MINI-COURSE SERIES
ANNUITIES Part VII
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
ANNUITIES
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INVESTOR BEHAVIOR There is a huge difference between statistics and reality. You need look no further than the U.S. stock or bond markets. The truth is that few investors experience returns even close to what market indexes reflect. The disparity between historical returns and what investors actually experience is due to: [1] a buy-and-hold mentality is not maintained for the long-term and [2] costs. Dalbar, a well-known data-gathering firm, publishes investment results on a regular basis. The company best known for showing how popular indexes performed compared to what mutual fund investors actually experienced. For example, according to Dalbar, over any given 10-year period, equity mutual fund investor experience just 25-80% of the returns of the S&P 500. The fund investors include those that are in foreign, value, growth, mid cap and other equity styles. Despite the different options, these same investors always underperform the S&P 500 over any given 5-10 year period for two reasons—the typical fund has an expense ratio of about 1.4% per year and, more importantly, fund shareholders tend to move their money around, often making changes at exactly the wrong time. Dalbar also points out the disparity between the performance of bond indexes and fixedincome mutual fund shareholders. The typical bond fund investor experiences about 50-75% of the returns of the index that best matches the fund. The range for bond (50-75%) and equity (25-80%) fund investors versus the underlying indexes varies due to the time period cited. During one 10-year period, the gap could be a 75%+ difference (e.g., 1984 through 1993); during a 10-year period that starts 1-2 years earlier or later, the gap might be in the 25% range. In the case of brokerage firm “wrap accounts,” expenses and management fees impact the gap between an index and the accounts’ returns even more. However, it is investor impatience that is the real culprit. And, this is where EIAs have a tremendous conceptual advantage. The EIA investor has no need to make changes because there is no chance of loss if the investment is held for its term (thereby avoiding any withdrawal penalty plus receiving any and all indexing credit due). Few investors have the patience to ride out rough periods. For the 10-year period 19982007, the S&P 500 averaged 10.5% per year, but a large number of stock investors bailed out of the market after experiencing 1-3 bad years along the way: -9.1% in 2000, -11.9% in 2001 and -22.1% in 2002 (note: the losses were even greater if you factor in the typical expense ratio of 1.4% and/or a managed account fee of 1.0-1.5% per year). So, even though annualized returns over the period 1998-2007 were actually about average for the S&P 500 from an historical perspective, few enjoyed the 28.7% gain in 2003 (because they probably bailed out a year or so earlier). PART VII
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A 2011 Dalbar study showed the following: [1] for the 20-year period (1991-2010), equity fund investors averaged 3.8% a year, asset allocation fund investors averaged 2.6%, and fixed-income fund investors averaged 1.0% annually; [2] over the same 20 years, the S&P 500 averaged 9.1% and the Barclays Aggregate Bond Index returned 6.9% a year; and [3] the average equity investor holds onto a stock fund for 3.3 years. The table below shows the frequency of declines in the Dow from 1900 through 2010. As you can see, market declines occur on a regular basis.
Dow Declines [1900—2010] Type of Decline
Average Frequency
Average Length
5% or more
~ 3 times a year
47 days
10% or more
~ once a year
113 days
15% or more
~ once every 2 years
215 days
20% or more
~ once every 3.4 years
340 days
Assuming reinvestment of dividends, it took 16 years for the Dow Jones Industrial Average (Dow) to reach its previous high after the 1929 crash, five years after the 2000 drop (which lasted three years), 23 months after the 1987 crash and less than eight months after the 1990 drop. The recovery period becomes even longer if you exclude dividends (like all EIAs do). For example, recovery from the severe decline beginning in 2000 took almost seven years if you exclude dividends. From the Dow’s October 12, 2007 peak (14,093) to its March 6, 2009 bottom (6,627), the Dow dropped 53%. By May 12, 2011 the Dow (12,696) was still down almost 10% from its October 2007 peak.
RISK EVALUATION By some measurements, EIAs have no risk since there is a guarantee of principal plus perhaps a minimum annual rate along the way. But principal preservation has its costs: opportunity cost, purchasing power risk and ordinary taxation on any withdrawals of gain. Still, a strong argument can be made for an EIA: it allows your clients to take market risks they would not normally take and there is no chance of loss (unless there is a premature liquidation). However, the question of “loss” can be debated. Suppose an EIA investor ends up with an annualized return of 5%; she will net 3% once taxes are subtracted (this assumes a combined state and federal tax rate of 40%). If inflation for that period averages more than 3%, real purchasing power has been lost.
