Age – Risk = Index Annuities Fa06  
The average long-term U.S. stock market return over the last 200 years has been 6.8%. Indeed, a look at 50 year plus periods since 1802 finds returns of between 6.6% and 7.0% consistently over the two centuries. By contrast, bond returns have been on a long-term decline averaging 4.8% in the 19^th century and only 2.3% when calculated over most of the 20^th. Even though the falling interest rate periods of the last 25 years generated annualized bond returns of over 8% from 1982-2004, a longer look covering 1946-2004 produces an annualized bond return of 1.4% versus the 6.8% of the stock market.

The story gets worse for bonds. If you look at 10 year holding periods from 1870 onward stocks beat bonds 83% of the time. For 20 year periods stocks were a winner for 95% of the scores and for 30 year periods stocks KO’d bonds for every period occurring since Ulysses S. Grant was president. Historical results appear to make nonsense of that “100 minus your age” heuristic when it comes to determining the percentage of bonds in the portfolio because a 100% stock portfolio would appear to be the better choice for most people if they have at least a 10 year horizon, and certainly optimum if they have a 20 year or greater timeframe. Unfortunately, consumers seem to behave as if long-term horizons have the same risk as short-term ones.

Studies by Benartzi & Thaler find that people tend to base their willingness to accept risk of loss not on the time horizon of their investment period but on the length of the evaluation period used. Say two consumers look at and adjust their investment portfolio once a year, but Consumer A plans to spend his money in twelve months while Consumer B won’t use the money until 30 years from now. Even if both consumers were fully aware of the stock and bond return histories mentioned previously both consumers would allocate their portfolios the same way – with a strong emphasis in bonds – because their evaluation periods are on 12 month cycles, even though this near-sighted view is costing Consumer B a considerable loss in potential returns.

This short-term approach to long-term horizons has been found to be true for both part-time investors and professional pension managers (because pension managers must show short-term results they also tend to be too risk averse to maximize long-term returns).

The problem is an irrational fixation on the possibility of ending the next year with a loss even though over the long haul the effect of a loss in any given year is minimal; the result is too much money is kept in lower returning bonds. A possible solution is to use an alternative to bonds that offers a potential for higher returns without the risk of loss that is prompting this behavior. This alternative would be an index annuity.

It is possible index annuities using annual reset methodologies could be used as the bond alternative in a portfolio. The annuity’s protection of principal and credited interest from market loss should satisfy the risk aversion need perceived in bonds while the linking of credited interest to the movements of a stock index could result in higher returns than bonds would provide.

Example: The graph compares the annualized returns of long-term bonds with an annual reset approach to the S&P 500 over different periods. The annual reset method credits 60%, 50% or 40% of any index gains for the calendar year and treats years with losses as years of zero gains. The annual reset calculations do not include reinvested dividends.

What is discovered, with the exception of the bond favorable 1982-2004 period, is that an annual reset approach to the S&P 500 Index produced returns that were considerably higher than bond returns. Even at a 40% participation rate the annual reset method produced index-linked returns that averaged almost 5% higher than bonds. Although the annual reset styled returns were generally lower than stock market returns they were still 3.3% to 9.6% higher than bond returns for the periods. Even during the period where bonds and stocks posted losses the annual reset approach generated positive returns.

Annualized Returns

Participation rate applied to S&P 500 without reinvested dividends. S&P 500 does not endorse any index annuity. Information from sources believed accurate but is not warranted and is intended to be educational and is not investment advice.

A strong argument can be made that an index annuity with an annual reset structure may outperform bonds, and because it is a fixed annuity that protects both principal and interest earned from market loss that the index annuity will quell consumer risk aversion fears. It is possible that the index annuity could result in more money placed on the stock side of the equation because the consumer feels there is even less risk of loss with index annuities than there is with bonds.

