Annuity Anomaly: EIA + GLB > SPIA?

My mother sends me all sorts of strange emails, ranging from health and weight tips to YouTube videos of animals doing bizarre and unnatural things. I’m sure your retired mom does the same. But a few weeks ago she quite frankly stepped over the line. In a 7MB email, she sent me a legal prospectus for an equity-indexed annuity (EIA). Heavens!

Actually, what she did was forward to me an email from a neighbor of hers—who happens to be a licensed insurance agent—who was trying to sell her an EIA. Now, let me make it quite clear: Despite the genetic connection and all, my mom really isn’t the financial type. So, the email with six PDF attachments and numerous spreadsheets included a brief note from her: “He is a very nice man. Do you think this is a good idea?”

The first thing that came to my mind—after “you have got to be kidding me”—was to channel Humphrey Bogart’s line in Casablanca, “From all the geriatric joints in all the world this guy had to step into my mom’s?” Hey, where is FINRA where you need them?

Tasting blood, I reached out to the aforementioned nice man (having learned from Reese Witherspoon not to start with: “Do you know who I am?”) and asked a simple question: “EIA? For income, why not a life annuity?” After all, a life annuity is the cheapest and most efficient way to generate a guaranteed lifetime of income, because of the risk pooling, mortality credits, etc.

Alas, here is where things got interesting. The nice man countered that an equity-indexed annuity purchased together with a guaranteed living benefit (GLB) rider, might ­actually provide more guaranteed income than a single premium income annuity (SPIA).

“Yeah, right” was my gut reaction. Had he not heard of no-arbitrage relations, put-call parity and all the no-free-lunch identities we indoctrinate into our graduate students in finance? Heck, that would be like gravity being reversed or the Maple Leafs winning the Stanley Cup.

But lo and behold, after much back and forth, it seems he was right. Occasionally there are insurance (mis)pricing anomalies. The EIA + GLB combination at the right age and for the right person can occasionally dominate or come within inches of an SPIA. Allow me to elaborate.

EIA Background

The EIA—which is also known as a fixed indexed annuity (FIA)—is the Rodney Dangerfield of the already maligned annuity universe. If you Google either EIA or FIA or some other permutation, you will stumble across dozens of recent enforcement actions against advisors who have misrepresented and mis-sold them, including the occasional jail sentence!

In fact, looking back at the many ­articles I have written about annuities in the past few years, the vast majority of them have focused on variable annuities (VAs) with guaranteed lifetime withdrawal benefit (GLWB) riders, single premium income annuities or my academic favorite, advanced life delayed annuities (ALDAs). I haven’t given much ink or attention to equity-indexed annuities, partially due to their perceived toxicity. Why get involved?

And yet, EIAs were a $35 billion (in sales) business in 2012, according to LIMRA. Sure, that isn’t as large as the $147 billion VA business, but it certainly trumps the $7.7 billion of immediate annuities sold in 2012. The big players in the EIA space include Aviva, American Equity, Security Benefit and Allianz, along with other household names. More to the point, approximately 75% of EIA buyers are now electing (and paying for) a lifetime income rider such as a GLB. It’s time to have an opinion.

Boiled down to its economic essence at the 50,000-foot view, the EIA + GLB combination is quite similar to a variable annuity with a guaranteed living withdrawal benefit. In both cases the client hands over a sum of money to an insurance company, a premium that is invested on behalf of a client. As with the VA, the insurance company keeps track of and reports two numbers on the statement. The first is the actual account cash value and the second is the hypothetical benefit base.

Clients can access the account value at any time as long as they are willing to forfeit some (initially steep) surrender charges. In contrast, the benefit base is used to determine clients’ guaranteed lifetime income if and when they turn on the rider. The longer they are willing to wait, the higher the benefit base is likely to be and the more income they can expect for life. Once again, I could be describing either a VA + GLWB or an EIA + GLB.

Yes, I know that with an EIA you don’t have much choice in terms of the investment allocations, which are usually linked to an S&P 500 index ­minus any dividends, while the VA gives you a robust line-up of many different funds and subaccounts. And yes, the EIA ­imposes low caps and tight participation limits on the growth of the account value, which reduces the probability you will get anything more than the guaranteed minimum. Also, one is a security while the other is an insurance policy. These are important, but secondary, details.

I should point out that as ­insurance companies continue to place asset ­allocation restriction on the sub-­accounts within the VA + GLWB and policy-holders are given less freedom to ­allocate and move money around, the actual performance of these accounts might soon resemble a neutered and passive equity index.