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EIA FACTORS TO COMPARE Comparing EIA contracts is difficult. There are a number of different participation and cap rates. These rates, as well as any other charges, may change annually or be guaranteed for the entire term of the contract. Obviously, contract comparison becomes more meaningful the fewer the moving parts. On a similar note, one cannot say that annual reset is better or worse than point-to-point or high-water mark with annual-reset—all three of these designs can perform well under different types of markets. During some types of markets, one design can result in a return that is moderate or significantly different from other crediting methods. No matter what EIA design you review, make sure your index comparison is proper. For example, an historical hypothetical of the S&P or a comparison of an EIA to an indexed ETF, mutual fund or variable annuity should start off by noting that the EIA investor is never entitled to the dividends of the underlying index. To show the impact of not having dividend compounding, consider the two tables below. The first table shows the annual returns of the S&P 500, including the reinvestment of dividends. The second table also shows S&P 500 annual returns but without dividends.
S&P 500 Total Returns, 25 years [1986-2010] [dividend reinvestment included] 1993
10.0%
2002
-22.1%
1994
1.3%
2003
28.7%
1986
18.5%
1995
37.4%
2004
10.9%
1987
5.2%
1996
23.1%
2005
4.9%
1988
16.8%
1997
33.4%
2006
15.8%
1989
31.5%
1998
28.6%
2007
5.5%
1990
-3.2%
1999
21.0%
2008
-37.0%
1991
30.5%
2000
-9.1%
2009
26.5%
1992
7.7%
2001
-11.9%
2010
15.1%
annualized return for entire period (25 years) = 9.8% annualized return last 10 years (2001-2010) = 1.4% annualized return last 5 years (2006-2010) = 2.3% annualized return last 3 years (2008-2010) = -2.9%
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S&P 500 Returns, 25 years [1986-2010] [without dividends—how EIAs are credited]
1993
7.1%
2002
1994
-1.5%
2003
-23.4% 26.4%
1986
14.6%
1995
34.1%
2004
9.0%
1987
2.0%
1996
20.3%
2005
3.0%
1988
12.4%
1997
31.0%
2006
13.6%
1989
27.3%
1998
26.7%
2007
3.5%
1990
1999
19.5%
2008
1991
-6.6% 26.3%
2000
-10.4%
2009
-38.5% 23.4%
1992
4.5%
2001
-13.0%
2010
12.8%
annualized return for entire period (25 years) = ~7% annualized return last 10 years (2001-2010) = -0.5% annualized return last 5 years (2006-2010) = 2.6% annualized return last 3 years (2008-2010) = -5%
For the 25-year period 1986-2010, dividends represented over 50% of the S&P 500’s total return; $1 grew to $10.69 with dividends—capital appreciation alone (no dividends) resulted in $1 growing to $5.95.
S&P 500 Dividends Not Credited to the EIA [1986-2010] 1993
3.0%
2002
1.3%
1994
2.9%
2003
2.3%
1986
3.8%
1995
3.5%
2004
1.9%
1987
3.2%
1996
2.7%
2005
1.9%
1988
4.2%
1997
2.3%
2006
2.2%
1989
4.4%
1998
1.9%
2007
2.0%
1990
3.5%
1999
1.5%
2008
1.5%
1991
4.2%
2000
1.0%
2009
3.0%
1992
3.1%
2001
1.2%
2010
2.3%
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Over the past 25 years (1986-2010), S&P 500 dividends averaged 2.6% annually (2% over past 10 years). These returns were not credited to the EIA investor. The impact of not receiving dividends is compounded because there is no reinvestment effect (e.g., 3% compounding tax-deferred for 10 years results in additional crediting of 34%) of principal. Reinvestment of dividends is reflected in the percentage figures in the table above for each year.