There are a few points to keep in mind. Index annuities have been around only ten years and although my research shows they have generally been competitive with bond vehicles over various 5 year periods they have a short track record. And, of course, the past is no guarantee of the future. Jeremy Siegel of the Wharton School forecasts a low inflationary future in which stock returns are 5.5% to 6% and bond  returns are 3.5%. The degree that an index annuity benefits from an index is dependent on the interest rate climate, and the low bond rates predicted in this future would lessen the money available to provide the index benefit.

The stock market has produced significantly higher returns than bonds over the last 200 years and may very well continue to do so, but irrational fears of loss get in the way and make consumers too risk averse so that they put too much in bonds and hurt potential returns. Index annuities remove the element of market loss from the decision and provide the possibility for greater returns than bonds may give. Index annuities may well be a viable alternative to bonds.

S. Benartzi & R. Thaler (1995); Myopic loss aversion and the equity premium puzzle, The Quarterly Journal of Economics, February, pg. 73-92

N. Siebenmorgen & M. Weber (2004), The Influence of Different Investment Horizons on Risk Behavior, The Journal of Behavioral Finance; 5, 2; pg. 75–90

Siegel, Jeremy (2005); Perspectives on the Equity Risk Premium, Financial Analysts Journal; 61, 6; pg 62

Fixed & Variable Annuity Differences  Sp07
There are variable annuities and fixed annuities. When newspapers and magazines mention annuities they are almost always talking about variable annuities. In a variable annuity, income or account value is based on the value of the stocks or bonds backing the annuity assets, so the income and/or account values fluctuate. Unlike fixed annuities, the investment risk in variable annuities is borne by the annuity owner; so variable annuities are considered investment securities and would be a risk money place.    

Fixed Annuities
Fixed annuities provide a guaranteed minimum interest rate and are considered savings instruments. All fixed annuities are issued by insurance companies and are not government or bank obligations so naturally they are not FDIC insured. However, fixed annuities have an extraordinary record of safety and offer other benefits.

How Index Annuities Earn Interest
Fixed annuities provide a minimum guaranteed interest rate. If the insurance company believes  they can pay extra interest from their general account, above and beyond this minimum guarantee, they use the extra interest to link the earning of interest to the performance of an external index for the period. The major difference between a fixed rate annuity and a fixed index annuity is in the crediting of excess interest above the minimum guarantee.

How Do They Pay Interest?
It might be easier if we compare how an fixed index annuity pays interest with the way a fixed rate annuity pays interest.

You place your money with the insurance company, earn a return, and after subtracting their costs pay you net interest rate for a stated period of time. Your principal does not fluctuate, but the interest you receive can, and usually does, fluctuate from period to period.  But in any case, this sums up how a fixed rate works.

An index annuity operates the same way, You place your money with the insurance company they invest this money, earn a return, and after subtracting their costs pay you net interest. The difference between the fixed rate annuity and the fixed index annuity is that the amount of interest paid is linked to the movement of an external index. When the index goes up the amount of interest earned increased. However, because this is a safe money place and not an investment the index annuity does not share in any decreases of the index.

If you look back over time the stock market has gone up many more years than it has gone down, but when it does go down it can hurt, sometimes a lot. What the index annuity lets you do is participate in the up periods without sharing in the losses. The worst thing that can happen in an index annuity is you don’t lose money, because you can never lose principal or credited interest if the index declines. What’s the catch? You are probably not going to get all of the upside. It costs the insurance company to provide this protection.

One Year Or Multiple Year Rate Lock-Ins
All index annuities guarantee the rate of participation in the index annuity for a full year. Typically, an index annuity will guarantee index participation for one year at a time and declare the new index participation on the policy anniversary for the next year. Some index annuities lock-in all of the initial participation elements for two years, three years, or even for the entire penalty period of the annuity.

The amount of index participation may be expressed in many different ways. Some index annuities state you will receive a stated percentage of any calculated index gains over the periods, others may give you all the calculated index gain up to a certain interest ceiling or cap, others may use averaging or other variations. No index-link method is good or bad and any method can be the winner in a given period. The key is understanding how it works.  

