Everyone reading should know that I am an actuary, as well as a quant and a financial analyst. Math is my friend.
Math is not the friend of many of my readers, so I usually don’t bother them with the math. Tonight’s post will be no different. It stems from my time of creating investment strategies for what was at that time a leading indexed annuity seller.
What is the return that you get from an indexed annuity? It is the return from index options, subject to a certain minimum return over a 7-15 year period. Now, on average, what is the return you get from buying any fairly priced option? You get the return on T-bills plus zero to a slight negative percentage. So, if the option premiums paid are cumulatively greater than the guaranteed minimum return, the product should return more than the minimum on average — but likely not much more on average.
Why is that? Options are a zero sum game, and usually there is no inherent advantage to the buyer or seller. There are some exceptions to this rule, but it favors at-the money option sellers, never buyers. Buying options is what happens with indexed annuity products.
Now, over any short amount of time, like 5-10 years, you can get very different results than the likely average. That doesn’t affect my point. With games of chance, some get get good outcomes, and other get bad outcomes.
Now, the indexed product sellers will tell potential buyers that they will never lose money if the market goes down. True enough. What they don’t tell you is that over the long haul, you will most likely earn more investing in one of Vanguard’s S&P 500 funds or even their Balanced Index Fund. You may even earn more investing in their high yield fund, or even their bond market index fund.
In exchange for eliminating all negative volatility, you end up getting very modest interest credits, while still being exposed to the credit risk of the insurance company. In an insolvency, your policy will be affected. The state guaranty funds will likely protect you if your policy is underneath the coverage limits, but still it is a bother.
Add to that the illiquidity of the product. Yes, you can cash it in at any time, do 1035 exchanges, etc., but before the end of the surrender charge period you will pay a fee that compensates the insurance company for the amortized value of the large commission that they paid the agent that sold you the policy. For most people, the surrender charge psychologically locks them in.
Thus I say it is better to be disciplined, and buy and hold a volatile investment with low fees over time, rather than own an indexed annuity that will tend to lock you in, and deliver lower returns on average. That’s all, aside from the postscript.
How does an insurance company make a profit on an indexed annuity? They take the proceeds of the sale, pay the agent, and use the rest to invest. About 90% of the money will be invested in a bond that will cover the minimum guarantee. The remainder will buy option premiums — the amount of money that gets applied to that is close to the credit spread on the bonds less the insurance company’s fees to pay the costs of the company and a charge for profit. Not a lot is typically left in a low yield environment like this. The company tries to buy the most attractive options that they can on a limited budget. Inexpensive options typically imply that most will finish out of the money, and/or when they do finish in-the-money, the rewards won’t be that large.