When you think about all the different obstacles consumers must face today on their way to a fruitful retirement, it boggles the mind. First, there are the endless choices with regard to financial products, from mutual funds to annuities (both fixed and variable), to individual securities like stocks and bonds, to bank products. The list goes on and on. And then there’s life insurance, from term and universal life, to indexed universal life and variable life to whole life.
Fortunately, indexed products today are perhaps among the simplest solutions to help consumers cut through the endless clutter of product choices and ensure they minimize or eliminate uncertainty in their financial futures. Simply put, having indexed products as a core holding of an insurance and retirement portfolio can help ensure clients don’t find themselves in the wrong product at the wrong time. In addition, owning an indexed product as a core holding will help reduce the temptation consumers often have to do the wrong thing at the wrong time, even if for the right reasons.
Consumers: Their own worst enemy
DALBAR, an independent, Boston-based financial research firm, recently released its latest edition of the Quantitative Analysis of Investor Behavior (QAIB). Using monthly fund data supplied by the Investment Company Institute, QAIB calculates a proxy for investor returns and compares this number to the returns produced by the broad market as defined by the S&P 500.1
For the 20-year period from 1992 to 2011, the S&P 500 returned 7.81 percent, on average, per year. It should be noted that this number is significantly lower than in past years, reflecting a downtrend in long-term average returns for equities resulting from two deep bear markets, 2000-2002 and 2008-2009. For example, the average annual return for the 20-year period ending in 1999 was a whopping 18.01 percent. For the period ending in 2007, it was 11.81 percent.
Clearly, the most recent 20-year return is disappointing compared to past 20-year periods. Worse still, the average equity investor continues to do far worse than the market itself, and this underperformance is entirely due to poor market timing decisions.2 Simply put, rather than stand by the old maxim of “buy and hold,” most equity fund participants have darted in and out of their funds at the worst times. Fear and greed are the enemies of investing success, and they continue to prevail. Fear drives investors to sell when the markets are in a tailspin, and greed compels them to buy after market gains have already been booked.
Take, for example, that 20-year period ending in 1999, in which the market returned 18.01 percent per year on average. In stark contrast, the average equity fund investor earned far less, only 7.23 percent per year, during this time frame. Putting this into perspective, the average annual investor return during the best 20-year period of market performance still underperformed the average market return during the market’s worst 20-year performance, which happened to end in 2011.2
The reason for this poor outcome is simple—as Michael Jackson once said, “It’s the man in the mirror.” Individuals are their own biggest obstacle when it comes to successfully accumulating wealth over the long term, due to the powerful pull of fear and greed.People, more often than not, succumb to loss aversion, in which the pain from their losses is greater than the pleasure from their gains. As a result, they are quick to flee the discomfort caused by excessive market volatility, and, subsequently, they miss out on the big gains that always come without warning.
In contrast, they usually only want to get back into the markets once they’ve heard about the big gains that have already taken place. I mention “usually” because, this time, after a horrific decade of volatility and seemingly endless bad economic news, the markets seem to have quietly recovered, and yet, no one seems to notice or care. I suspect this is because they all think this may be yet another “head fake” designed to lure them in only to collapse and spit them back out, poorer for it once again.
As I write this, on March 18, the Dow Jones Industrial Average just crossed 13,000; the NASDAQ broke the 3,000 barrier for the first time since December 2000; and the S&P 500 Index crossed the 1,400 level for the first time since May 2008.
All of this happened during the week of March 12, exactly three-and-a-half years since the financial crisis officially kicked off in September 2008.
Only three short years ago, in March 2009, these indices were hovering at roughly half of these current levels, as the global economy appeared on the verge of total collapse. Given the well-documented behavior of individuals reacting to financial volatility, it is fair to assume that not many went for broke in March 2009 to see their portfolios double in value by March 2012. Instead, like the rest of the world it seems, the bunker mentality was and is in full effect, leaving the equity markets to rise with little fanfare and the fixed income markets to continue rising while relentlessly pushing down yields.