How Much Interest?
The index annuity offers an alternative to concerns over rising interest rates by linking interest to changes in an external index. An index annuity participates in increases calculated for the index over a period, but even if the index goes down you can never lose principal or previously credited interest. 

The highest index annuity interest rate credited for one year was over 40%. In 2002 the major stock market indices went down and index annuities linked to these indices credited 0% for the year, but no previous interest was lost. Index annuities are designed to provide a long-term return somewhere between stock market vehicles and other no market risk to principal - and they have performed as intended.

Minimum Guarantee
A fixed annuity guarantees to credit a minimum yield and that is what makes a fixed annuity a fixed annuity instead of an investment. In the case of an index annuity the minimum guarantee is usually structured to simply protect the premium and perhaps pay back a few extra bucks, rather than crediting a minimum interest rate each year.

For example, an index annuity might guarantee to return a minimum of $1.10 for each original $1 of premium at the end of seven years. If the index does not produce at least this minimum index-linked return the insurance company will retroactively go back credit enough interest to reach $1.10.

GLWB: Guaranteed Income For Life Without Losing Control Fa07

One of the advantages of a fixed annuity is unlike any other financial instrument it can guarantee an income for as long as you live. It is the only instrument that promises if you chose to annuitize for life you will not outlive your money. However, there is a downside if you annuitize – you lose control of your principal.

You could also try to live on the interest being produced and leave the principal intact, but what if interest rates are around 3% and you need 6% to get by on? Well, you could withdraw 6% a year and hope that future interest rates are higher, but what if they aren’t? You could run out of income before you run out of time. 

Receive regular payouts and still retain control of the principal

 The age-old choice has always been take a guaranteed income and say goodbye to your principal, or “self-insure” your income and hope the income lasts as long as you do. But beginning last summer fixed annuities were introduced that guarantee an income for as long as the consumer lives, AND still provide access to principal, through a special rider to the annuity policy called a Guaranteed Lifetime Withdrawal Benefit or GLWB.

 The GLWB assures a guaranteed withdrawal level, usually based on the age when withdrawals begin, that stay the same as long as the consumer lives. For example, if the annuity buyer was 70 or over it might guarantee that 6% of the accumulated value of the annuity may be withdrawn each year for as long as the consumer lives. What if the policy doesn’t ever earn 6% and the accumulated value is used up over the years? The insurance company takes over the burden and continues to pay 6% for as long as the consumer lives.

The heirs get the balance, not the insurance company

What happens if the annuitybuyer dies? The beneficiary gets whatever is left – the remaining balance calculated after adding in the interest earned and subtracting the money withdrawn.

What if one simply want the money in a few years – Again, it’s based on the remaining balance calculated after adding in the interest earned and subtracting the money withdrawn (and less any policy surrender penalties that might apply).

Do you have to start withdrawing interest immediately? You never have to withdraw interest at all if you don’t want to, nor do you have to take the full permitted withdrawal if you don’t want to. If you don’t need the withdrawal the money remains in the annuity.

Can the income lasts as long as a spouse lives too? Yes, there are annuities out there that will guarantee the withdrawal rate for as long as the surviving spouse lives.

What’s the catch? Some fixed annuities charge up to 40 basis points (0.40%) for the GLWB protection and have the ability to charge up to 100 basis points. However, there are a couple fixed annuity insurers that do not have an explicit charge, the benefit is simply included in the annuity.

A fixed annuity already offers minimum guarantees, the GLWB is simply an additional level of safety that allows the consumer to stay in control of their money. Make no mistake, if you annuitize for life you will receive a higher income than you would get from a GLWB. But if the goal is to guarantee both an income and control of your money the GLWB can make sense.  

The Maturity Date Is Not The Surrender Period Fa07
The maturity date, also called the annuity date, is the longest one can keep annuity interest deferred before it must begin to be taken out. Maturity dates usually occur when the annuitant celebrates their 80th to 100th birthday depending on the annuity selected. As an example, a consumer might buy an annuity with a maturity date of age 95. This means age 95 would be the longest the consumer could delay before beginning to receive annuity payments.

