The Mathematics of Selling Equity Index Annuities

If you want to sell a lot of your product and do it ethically, you must be an expert.  You cannot and should not sell annuities that you don't understand. Unfortunately, the majority of agents selling equity index annuities don't understand the basic math of compounding.

Let me illustrate (refer to table below). The compounded return of an equity index annuity over 33 years with a 12% cap is 6.98% (this assumes a 100% participation--a hypothetical feature that is far more generous than anything offered on the market).  The return of the S&P 500 over the same period is 10.98%.  Therefore, it seems safe to conclude that an investor choosing an equity indexed annuity will earn 63% (6.98/10.98) of the market return and get principal protection.  One could assume that an accurate statement to a client is that they will have 1/3 less by investing in the EIA as opposed to investing in the market. But that ignores compounding.  Because if we start with $10,000 in year 1 in the equity indexed annuity and $10,000 in the market, we end up 33 years later with $311,407 in our market account 92,592 in our equity indexed annuity. We have 70% less in the equity indexed annuity because of compounding.  That’s not to say there is anything wrong with equity indexed annuities other than wholesalers and agents should understand the math of what they sell so that they make accurate statements to prospect and clients.  In 2008, you cannot be a salesman.  You are forced to be an informed retirement advisor.

Year	Standard and Poors 500 Total Return	Standard and Poors 500 Value	Standard and Poors 500 Index change	Standard and Poor’s 500 with 12% cap*
		10000.00			10000.00
1973	-15	8500.00	-17.37	0	10000.00
1974	-26	6290.00	-29.72	0	10000.00
1975	37	8617.30	31.55	12	11200.00
1976	24	10685.45	19.15	12	12544.00
1977	-7	9937.47	-11.5	0	12544.00
1978	7	10633.09	1.06	1.06	12676.97
1979	18	12547.05	12.31	12	14198.20
1980	32	16562.11	25.77	12	15901.99
1981	-5	15734.00	-9.72	0	15901.99
1982	21	19038.14	14.76	12	17810.23
1983	23	23416.91	17.27	12	19947.45
1984	6	24821.93	1.39	1.39	20224.72
1985	32	32764.95	26.34	12	22651.69
1986	18	38662.64	14.63	12	25369.89
1987	5	40595.77	2.03	2.03	25884.90
1988	17	47497.05	12.41	12	28991.09
1989	31	62221.13	27.26	12	32470.02
1990	-3	60354.50	-6.56	0	32470.02
1991	30	78460.85	26.31	12	36366.42
1992	7	83953.11	4.46	4.46	37988.36
1993	10	92348.42	7.06	10	41787.20
1994	1	93271.90	-1.54	0	41787.20
1995	37	127782.51	34.11	12	46801.66
1996	25	159728.13	20.26	12	52417.86
1997	33	212438.42	31.01	12	58708.01
1998	29	274045.56	26.67	12	65752.97
1999	21	331595.12	19.53	12	73643.32
2000	-9	301751.56	-10.14	0	73643.32
2001	-12	265541.37	-13.04	0	73643.32
2002	-22	207122.27	-23.37	0	73643.32
2003	29	267187.73	26.38	12	82480.52
2004	11	296278.38	8.99	8.99	89895.52
2005	5	311407.29	3.00	3.00	92592.39
1 year return		5.00%			3.00%
3 year annualized		14.56%			7.93%
5 year annualized		.63%			4.69%
10 year annualized		9.32%			7.06%
15 year annualized		11.56%			7.24%
20 year annualized		11.92%			7.29%
33 year annualized		10.98%			6.98%
* does not include S&P 500 dividends

This provides some insight into how the SEC got involved--lots of agents misrepresenting the product and what returns can be obtained, not intentionally, just of of ignorance of the annuity products they sell and how the math works.  Don't sell what you don't understand.

Related to this issue is agents failure to understand the stock market and how to invest in stocks.  This leads them to believe stocks are risky relative to fixed annuities and that stocks should be sold by seniors.  This point of view again, is ignorant because it ignores how the world REALLY works.

Having retirees get out of stocks is advice sure to bankrupt your clients.  The Trinity Study tracked various portfolios using actual year by year returns from 1926 to 1995. Here were the results:

The conclusion is that for a retiree withdrawing 7% of their nest egg annually, the probability of that net egg lasting for 30 years is 88% with a portfolio of 75% stocks and 25% bonds.  But if we get more conservative and reduce the exposure to the market to only 25% stocks with 75% bonds (you can substitute "annuities" for "bonds" in the preceding paragraph), the chance of their portfolio lasting falls to just 32%. In other words, stocks have helped portfolios retain a competitive return and have helped protect retirees from running out of money.

But look at current events you say--people in stocks have lost a big chunk of their nest egg!  Retirees can't afford that! This is only true of people who don't understand that in retirement, risk assets are to be placed in buckets using the strategy explained in the Graangard Strategy (read this book) or in this article http://www.davidmacchia.com/Articles_Feb2005.html.  The point is, a retiree should have little if any exposure to the stock market for assets they will use in the next 10 years.  That way, markets like 2008 won't have any impact on their lifestyle.  As long as the market recovers in 10 years, the 2008 drop is a non-event.

There is no such thing as a “good”  or “bad” investment or type of insurance.  It’s a matter of what is appropriate for the client’s situations and an accurate understanding and representation by the advisor.  This of course requires that the advisor understands the products they sell and doe not merely repeat what they have been told.  Unfortunately, issues like the above are not covered on securities exams or insurance exams so much self education is needed to be a valuable advisor with fundamental understanding.

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