EIAS: THE DIVIDEND DISCUSSION Often times, EIA literature and continuing education course material talk about the virtues of investing in stocks. In the case of the S&P 500, it is pointed out that the investor has tremendous diversification (since they are owning 500 different stocks), an investment that has been an excellent hedge against inflation and has done much better than fixed-income instruments such as bonds. It is a well-known index that has been around for decades (and often used as a benchmark for fund management bonuses), it contains stocks from the NYSE, AMEX and NASDAQ, hundreds of billions of dollars are invested passively in this index (mutual funds, ETFs, EIAs and VAs) and it is used by the U.S. Department of Commerce as a leading indicator. What is often left out of the discussion (or glossed over) is that the index does not include dividends or their reinvestment (unlike mutual fund, variable annuity or ETF indexed portfolios). This also means that EIA investors are not credited any dividends from S&P 500 stocks. As shown in the charts and illustrations below, not benefiting from dividends can have a greater impact than one might suspect. The following example shows returns of a hypothetical investment over a seven-year period, compared to an EIA that has an annual reset, an 80% participation rate and a 15% cap rate. The example assumes a mutual fund or ETF that is indexed to the S&P 500 and an EIA whose index is also the S&P 500. The example also assumes the ETF or fund investor enjoys a 2.0% annual dividend that the EIA does not receive. Finally, the 2.0% annual dividend credit is reduced to 1.5% to reflect a ½% expense ratio (EIAs do not have any expense ratio). Although math computations are not shown for the EIA contract example below, the return credited for every positive year (all years except year 3 and year 6) is based on 80% of the S&P 500 (since the participation rate for this contract is 80%) without dividends. Furthermore, in year five, when the index fund is credited 22.0% plus a 1.5% dividend, the EIA contract is credited 15% (because of its 15% annual cap). On a positive note, the EIA contract is not dinged in years three (-14%) and six (-12%). During those two negative years, the EIA contract is not credited a gain or a loss.
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$10,000 Investment in a S&P 500 Index Portfolio vs. EIA with 80% participation rate & 15% annual cap End of Year
S&P Return Without Dividend
EIA
Index Fund—S&P 500 With 1.5% Dividend
1
+18.0%
$11,440
$11,950 ($10,000 x 19.5% total return)
2
+7.0%
$12,081
$12,966 ($11,950 x 8.5% total return)
3
-14.0%
$12,081
$11,345 (87.5% of $12,966)
4
+6.0%
$12,661
$12,196 ($11,345 x 7.5% total return)
5
+22.0%
$14,560
$15,062 ($12,196 x 23.5% total return)
6
-12.0%
$14,560
$13,481 (89.5% of $15,062)
7
+4.0%
$15,026
$14,222 ($13,481 x 5.5% total return)
As you can see from the table above (which shows actual S&P 500 returns over a recent seven-year period), the EIA investor has done better than the mutual fund investor. The EIA would have also been a better choice if its cumulative return was a few thousand dollars less than the S&P 500 index fund investor on a risk-adjusted return basis (since there was no chance of loss for the EIA). This illustration clearly shows the impact of 1-2 years of negative returns for an investment vehicle that does not have any downside protection, such as a mutual fund or ETF.
EIA HISTORICAL RETURNS Premium Producers Group (PPG) compared the hypothetical performance of 15 EIAs to the actual performance of an S&P 500 Index fund under market conditions that occurred from August 1996 to August 2006. Over that period, a $100,000 investment in the S&P Index fund would have grown to $313,000 (a gain of more than 200%). By comparison, the 15 different index annuities in the analysis would have grown to between $158,000 and $213,000, a gain of between 58% and 112%. Thus, the best-performing EIAs produced a little over half the stock market return. Jack Marrion of Advantage Compendium collects data from insurance companies that sell EIAs and periodically reports their results on his Web site (indexannuity.com). According to his data, from November 2001 to November 2006, of those EIAs that reported results, the return was between 2.2% and 6.2%, roughly 4.2% on average. Over the same period, the S&P 500 averaged about 5% a year while the average stock fund returned 8.3%, 5% for bond funds and 2.3% for bank CDs.
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THINGS TO DO Your Practice EIAs are a legitimate alternative to bank CDs. Often times, EIAs have been marketed in misleading ways; still, this is a tool that should be added to your list of possible investment vehicles. When actual investor behavior is added into the equation, fixed-rate and variable annuities become much more appealing and satisfying. How many stock investors do you know have matched the returns of the S&P 500 for the past 15-20 years? Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about its designation programs: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.
PART VII
IBF | MINI-COURSE SERIES