The result of this insatiable appetite for fixed income and, in particular, the version backed by the full faith and credit of the United States is yields low enough to get swallowed by inflation. The 10-year Treasury just recently broke out of its months-long trading range of 1.8 percent to 2.1 percent to a recent high of 2.3 percent during the week of March 12. When you factor inflation into the mix at roughly 2 percent, the real return is zero.3
Have we become so gun-shy about stock markets that we are now willing to settle for no real return on our money? Since when did capitalism require guaranteed returns on everything ever put at risk, whether our labor or our capital? What ever happened to the old maxim “nothing ventured, nothing gained?”
Fortunately, the rise of indexed products in the last few years could not have come at a better time in financial history. Whether fixed indexed annuity products (primarily used for retirement) or fixed indexed life insurance products (used primarily for protection but also as a retirement supplement), the value proposition they deliver is exquisitely crafted for the times we live in right now. Whether you think we are embarking on the best of times or the worst of times, a case for indexed products can be made either way.
Let’s assume the glass is half full, and almost four years since the financial crisis began, the skies are brightening for the long term. Your client needs more life insurance protection for his family and a place to stash more supplemental retirement savings. The low interest rates on fixed annuity products don’t give him much, if any, real growth potential. Those same low rates make traditional guaranteed universal life products more expensive as prices need to accommodate low interest rate assumptions in the future.
Enter the indexed annuity and indexed UL policy with secondary guarantees. If we are in for a seemingly long overdue and sustained rise in the equity markets, both will have the market exposure necessary to help provide a greater potential return than that offered by traditional fixed products. Yet that exposure won’t come with the sickening volatility that pure equity products have produced in the last decade.
The worst of times
OK, so your client thinks the rise in the markets over the last three years is just another head fake. Or is it? If he tends to think negatively about the future prospects for the market, being in an indexed product isn’t the worst place to be. Sure, there’s a chance that he will earn nothing, but what is he giving up if this happens? His opportunity cost is low, as defined by the 1 percent or 2 percent yield on the fixed products that he passed up. And most importantly, if the market does what he thinks it won’t—perform well—he will already be in the right place at the right time, with no need to make anguished decisions about being in equities.
Time: The critical value of indexed products
Whether we are in the best of times or the worst financially, the value proposition of indexed products boils down to this: the guaranteed nature of indexed products should remove the loss-aversion factor that the DALBAR study mentions. This loss aversion is what causes individuals to flee from stocks as the fear of losses drives them to seek cover in the form of guarantees. Typically, this fleeing only takes place once markets have already collapsed, thus locking in poor returns.
The unique beauty of long-term ownership of indexed products is, without fear of losses to contend with, individuals will be exposed to rising markets from the trough to the peak. No, they do not have pure exposure and thus won’t enjoy the full return. But they will have some exposure to the full force of the upward moves, in turn giving them a better return potential than fixed products—and a better return potential than individuals who choose to participate in equity markets in unprotected fashion.
- Indexes do not take into account the fees and expenses associated with investing, and individuals cannot invest directly in any index. Past performance cannot guarantee future results.
- Average stock investor, average bond investor and average asset allocation investor performance results are based on the DALBAR QAIB study. Using monthly fund data supplied by the Investment Company Institute, QAIB calculates investor returns as the change in assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions, and exchanges for the period.
- Bond benchmark performance and systematic bond investing examples are represented by the Barclays Aggregate Bond Index, an unmanaged index of bonds generally considered representative of the bond market. Indexes do not take into account the fees and expenses associated with investing, and individuals cannot invest directly in any index. Past performance cannot guarantee future results.
Systematic investing examples are hypothetical and for illustrative purposes only. Systematic investing involves continuous investments regardless of security price levels. It cannot assure a profit or protect against loss in declining markets.
Standard & Poor’s, S&P, and S&P 500 are registered trademarks of Standard & Poor’s Financial Services LLC and have been licensed for use by American General Life Insurance Company. Standard & Poor’s does not sponsor, endorse, sell or promote any insurance products linked to the S&P 500.
American General Life Companies, www.americangeneral.com, is the marketing name for a group of affiliated domestic life insurers.
For producer use only — not for dissemination to the public.
For more on indexed products, see:
- Indexed UL Finds the Sweet Spot—and Stays There
- The Merits of Annuities
- New Players Enter Indexed Annuity Space