A Rational Look at a Much Maligned Product

Accordingly, "some index annuities have produced returns that are competitive with other asset classes, such as equities and equity/T-bill combinations. Although FIAs are not designed to be direct competitors of index investing (rather for safety of principal with returns linked to upside market performance), our findings on FIA returns contrast with assertions in other studies — based on no actual return data — that the structure of FIAs necessarily relegates them to being inferior or unsuitable products."

When I referenced the research with respect to "real-world" FIA returns noted above to a FINRA regulator, I was told that the study had to have been paid for by an insurance company and that any citation of it would require a disclaimer to that effect. That response tells you pretty much all you need to know about FINRA's view of FIAs. However, I have received outraged written confirmations from the study's authors denying any request for or receipt of sponsorship for their work. In fact, they turned down overtures of industry sponsorship. 

That is not to say that all questions about FIAs have been answered. The "real-world" study has some serious shortcomings, most notably the paucity and potentially biased nature of the data and the inability of other researchers to analyze it. FIA performance was also measured in a particularly difficult period for the market, when principal protection should be especially valuable. 

In a follow-up piece in JFP entitled "Can Annuities Offer Competitive Returns?," Prof. Reichenstein expanded upon his criticisms of FIAs. His primary argument is that because of their design, FIAs cannot add value to offset their embedded costs. He comes to this conclusion not based upon data and testing, but upon a conceptual proof using the "arithmetic of equilibrium accounting" and the work of William Sharpe contrasting active and passive management. However, my review of scores of actual FIA contracts suggests otherwise. I suspect the flaw in his logic is that the leverage provided by the options FIA carriers use to provide interest undercuts Sharpe's argument on costs.

Fixed income annuities are designed to provide principal protection with annual returns roughly 1-2 percent better than traditional fixed annuities. Based upon those standards, FIAs appear to have succeeded. Indeed, according to a predecessor "real-world" study, FIA returns have averaged well over 5 percent per annum in a variety of market conditions since their inception. As the Wharton School's Prof. David Babbel, one of the study authors, noted, "for most levels of risk aversion, [FIAs] have dominated the alternatives." Indeed, "FIAs outperformed the alternatives over the lifetime of their existence (since 1995) for every year that they have been issued."

More research is clearly needed with respect to FIAs. Additional transparency and the broad release of performance data by FIA carriers would surely facilitate that work. However, FIAs seem to have far more promise for those with serious risk aversion than has been allowed by their critics to this point.  

Bob Seawright is chief investment and information officer for Madison Avenue Securities in San Diego and a frequent writer on financial planning and related matters. He was educated at Duke University, where he received his J.D. in 1981. He holds securities and insurance licenses as well as a number of industry designations.