A surrender charge, also called a withdrawal charge, is a penalty imposed by the carrier on money taken out of the annuity; surrender charges vary in severity. The charge is assessed during the surrender period on what the annuity contract says are excess withdrawals – typically withdrawals over 10% a year – and typically disappear after the period ends. As an example, a consumer might buy an annuity with a 10 year surrender period with surrender charges that begin at 10% of the annuity value that decrease by 1% a year. If the consumer cashed in the policy after the fifth year a 5% surrender charge would be imposed on 90% of the annuity value (the first 10% withdrawn would not incur a charge). If the consumer cashed in the policy at anytime after the tenth year there would not be a surrender charge.

A Maturity Date Is Not Life Without Parole
One of the stranger conclusions I once read was that annuities lock up your money for 40 or 50 years, and the reason is the writer confused maturity date with the surrender period. Suppose an age 65 consumer purchased an annuity with a maturity date of age 95 and a 10 year surrender period. The consumer would probably incur a penalty if the annuity was cashed in before age 76. However, there would be no charge for almost every annuity on the market if the consumer cashed in the policy after 10 years. What about the age 95 maturity date? All this means is the consumer must begin to withdraw money from their annuity at age 95. 

The maturity date is the longest the consumer can force the insurer to keep the money, not the other way around.

No Penalties On Death (Usually)
The vast majority of annuity contracts waive any remaining surrender charge upon death of the annuityowner.

The Penalty Period Does End (Almost Always)
With the exception of a handful of annuities offered by a couple of carriers the surrender penalty period has a finite life. There are a very few annuities, often referred to as two-tier annuities, where a penalty may continue to be assessed against interest earned unless the annuity contract is annuitized.

The overwhelming majority of fixed annuities have specific surrender charges and periods, and the consumer needs to ensure that the annuity selected meets their liquidity needs. But even during the surrender term the overwhelming majority of fixed annuities allow annuityowners to withdraw 10% each year of the annuity value, and waive all penalties if the annuityowner dies.

Fixed annuities have maturity dates that permit the consumer to keep an annuity until age 85, 95, or even 105. However, saying that this locks you in is like saying if you get on Interstate 80 in New York you can’t get off until you reach San Francisco. A fixed annuity is a financial highway, and just like on the Interstate the driver can choose to exit at any time, but they need to be aware of any early tolls.  

5 Year Index Annuity Returns   W07
There were 25 carriers active in the index annuity market in September 2002. Farmers, IDS, SunAmerica and Transamerica marketed term end point designs that have not yet reached the end of their index period and they cannot be included in the study. I asked the remaining 21 carriers for copies of customer statements with customer information whited-out for contracts issued closest to 30 September 2002 for a five year period ending 30 September 2007. Nineteen companies responded with details about 23 different products. This is the fifth year I have collected 5-year return data and I deeply appreciate the cooperation and support of the carriers, representing almost 90% of the industry, that were open in sharing what some of their policyowners earned in their index annuities. This carriers are:

Allianz	American Equity	American Investors
AmerUs	Conseco	ING
Jackson National Life	Lafayette Life	Lincoln Benefit Life
Lincoln Financial Group	LSW	Midland National Life/NACOLAH
National Western	OMFN	RBC
Sun Life	Standard Life of Indiana	Union Central

What Is Important
Index annuities are designed to be competitive with stated-rate annuities and to the best of my knowledge they are demonstrating that competitiveness. Half a dozen products credited annualized interest of 7% to 8% and almost all the rest credited interest in the 5% to 6% range.

 FIAs credited from 27% to 254% more interest than the average CD over the last 5 years 

The S&P 500 was running at an annualized return rate of 13.4% for the period and the average U.S. stock mutual fund hit 16.1% a year, a strong statement demonstrating that index annuities are not designed to compete against equity investments. However, the average annualized index annuity yield of 6.12% compares very favorably to the 5.0% attained yearly by the average taxable bond fund return, blew the socks off the 3.5% that was earned by a U.S. Savings Bond issued in September 2002, and pole-vaulted over the 2.5% achieved by the average CD over the same 5 years.  

