What is Normal?

I subscribe to the Index Compendium, and recently came across an article titled “Index Annuities are the New Normal.”  It really enforces what I’ve been telling my clients for years and I thought it’d benefit you to share it here.

The average reported S&P 500 index annuity return beat the real S&P 500 return in 63% of actual five-year periods.  Index annuity detractors often retort those bad periods were exceptions, because when you take into account the good ones, and add on reinvested dividends, you more than make up for the bad times because “everyone knows” mutual funds perform much better than index annuities.  However, if you had invested $10,000 at the beginning of every five year period – a total of $80,000 in each since 1997 – the index annuities would have grown to $104,991 and the S&P 500 index with reinvested dividends would have been worth approximately $103,574¹

What if the investment markets of the last decade are not an aberration, but represent the new normal investing environment? If these times are the new normal then index annuities are the clear winners.

However, rather than accept the reality that index annuities have proven their work the detractors fall back on their other argument, which is index annuities may have performed well since they were introduced in 1995 but these aren’t normal times.  Their refrain is if these were normal times the mutual funds would have won big.

The detractors typically use two “normal” periods to support their position.  The first big period usually starts in the mid 1920s and ends at the millennium.  It results in those 12% return numbers cited by folks like Ibbotson.  The second period used is the more recent 20 or 25 years that include returns for the ‘80s and ‘90s; the average annual stock market return for those two decades was 17.6%².  The detractors then apply today’s index annuity participation rates to these periods and say, “see, in normal times mutual funds heartily beat index annuities.”  However, I submit those periods (to say nothing of the participation rates assumed) are also not representative of normalcy.

If you could have invested $10,000 in the U.S. stock market on New Year’s day 1980 your account balance on 1 January 2000 would have been $253,766!  However, if you had done this from 1970 to 1990 your balance would have been $87,586, and starting in 1960 and ending in 1980 your $10,000 would have grown to $36,905.

Some people use Ibbotson’s 12% return as representative of a normal stock market, but even using their 80 year timeframe as “normal” 96.8% of the 20 year returns will be less than the 1980-2000 period.  And if you use the first 80 years of the century instead of the last 80 years as normal, the likelihood of not getting a 1980-2000 style return is 99.99%.

What is normal?

Professor Siegel of Wharton looked at periods beginning after World War II and found the average annual stock market return for the next six decades, including reinvested dividends, was 6.83%³.  If you could find a annual reset index annuity that averaged a 50% participation rate for the same period your annualized return would have been 7.13% without reinvested dividends.

In my modeling of the Great Depression, if you could have purchased an index annuity each month beginning in August 1929 with only a 30% participation rate your average annual index annuity return would have been 6.4%.  All of this during a decade where the stock market ended 65% lower than where it began and blue chip stock market investors lost a lot of money.

The ten years following 1972 resemble the decade after 1999 in stock market movement.  In this earlier era the S&P 500 finished 3.8% higher than where it began, but an index annuity annual reset approach would credit interest based on a total period gain of 124%.

Frankly, I don’t know if the next 10 or 20 years will be like the last, but it appears extremely unlikely that the 1980-2000 period returns that occurred only once in the last 200 years should be used as “normal” times⁴.

I couldn’t agree more.  You can read the rest of the article by Clicking here for the PDF. (thanks Jack!).

For more articles by Jack Marrion, visit the IndexAnnuity.org.

The article was researched and written by Index Compendium Editor, Jack Marrion. Copyright 2010. Reproduction is not permitted without written permission of editor..  The Index Compendium does not provide investment, tax or legal advice. Information believed accurate but is not warranted.

1. The index annuity returns are actual policy returns for 5-years periods generally beginning and ending at or around 30 September.  The $103,574 index return assumes reinvested dividends of 1.72.%, which was the S&P 500 dividend average yeld from 1997 through 2009.

2. Bogle, John, 2003.  The Policy Portfolio in an Era of Subdued Returns. Bogle Financial Center.

3. Siegel, Jeremy (1992) The Equity Premium: Stock and Bond Returns since 1802.  Financial Anaylists Journal; 48, 1; pg 28

4. Schwert, G. William 1990. Indexes of U.S. Stock Prices from 1802 to 1987. The Journal of Business. 63,3; 399