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Retirement Planning > Retirement Investing > Annuity Investing

Keep Inde Products Simple

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Insurance products tied to the Consumer Price Index first appeared in 1968, with the introduction of The Cost of Living Policy. This was just in time for the arrival of a period of high inflation (1969-1982).

From that simple start, the insurance products world has moved ever deeper into offering contracts that take advantage of indexing. As will be seen, this indexing is going somewhere.

Many variations of the cost of living policy came on the market after that first debut in the 1960s, some as chassis products and some as riders. (Similar developments occurred in many foreign countries). Sales tended to track the upticks and downticks in the CPI. But when the period of low inflation arrived in 1983, the product seemed to go out of favor.

Or did it? Chart 1 shows that products indexed to the CPI still exist. Most widely popular are the CPI riders on long term care insurance policies.

As soon as CPI products were developed in the late 1960s, the idea immediately arose of tying products to stock market indexes. This idea took a long time to become a reality, but the insurance industry now has the result–the index annuity products, which first debuted in the mid-1990s and which have been making sales headway in the 2000s.

In the meantime, S&P 500 clone mutual funds arose as did many other index funds, which now number 700 or so.

The S&P index funds attempt to duplicate the performance of the stocks in the index. I’ve been following eight such funds. On Nov. 1, 2005, they showed an average year-to-date yield of + 0.85%, with little variation from fund to fund. The S&P 500 Index itself had decreased .41% for the year to date. So, the difference, 1.26%, would represent the cash dividends on the stocks. (This cash yield seems reasonable.) It would seem that these eight clone funds have done a very good job of actually tracking the S&P 500.

The eight funds are all associated with large investment firms that are not historically connected to the insurance industry. But “convergence” of financial products does exist these days, so the development is worth following.

On another note: 2005 has not been a good year for stocks. (Chart 2 shows results since 2000.) This impacts performance of equity indexes and of the financial products that rely upon or link to those indexes.

Now is the time to mention that the Chicago Mercantile Exchange and the Chicago Board of Trade offer financial futures in the S&P Composite Index, the Dow Jones Industrials Index and the NASDAQ 100 Index. This financial futures market may be of some use to companies in the pricing and management of stock market indexed products, such as the index annuity.

The index annuity, a relative newcomer by insurance industry measures, seems to be catching on. From 35 to 40 or so companies currently are issuing such annuities, though the top three to five performers take most of the market share. There are numerous design variations with certain typical elements.

The most typical index used in the index annuity is the S&P 500 Stock Index. The index feature applies only during the accumulation period and only to yield.

The credited annual yield is the greater of (1) the index increase, as adjusted by caps and participation features, and (2) a guaranteed minimum yield. The principal is therefore guaranteed; yield cannot be less than the guaranteed minimum; and participation in the index is supplied. The usual tax deferral applicable to all annuities is, of course, available.

All of these are very attractive features. (They are financed by various internal charges such as fees, basis point charges, surrender charges and participation limits). The product is strongly regulated.

My best advice to product developers of index annuities and other index products is to keep them as simple as possible, and explain them carefully to buyers. To a lot of distributors and consumers, indexing is still new and/or fuzzy, so clarity and consumer-friendly approaches are imperative.

Incidentally, the safety of principal and minimum yield guarantees, mentioned above, also are available, by rider, on variable annuity products.

Also, the latter products (unlike index annuities) always have a variety of optional funds in which the money may be invested–including index subaccounts. Offering S&P index funds within variable policies seems to be a good idea, because that option gives policyholders a way to “buy the index,” unaltered and with no manager involvement. That should appeal to buyers who prefer direct investing but who want to do so within an insurance and annuity environment.

Availability of numerous index products is very much in the public interest due to the broad market exposure they allow and the tracking with known indexes. The concept makes sense. But this will stay that way only if the financial product developers keep the products simple.

John M. Bragg, FSA, ACAS, MAAA, is actuarial consultant at John M. Bragg and Associates, Atlanta; past president of Society of Actuaries; and past CEO of Life Insurance Company of Georgia. You can e-mail him at [email protected].


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