Once again, index annuities did what they were supposed to do – be a safe money place with the potential for more interest.

No index sponsors, endorses or sells any index annuity. Information is for educational purposes and is not intended as investment or tax advice. Past performance is no indication of future results.

Helping Seniors Make Better Decisions  Sp08
Last summer Advantage Compendium looked at research on aging to see whether there was any consensus that the decision-making capabilities of seniors decline as they age. At the time the results of the research appeared contradictory. However, a research article published last December prompted another look at the topic of aging and decision making because the article proclaimed that 35% of the older adults in the study were mentally impaired due to aging and provided evidence that they made bad decisions^*. The University of Iowa study went on to say that their research shows why a sizable portion of seniors fall victim to fraudulent advertising, and posit this could explain why seniors are often victims of fraud in general.

Altho there are other studies that offer alternative explanations to the conclusion reached by the Iowa study, it is likely that more “normal” seniors than young adults have impaired decision-making powers. What is the extent of this impairment, and whether it is treatable with drug therapy or perhaps with a form of decision-making training, will require more research. Much of the research concerning aging and decision-making has been to determine whether aging worsen these skills and not on how to maintain them. After conducting this new research I believe that decision-making powers probably do get worse for some otherwise normal seniors.  

There are things that can be done to help seniors (and everyone else) in making better decisions.  

Disclose all RELEVANT facts
In the Iowa Study even the impaired seniors were able to make the same quality decisions as unimpaired seniors when they were given the facts. Relevant annuity facts include principal safety and the costs of liquidity.

Disclose ONLY relevant facts
The studies show that giving too much information and too many choices to everyone – especially seniors – can cause inferior decision-making, and yet variable and index annuity providers seem to delight in making their products ever more cumbersome and complicated. The simple solution for both consumers and agents is if the product looks more like a Swiss army knife than an annuity do not use it.

Use symbols
I only found one study that directly tested this, but seniors made better decisions when they could use symbols to evaluate and compare choices. It’s the idea of perhaps noting mortality expenses by $ (lowest) to $$$ (highest) symbols rather than as percentages. Or, a fixed annuity might represent a 3% minimum guarantee with a happy face, a 1% guarantee with a sad face, and a floating guarantee with a neutral face. Regulators could help carriers develop standardized rating symbols. 

Determine the senior’s goals
The goals of a 75 year old are different from a 25 year old and the decision-making process reflects this. A senior is less likely to want to know how the watch works, but be more interested in knowing how owning the watch will make their life better. Concentrate on solving the emotional needs.

Give them time
The Iowa study says more time does not help impaired decision-makers, but many other studies clearly say not rushing people and allowing them to make decisions in their own time results in better decisions.

* Denburg, N. C. Cole, M. Hernandez, T. Yamada, D. Tranel, A. Bechara, R. Wallace. 2007. The orbitofrontal cortex, real-world decision making, and normal aging. Ann. N.Y. Acad. Sci. 1121: 480–498

Fixed Annuities Are Competitive With Taxable Bond Funds  Sp08
Advantage Compendium compared fixed rate annuity, fixed index annuity and taxable bond fund returns for five year periods beginning in 1992 and ending in 2007. My conclusions are that both fixed rate and fixed index annuities have been competitive with U.S. taxable bond mutual funds and that index annuities are better positioned to provide a no-market-risk alternative to these bond funds than traditional fixed rate annuities.

From 1997 thru 2007 the taxable bond fund averaged 5.29% a year while the index annuity averaged 5.79%

If you look at the period from 1997 through 2007 the 5-year annualized returns for the index annuities averaged 5.79%, the average taxable bond fund return was 5.29% and the average fixed rate annualized return was 4.73%. For the periods from 1992 through 2007 the average taxable bond fund return was 5.71% and the average fixed rate annuity return was 5.18%.

