Academic journal article Financial Services Review

Financial Analysis of Equity-Indexed Annuities

Academic journal article Financial Services Review

Financial Analysis of Equity-Indexed Annuities

Article excerpt


This study examined historical returns on four equity index annuity (EIA) contract designs and 13 contracts for 1957-2008, the period since the S&P 500 began. None of these contracts could match returns on one-month Treasury bills. Based on alphas and Sharpe ratios, none of the contracts could produce competitive market-based returns. More important, because of their design, index annuities must underperform returns on similar risk portfolios of Treasury's and index funds. EIAs impose several risks that are not present in market-based investments including surrender fees and loss of return on funds withdrawn before the end of the term. This research suggests that salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.

© 2009 Academy of Financial Services. All rights reserved.

Keywords: Indexed annuities; Equity indexed annuities; Suitability

1. Introduction

Most indexed annuities promise investors part of market returns, while protecting them against market decreases. The investor shares in positive returns, while avoiding losses. The promise is alluring, but how do they perform in practice?

This study addresses this issue. Indexed annuities (IA) including equity indexed annuities (EIAs) are complex investment contracts. One goal of this study is to explain some of the complexities of IAs. Another is to discuss the regulatory issue of whether IAs offers competitive risk-adjusted returns. To address that question, this study simulates historic returns for 1957 through 2008 on popular EIA contracts. It concludes that none of these contracts offered competitive risk-adjusted returns for the period since the S&P 500 began. More important, because of their design, IAs must underperform returns on similar risk portfolios of Treasury's and index funds.

Section 2 discusses a key regulatory issue and explains terms used in the annuity industry. Section 3 presents methods used to calculate returns credited to investors' accounts. Section 4 presents the literature review. Section 5 discusses the competitiveness of IA returns. In addition, it presents data and methodology and then presents the analysis of EIAs hypothetical risk-adjusted performance. Section 6 concludes.

2. Industry background

2.1. Regulatory issue

A key regulatory issue is whether indexed annuities are suitable investments. Not surprisingly, there are gray areas when deciding whether an investment is "suitable." National Association of Securities Dealers (NASD), now part of Financial Industry Regulatory Authority (FINRA), defines certain conditions that must be met before an investment can be considered suitable. In Notice to Members 03-71, NASD (2003) "remind members that the sale of NCIs [nonconventional investments], like more traditional investments, requires them to:

1. Conduct appropriate due diligence with respect to these products;

2. Perform a reasonable-basis suitability analysis; . . . and

6. Provide appropriate training to registered representatives that sell these products.

Given the complex and, at times, difficult-to-understand nature of NCIs, members should take particular care to assure that they are fulfilling these obligations."

Concerning the "due diligence" requirement, this notice says:

"A reasonable-basis suitability determination is necessary to ensure that an investment is suitable for some investors (as opposed to a customer-specific suitability determination, discussed [in the Notice], which is undertaken on a customer-by-customer basis). Thus, the reasonable-basis suitability analysis can only be undertaken when a member understands the investment products it sells. Accordingly, a member must perform appropriate due diligence to ensure that it understands the nature of the product, as well as the potential risks and rewards associated with the product. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed


An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.