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SMar 31, 2010

When Comparing Investments Don’t Rely on a Single Source

Scott Burns

Q. I have a nephew in Iowa who sells equity indexed annuities (EIAs). He is a staunch believer in them. Recently, he sent me a copy of a chart provided by American Equity Investment Life Insurance Company based in Des Moines, Iowa. The graph showed a history of American Equity's Index-5, based on returns from September 30, 1998 to September 30, 2009. This product is no longer available for sale. The graph shows the value of $100,000 invested for the period. It shows that the S&P 500 investment was worth $100,770 while the EIA was worth $156,857, with a minimum guaranteed value of $138,423. He also sent me articles. I don't believe in EIAs, but the pitch seems to be convincing. Your comments? —C. A., Horseshoe Bay, Texas

A. The problem with this comparison is that it is (1) selective in time period and (2) limited to a single asset class, domestic common stocks. The time period just happens to be one of the worst periods in history for the U.S. stock market, so it can hardly be considered representative of the return on stocks compared to the return on equity index annuities. We also don’t know how this particular EIA product compared to the average EIA over the period.

Beyond that, the industry wants EIAs to be considered a fixed-income product whose yield happens to be determined by the stock market. Basically, you accept a return that is lower than equities for the greater safety of a fixed-income yield.

So let's see how this EIA did compared to conventional fixed income and hybrid portfolios. If you do the math, you'll find that growing from $100,000 to $156,857 over a 10-year period amounts to an annualized return of 4.6 percent. The same investment in Vanguard GNMA fund grew to $182,637 over the period, an annualized return of 6.21 percent. Fidelity GNMA fund grew to $179,234, a return of 6.01 percent. Vanguard Total Bond Market grew to $179,820, a return of 6.04 percent. According to the Federal Reserve, the yield on a 10-year Treasury purchased at that time was 6.11 percent.

So, at the end of 10 years the equity indexed annuity doesn’t look too good as a fixed-income investment.

Now let's take a broader look. Over the 10 years ending 12/31/2009 the average intermediate term government bond fund provided an annualized return of 5.3 percent while the average long term government bond fund provided an annualized return of 7.4 percent. The time period differs by 2 quarters of 40, but it's clear that the EIA under-performed average fixed income investments that don't have all the restrictions and limitations of equity indexed annuities.

Over the same time period, a $100,000 investment in many of the well-known balanced funds would also have done better than the EIA investment, although the EIA did better than the average balanced fund over the period. Here, for instance, are the figures for some funds:

Franklin Income $197,211
Vanguard Wellesley Income $187,786
Dodge & Cox Balanced $183,955
Vanguard Wellington $177,701
American Funds Inc. Fund of America $170,608
Vanguard STAR $166,932
American Funds Balanced $165,375
Fidelity Puritan $148,719

The bottom line here is that investment comparisons should be made in a full context. That context should also include the restrictions, limitations, penalties, and liquidity of the investments.

Q. Could you refer me to a web site that would help me determine which type of IRA would be advisable for a 67-year-old couple and also for their 33-year-old married daughter? Where is the best place to purchase an IRA? And are there fees attached to an IRA whose investments we could manage? —R. S., by email

A. It isn’t about the “type” of IRA so much as the size of the account. With a relatively small IRA account you may face an annual account fee. Such fees generally disappear when your account value exceeds certain amounts. Today, you’ll find relatively low cost accounts at Vanguard, Fidelity and Schwab. The advantage of the Vanguard account is that Vanguard has a multitude of index mutual funds that you can buy with no commission fees, in minimum initial purchases of $3,000.

Fidelity recently initiated a no-commission purchase program for a variety of exchange traded funds. They did this to counter Schwab’s launch of a family of no-commission exchange traded funds. You’ll have the broadest choices without commissions at Vanguard, but you can now build a basic portfolio at all three using no-commission exchange traded funds and/or mutual funds.

Filed Under: Q&A (from print), Annuities