May 31, 2011
Critiquing the authors’ critiques
Let’s now turn to the section of the study where the authors fault previous research regarding EIAs. Below are some of the claims the authors make, along with explanations of why their assertions are unfounded.
The authors criticized previous research, such as that by Reichenstein, for examining the performance of annuities using historical data prior to 1997, the year EIAs became available. In my correspondence with Reichenstein, he said his study used real-world contracts that represented what was available in the marketplace from 1998-2005. He modeled four contract designs and for each design considered a range of specific contract terms, and he did indeed assume that at least one of these would have been appropriate had EIAs been around in 1957, the beginning of his historical data series. That is precisely the type of analysis that should be applied to EIAs – examining their performance using realistic, long-term data series.
The authors state that no study has been published that compares the costs of EIAs to those of mutual funds. They fail to acknowledge, however, the Reichenstein (“Financial analysis of equity-indexed annuities,” Financial Services Review 2009) calculated the costs of EIAs by analyzing the financial statements of the insurance companies that sell them. He conservatively estimated those costs to be 200 basis points annually, which is far more than that of a comparable 85/15 portfolio.
The authors criticized Reichenstein for his use of the Ibbotson Associates data set, claiming that dataset is rebalanced monthly. This data set has been used in hundreds if not thousands of studies. As stated in each year’s Classic Yearbook, Ibbotson (2011) says, “one-bond portfolios are used to construct the intermediate-term government bond index. The bond chosen each year is the shortest non-callable bond with a maturity not less than five years, and it is ‘held’ for the calendar year.” Neither Ibbotson nor Reichenstein makes the assumption that the authors allege.
The authors assert that consumers have several layers of protection against the possibility that sellers of EIAs would not act in their best interests. This is a serious concern, since EIAs are sold by insurance companies, whose agents are not held to the same fiduciary standard as Registered Investment Advisors.
One of the study’s authors, Babbel, however, took a different position on the issue of consumer protection in a 1999 article on life insurance:
“Perhaps the area of greatest concern in the area of actuarial risk is the misalignment of incentives between owners of the insurance firm and its sales and marketing staff. … The typical arrangement is to pay commissions for sales of new policies, with the commissions on a multi-period contract heavily front-loaded. … This creates a tremendous incentive for agents to sell as much business as possible, whether it is profitable for the company or not. It also creates strong incentives to replace existing policies, whose commissions rates have dwindled to the low single-digit percentage range, with new policies that pay commissions ranging from 20 to 100% of the first year premiums. Sales managers and marketing personnel are also often rewarded based on volume of sales. Even senior management may sometimes have their compensation tied to sales growth.”
How can Babbel argue in 1999 that insurance salespeople are primarily commission-driven, yet in this article argue that they have a fiduciary duty to their clients?
The authors also criticized previous research for using unrealistic product structures, such as a study by Patrick Collins, et al. (“Equity Indexed Annuities: Downside Protection, But at What Cost?” Journal of Financial Planning 22, 5; May 2009).
Collins, et al., used contract specifications largely drawn from a Moody’s Credit Research Report published in 2001. Although the authors did not cite this report, here is what Marrion wrote about it in 2002: “Moody’s Investors Service published a Special Comment report in November of last year titled Equity Index Annuities: Complexity Personified. The report is a fair representation of the potentials [sic] and concerns associated with an insurer’s decision to offer index products. ”
The problem is that EIAs are extremely complex and there is no definitive resource to rely on for detailed product information. Marrion admits this on his web site: “Even though all index annuities use the same basic building blocks, with over 30 crediting methods in use it is difficult to determine if one annuity’s long term index participation reflects overall market changes, and direct comparisons are difficult.“
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