Few products within the financial services industry have received as much consistent criticism as fixed index annuities. An FIA is a type of deferred fixed annuity that earns interest or provides benefits that are linked to an external reference or index, most commonly the S&P 500. The insurer underwriting the FIA generally funds its contracts using bonds and call options on the referenced index. FINRA — which does not regulate FIAs but wants to — said in an Investor Alert that FIAs “are anything but easy to understand” and compared them unfavorably to 401(k) plans. And, with numbing consistency, the financial press routinely recycles round after round of criticism of this product.
For example, in an article earlier this year, Money called FIAs a “safety trap” and alleged that they have “pervasive problems.” One major problem the magazine claimed is poor performance: “A typical index annuity would have lagged an investment portfolio with equivalent risk — 85 percent one-month Treasury bills, 15 percent U.S. large-cap stocks — by nearly two percentage points annually, on average, over the past 44 years.” This claim is based upon the research of Prof. William Reichenstein of Baylor University, who has also been a plaintiffs’ expert witness in lawsuits attacking FIAs.
Forbes called FIA sales a “protection racket” and claimed that “whatever your station in life, indexed annuities are in all likelihood a lousy investment.” The biggest complaint seems to have been that FIA performance doesn’t match index performance and does not include dividends, even though it should be obvious that principal protection comes at a cost. Forbes even claims that “some 99 percent of the time indexed annuities underperform a simple portfolio that’s 60 percent in zero-coupon Treasurys and 40 percent in a low-cost S&P 500 index fund,” citing a prominent plaintiffs’ consultant who seems to have made a pretty good living attacking FIAs. Last year Kiplinger’s advised consumers to avoid FIAs citing “skimpy returns” despite “big promises.”
Businessweek has attacked FIAs too. Oddly, the primary “victim” cited in the piece is said to have earned, after having taken a 15 percent early surrender charge, “about 3 percent a year” as compared to the S&P 500, which “returned 6.3 percent including dividends in the same period.” Since the article says this victim held the FIA for about five years, it appears that its performance was essentially equivalent to that of the S&P 500 without principal risk. That hardly sounds like the returns of someone who was victimized. Since this alleged victim cashed out of her FIA in 2008, apparently for the higher potential returns of market exposure, I wonder what a performance comparison would have looked like a year later.
Despite the routine criticisms from the financial press claiming extremely lengthy terms and huge surrender penalties, most FIAs have now been retrofitted with shorter surrender periods and lower commissions. Broker-dealers commonly enforce a “10-10 rule” on FIAs whereby surrender periods cannot exceed 10 years and surrender charges cannot exceed 10 percent. Even the major wirehouse firms are now interested in them and some, such as Bank of America Merrill Lynch and Morgan Stanley Smith Barney, have already begun offering them.
Moreover, The Journal of Financial Planning (JFP) published a research study entitled “Real-World Index Annuity Returns” earlier this year that, for the first time, examined actual FIA returns. This study suggests that these poor FIA performance claims are not all they have been made out to be: “If your future included all of the 141 five-year periods from April 1995 through 2009, and you had purchased any of these real-world index annuities month after month, these actual index annuity results bested the S&P 500 alone over 67 percent of the time, and bested the 50/50 mix of one-year Treasury bills and the S&P 500 79 percent of the time.”
Rather than relying upon questionable hypothesized crediting rate formulae, constant participation rates and caps, and unrealistic simulations of stock market and interest rate behavior, this study examined actual FIA returns. The research relied upon by Money and Forbes received especially stinging criticism: “The flaw in these studies is that they do not take into account the real-world effect of changes in interest rate environments and the market volatility’s effect on the cost of providing the index participation. …Clearly the reach of the conclusions is limited by the unrealistic assumptions underlying the annuity modeled.”