steak.jpgThe most heavily marketed insurance product, the equity index annuity, is becoming the most litigated insurance product. Attorneys general in several states have filed suits against a number of EIA vendors. In addition, there are now four class action suits against Allianz Life, the most successful marketer of equity index annuities.

          This is too much smoke for there not to be a fire.

          The primary complaint in these suits is that the annuities are inappropriate investments for older people and that the buyers were not made aware of the onerous penalties if money was withdrawn earlier than the term of the contract.

          In spite of this, the sales force is still out there, inviting seniors to free seminars and free dinners to praise of the glory of their ultra-safe product. The National Association for Fixed Annuities continues to lobby to keep equity index annuities from being considered securities because it doesn’t want its marketing and sales to be subject to SEC scrutiny.

My mail bag continues to carry a heavy load of letters asking, “This equity index annuity sounds too good to be true. Is it?”

        The nutshell answer: Yes, the equity index annuity story is too good to be true.

 
        Responding to my recent column (“Equity Index Annuities: Long on Sizzle, Short on Steak”), the sales force pulled no punches. They complained that the study I cited had been done by economists who provide litigation support. Therefore, they said, it was biased.

If I was a good reporter, they wrote, I would not have used such clearly tainted figures.

          Ok then. I was just trying to keep things short and sweet. Here, at the specific request of members of the equity index annuity sales force, is some further data indicating that this product doesn’t cut it.

          Let’s start with research from one of the largest and most respected life insurance companies, Massachusetts Mutual. Several years ago it sent an analysis to its sales force. It wanted to explain why Mass Mutual wasn’t offering an EIA.

The analysis showed that over the 30-year period ending in December 2003, and assuming no dividends and a 9.4 percent annual cap on returns (because EIA contracts generally have some form of upside limit), Mass Mutual found that a typical equity index annuity would have provided a return of only 5.8 percent a year.

Did you get that number? Only 5.8 percent a year.

          During the same period, the S&P 500 with dividends returned 12.2 percent. Without dividends it returned 8.5 percent.

Riskless short-term Treasury bills returned 6.4 percent a year over the same period.

According to Ibbotson Associates, inflation ran at 4.8 percent over the period, so the EIA earned just 1 percent over the rate of inflation, with all kinds of strings attached. Unlike common stocks, its return was always taxable at ordinary income rates.

          Of course, it doesn’t sound like the EIA will return that little when the salesperson describes its wonders, but that’s what actually happens.

          Peter Katt, a nationally known insurance expert, has examined EIAs. He concluded they have little to recommend them. “My own testing,” he wrote in an article for the American Association of Individual Investors, “shows that equity index annuities have no investment return advantage compared with a fixed annuity. Equity index annuities tend to have larger commissions associated with them. Larger commissions do depress the overall yields, but more important, larger commissions are usually associated with higher surrender charges for longer periods, making them less liquid and less flexible.”

          That’s called faint praise.

          Another insurance expert, Glenn Daily, has been so inspired by the uncertainty of equity index annuity returns that he has created a new website where he will evaluate an EIA you already own for $495. If you don’t own an EIA but want to evaluate one you are being offered, he suggests you save your money and read the study I cited in my wretchedly ignorant and biased earlier column.

          One way to get the big picture is to consider the components of return for common stocks, a favorite exercise of Vanguard founder John Bogle. He notes that the investment return on common stock has three pieces:

·       the dividend yield,

·       the rise in value due to earnings growth,

·       and the rise (or fall) due to change in valuation---the price-to-earnings multiple.

          In a period with no P/E change, stocks would have a total return of their dividend yield plus earnings growth. In the current market this would be 1.7 percent plus the long-term growth rate of 7 percent, a total of 8.7 percent.

So the return on an equity index annuity would be 7 percent --- less the portion lost to the crediting method. That’s typically 10 percent to 20 percent. It means the long-term return on an equity index annuity is likely to be 5.6 percent to 6.3 percent, no more--- about what the Mass Mutual analysis suggested.

          Could it return more?

          Yes, if there is a surge in P/E multiples. But it can also return less if there is a decline in P/E multiples. In a market with stable valuations it will be 5.6 percent to 6.3 percent.

Add the gobbledygook and complexities of the contract and there are many better alternatives for your money.

Then why do we hear so much about them? Because the sales force is paid so well to sell them.

 

 

On the web:

 

Peter Katt on equity index annuities


Glenn Daily’s EIA evaluation website


Sunday, September 9, 2001: Lesser, Not Greater, Expectations from Common Stocks


April column on Equity Index Annuities