There’s No Free Lunch in Equity Indexed Annuities

Economics
History
Investing
By
John R. Brock, Ph.D., Vice President

Many investors, shaken by the 2008 decline in the stock market, have not yet regained their confidence in equities.  As a consequence, they have missed out on strong returns—the S&P 500 index rose from 826 on January 1, 2009 to 2,068 at the end of last week, well over doubling in value in less than six years.  That’s a compound annual growth rate of about 16.75%—before dividends.  In a flight to the perceived safety of less volatile assets following the 2008 market drop, some people invested more in T-bills or money funds.  However, given unusually low interest rates since then, many of these people have, not surprisingly, been very disappointed with low returns and have been searching for the investors’ “free lunch”—an asset that offers the superior returns of equities with the stability of T-bills.

One apparent free lunch turned up in the form of the equity-indexed annuity (EIA), which is typically a contract issued by an insurance company.  The customer pays an amount of money (the premium) and in return receives periodic payments at some future date.  The investment value of an EIA is based on the amount of money invested and on the gain in the index to which the annuity is linked, usually the S&P 500 (excluding dividends).  While the method used to calculate the investment return can be quite compli­cated and varies widely among insurance companies, it is important that investors understand that “based on” is usually not the same as “equal to.”  This is because typical EIA contracts have provisions that meaningfully reduce the investor’s return compared to the S&P 500.

In a commentary recently posted on our website, I discuss the results of my equity-indexed annuities study.  The primary question I addressed in this study was whether EIAs offer a free lunch by providing both protection of principal and meaningful investment growth at the same time.  I compared the average annual return of a hypothetical equity-indexed annuity offering typical EIA features with two alter­native portfolios invested in (i) the S&P 500 index, and (ii) U.S. Treasury bills.  The results may surprise you:  While the hypothetical EIA did reduce downside risk, it came with a substantial opportunity cost in the form of a significantly lower return than stocks.  The funds invested in my hypothetical EIA appeared to act much more like a Treasury bill investment, with low volatility and low returns, than an equity investment with greater long-run returns.  One clear observation from the study is that investors interested in an equity-indexed annuity should recognize that these products are best characterized as insurance policies rather than equity investments.  They do have the potential to capture some of stock index returns, but the numerous provisions severely limit that benefit.  So while equity-indexed annuities may sound attractive, investors should think twice before taking the plunge.