stock market and interest rate behavior. When actual policy data are used, the conclusions change.
• Our study is exploratory, because although it is based on actual contracts and actual crediting rates, our policy data set is neither randomly selected nor comprehensive.
Introduction
Financial advisors and financial planners have sought various programs to provide clients protection from systematic risk, also known as market risk. Various asset allocation strategies have been used with limited success when extreme market movements and “black swans” occur (Taleb, 2007). It has been known for close to 50 years that equity market returns do not conform to a Guassian, or Normal distribution (Mandelbrot, 1963; Fama, 1963).i Rather, probability distributions of market returns are typically skewed and leptokurtic (fat-tailed). When these leptokurtic events occur on the positive side of the distribution, clients are delighted, but the opposite is true when these events occur on the negative end of the two-tailed distribution.
Principal preservation products have evolved to address the needs of many risk-averse consumers by providing them a safety net for their investment/savings capital. The products are structured in a way that reduces correlations with other asset classes. To illustrate better the extremes of market returns, we can examine the Russell 3000 index that accounts for nearly 98% of the publicly traded U.S. equity market. A study by Eric Crittenden and Cole Wilcox (2008) at Blackstar Funds was conducted using Russell 3000 data from 1983 through 2006. The findings were that “about 40% of the stocks had negative returns over their lifetime, and about 20% of stocks lost nearly all of their value. A little more than 10% of stocks recorded huge wins over 500%” (Richardson, 2009). These data indicate that most of the positive market return over time comes from relatively few performers, which lends support to the use of stock index strategies as part of an overall portfolio. Furthermore it supports the notion that there is significant risk in the stock market and thus, for moderately to highly risk-averse clients, the need for principal protection programs such as fixed indexed annuities (FIA’s). Nearly 96% of FIA’s possess reset (or ratchet) features that allow for locking in positive returns each annual or biannual period. By eliminating the prejudicial effects occasioned by significant stock market declines, and locking in returns annually or biannually, there is less of a need to try and capture large upside market swings to recover from the declines.
As financial professionals, we are tasked with assisting our more risk-averse clients to protect themselves from black swans and many of us have a fiduciary responsibility. One of the significant developments for principal or asset preservation vehicles has been the fixed index annuity (VanderPal, 2004). During the past few years various articles have been written regarding the value in FIA’s and some people relying upon these studies have drawn misleading inferences from them.
The article begins by dispelling the two basic errors people often make in assessing the message of FIA studies. We will illustrate these misconceptions by using actual crediting rates on various kinds of FIA policies. With these data we are able to show actual returns on FIA’s rather than make inferences from hypothetical crediting rates derived from assumed (and often constant) rate caps, assumed crediting rate formulae, and hypothetical participation rates, often coupled with theoretical stock market and interest rate moves. This should help inform the public and correct the inaccurate information portrayed by some journalists and industry professionals. Furthermore, the article will delve into additional FIA features that provide advantages not found in ordinary securities and various principal preservation programs.