The DataBest’s Review was the source of the earlier annuity data representing the initial and renewal rates for 56 carriers for the first four 5-year periods. Fixed rate annuity returns for later years are from Noel Abkemeier of Milliman, Inc. and reflect rates for annuities offered by “AA” or higher rated carriers not using MVA. I am indebted to Noel for sharing this information. The index annuity returns reflect reported annual reset  returns ranging from 3 carriers for the period ending in 2002 to 18 carriers for the most recent figures. I have 5 year data for the periods ending in 2001 and 2000, but for only one index carrier and decided not to show it. The taxable bond fund data reflects the average annualized returns for taxable bond funds for the five year periods as reported by The Wall Street Journal. The index annuity data reflects 1 October to 1 October periods, all other data reflects 1 July to 1 July years.

Data Concerns
Fixed rate annuity return data for the first 5-year period is from flexible premium policies and I noticed flexible premium rates were tracking 11 to 18 basis points above single premium products in years when both reported. It is possible a larger data set for the 1998-2000 periods would have produced slightly higher returns. Fixed rate returns for the last seven 5-year periods are from annuities issued by highly rated companies that do not use a market value adjustment (MVA). It has been my experience that there is an inverse relationship between rating and yield whereby yields tend to increase as ratings decrease. I believe a larger data set that included lower rated annuity carriers would increase average returns. In addition, it is argued that MVAs allow carriers to increase rates because of the sharing of risk with the annuityowner. Although I have never seen evidence of this, including MVA products would theoretically increase overall reported yields.

The index annuity sample does not reflect returns from term end point structured annuities because it would have severely skewed the numbers. As an example, for the 5-year period ending in 2002 the annual reset index annuity returns were 7.8%, 8.2% and 8.7% for an average of 8.23%. The one term end point return was 12.2%, which would have raised the average return to 9.2%, higher than any actual annual reset return. In addition, the index annuity return data is self-selecting from the carriers. It has been my experience that carriers are less likely to send in return data when they perceive the returns as low, therefore I believe the average index annuity returns shown are higher than a larger, more random sample would have produced for the periods. Finally, the fixed rate and bond fund data uses July to July years whilst the index annuity years start and end three months later. I do not believe moving the fixed rate and bond fund returns by three months would substantially impact the data relationships or conclusions reached.

Stats – Annualized 5 Year Periods
1992-2007 The average fixed rate annuity return is 5.18% with a standard deviation of 0.675. The taxable bond fund average is 5.71% with a standard deviation of 0.676. There is a .74 correlation between the fixed rate and bond returns.

1997-2007 The average fixed rate annuity return is 4.73% with a standard deviation of 0.590. The taxable bond fund average is 5.29% with a standard deviation of 0.408. The average fixed index annuity return is 5.79% with a standard deviation of 1.395 There is a negative .11 correlation between the index rate and bond returns, which could have important asset allocation implications if this negative correlation is demonstrated in future return comparisons.

What Does It Mean
Altho past performance does not predict future results the data support that index annuities are a viable alternative to taxable bond funds. And altho overall fixed rate annuity returns averaged roughly a half percent less than bond funds in the study I believe if “A” rated carriers had been included the results would have been much closer. Index annuities may well be a superior choice than bond funds if the consumer falls into the trap of selling when rates are falling and buying when fund yields are peaking, moves that have been repeatedly demonstrated by investors in the past, and this logic would also make fixed rate annuities a better choice than bond funds for many consumers.

 * The Wall Street Journal, Average Annualized 5-Yr Taxable Bond Fund Returns; 7/3/96, 7/3/97, 7/6/98, 7/5/99, 7/10/00, 7/5/01, 7/5/02, 7/7/03, 7/5/04, 7/5/05, 7/5/06, 7/3/07

** Best’s Review, 3/96 p.51-57; 4/97 p.38-42

*** Milliman Inc. Companies rated AA or better by S&P or Moody's. Based on policies with equal annual premiums; consequently, renewal rates are influenced by premiums arriving in years 2-5.  No MVA or two-tier products.