May 31, 2011
In fairness, the authors provide a number of disclaimers regarding their data. At the end of this article, I’ll return to the question of whether those disclaimers sufficiently justify the publication of this study.
For the moment, however, let’s assume that the data were a representative sample of real-world policies and turn to the authors’ presentation of their results.
In table 1, they compare the performance of the EIAs in their sample to the S&P 500 without dividends. In a footnote to this table, they justify the use of this benchmark by stating that most EIAs are linked to this index when computing their payouts.
This is inappropriate for two reasons. The purpose of a benchmark is to allow investors to compare performance to an alternative investment with similar risk characteristics. No investor would choose the S&P 500 without dividends; if the S&P 500 is the right benchmark, then dividends must be included.
But the S&P is not the right benchmark. Bill Reichenstein is a business professor at Baylor University who has studied EIAs. Reichenstein has shown that the beta of a typical EIA is approximately 0.15, so an appropriate benchmark would be a mix of 85% risk-free Treasury securities and 15% equities (the S&P 500).
The use of an 85/15 benchmark is consistent with the investment goals of EIAs, which are to provide downside protection in bear markets and limited upside potential in bull markets. The use of an all-equity benchmark is not.
In a footnote to table 1, the authors state that their results are biased to favor the performance of the S&P 500 because, among other things, the performance they present for that index does not include taxes.
They fail to acknowledge, however, that the performance they measure for EIAs does not include taxes either. This omission is critical, since payments from annuities will be taxed as ordinary income, whereas the vast majority of returns on the S&P 500 will be taxed at the lower capital gains rate. Some returns on the S&P 500 will be dividends, which are also taxed at favorable rates, at least currently.
In figures 1 and 2, the authors compare EIA performance to the S&P 500 with dividends and, separately, to a 50/50 mix of the S&P 500 (with dividends) and Treasury bills. Two more problems are apparent, however, and both arise because EIAs typically contain onerous surrender penalties for the first 10 years a policy is owned. First, figures 1 and 2 contain five-year rolling returns. A long time horizon is necessary to assess the performance of any investment and, in the case of EIAs, that horizon must be at least 10 years.
Second, although the theory is mostly silent on this point, in this case I believe the appropriate risk-free rate should be the 10-year Treasury bond, not Treasury bills.
Even if we take the leap of assuming that the data were representative of real-world annuities, the authors needed to compare performance to the appropriate 85/15 benchmark on an after-tax basis, net of all fees, over a sufficiently long time horizon. Anything less than that tells an investor nothing that would help him or her make an informed investment decision.
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