No CAPE Fear Here: Buying FIA when the Market is Pricey
Does it make sense to purchase a fixed indexed annuity today when the chief index used in these products – that S&P 500 – has been on a tear since the earth cooled? Equities have had a great run, almost unabated, for more than a dozen years. But now equities face a tough starting point, with the Shiller Cyclically Adjusted Price Earnings ratio in rarified air today, at 38.89. (source: Shiller PE Ratio by Year (multpl.com)). It was last at these levels twenty years ago during the tech bubble. The ensuing five and ten year returns for those who invested in the S&P 500 in 1999, 2000, and 2001 were underwhelming to say the least.
And this metric has shown itself to be a decent harbinger of future market returns, as indicated in a July 2020 article by Michael Finke in Advisor Perspectives entitled: “The Remarkable Accuracy of CAPE as a Predictor of Future Market Returns.” In his article he shows a graph, with the Y axis representing S&P 500 ten-year forward returns, and the X axis representing Shiller CAPE ratios at the beginning of those ten-year periods. The visual is hard to forget, as the dot plots of future market returns, and Shiller PE are neatly overlaid on a pattern that runs northwest to southeast.
Which brings us to the point of this article: Is the CAPE relevant when determining whether to purchase a fixed indexed annuity? In other words, if the S&P 500 (or choose your index) is pricey today on CAPE or other measures, should one expect a FIA using that index for annual crediting to perform less well than if purchasing during a time of lower market valuations?
My strong belief is that it is generally irrelevant, for the simple reasons that a fixed indexed annuity, while using an underlying index to credit interest annually, is fundamentally constrained and thus somewhat immune from the future impacts of current high market valuations. With no risk of annual capital loss, and muted caps with maximum annual crediting of maybe 5% in today’s environment, the range of possible outcomes is narrow to begin with, unlike the index itself.
For example, let’s compare the performance of the S&P 500 price return index over two ten-year periods, and then do the same with a fixed indexed annuity using that index for annual crediting. 2011-2020 started with a much lower Shiller CAPE value – 22.98. 2001-2010 started at much higher levels closer to what we have today, with the Shiller CAPE at 36.98. (source: Shiller PE Ratio by Year (multpl.com)).
-
2011-2020:
- The Price Return index tripled during this period, turning $100,000 into about $299,000, for a compound annualized growth rate of 11.56%.
- Meanwhile, a FIA with a 5% cap and point to point annual interest crediting using this index would have grown $100,000 to about $140,710, for a compound annualized growth rate of 3.47%
-
2001-2010:
- The Price Return index lost about half a percent per year, turning $100,000 into about $95,000.
- In contrast, a FIA with a 5% cap and point to point annual interest crediting using this index would have grown $100,000 to about $136,097, or a compound annualized growth rate of 3.13%
So here we had two wildly different outcomes in the returns of the underlying index, but two very similar outcomes in the annuities that use the index for crediting. What gives? It’s simple: focus on those years during each decade in which the FIA crediting construct would have produced the same result.
- During each of those two ten-year periods, the price return index lost money or was flat in three of the years, meaning those three years produced the same result in a FIA during those two decades. The FIA credited nothing and lost nothing.
- As for the seven years in which the index was positive, any annual index returns over 5% - the cap – are irrelevant to the FIA, and the indexed annuity crediting is the same. As it happens, all seven positive years were above five percent in the underlying index during 2011-2020, while five of the seven positive years were above five percent during the 2001-2010 decade.
- That leaves only two of the ten years in which the annual results were different in the annuity bought in 2001 versus bought in 2011. As it happens, the S&P price return index gained 3.53% in 2007, and 3.0% in 2005. That means it gave up a total of about 2.5% in crediting over ten years to the FIA bought in 2011, which hit the 5% cap in all seven of its positive years.
The variability of FIA returns over multiyear holding periods pale in comparison to those of the underlying indexes. Bull or Bear, a FIA doesn’t care, elevated CAPE or not at the time of purchase.
© Rafferty Annuity Framing LLC
