Annuity Anomaly: EIA + GLB > SPIA?
July 8, 2013 by Moshe A. Milevsky
Yes, I know that with an EIA you don’t have much choice in terms of the investment allocations, which are usually linked to an S&P 500 index minus any dividends, while the VA gives you a robust line-up of many different funds and subaccounts. And yes, the EIA imposes low caps and tight participation limits on the growth of the account value, which reduces the probability you will get anything more than the guaranteed minimum. Also, one is a security while the other is an insurance policy. These are important, but secondary, details.
I should point out that as insurance companies continue to place asset allocation restriction on the sub-accounts within the VA + GLWB and policy-holders are given less freedom to allocate and move money around, the actual performance of these accounts might soon resemble a neutered and passive equity index.
From an insurance company accounting point of view, though, there is an important difference between what the company does with the VA money versus the EIA premium. In the former the company places the funds in a separate account and has to worry about hedging the downside risk. In the latter, the company places the funds in its general account and then has to worry about crediting you with interest on the upside. And, while financial economics might dictate that these are identical exposures, in practice things can be different depending on how the crediting formula is structured.
In fact, this is why you can occasionally find EIA + GLB combinations offering more income relative to a VA + GLWB, which shouldn’t be too surprising given the difference in underlying accounts, liquidity provisions, etc. But the irregularity that attracted my attention was EIA + GLB versus the SPIA.
Beat the SPIA
The table nearby provides some indicative quotes where the guaranteed minimum income from an EIA + GLB is compared to the guaranteed income from a SPIA. Take for example a 65-year-old couple with $500,000 dedicated to buying a life annuity, with income starting in 36 months (perhaps when they plan to retire).
The average payout quote for a joint-and-last survivor annuity was $30,390 per year, which is a payout of (approximately) 6% for as long as either of them lives. Now look at the column which says EIA. It offers the same couple a payout of $31,750 per year (starting in 36 months), continuing for as long as either of them is alive. This is about 5% more than the SPIA, but also offers upside potential.
Namely, if the underlying index does well (OK, more like a triple-lutz-triple-toe jump) in the next 36 months, the benefit base will be higher—but never less. Also, being an EIA it offers some liquidity and is cashable. Of course, you have to pay steep surrender charges, but remember, the SPIA would have offered you no liquidity whatsoever. Ergo, I consider this an anomaly that can’t be explained by credit risk or default concerns because all quoted companies were in the same risk bin.
Now, this EIA + GLB > SPIA anomaly doesn’t apply at all ages. Notice that at higher ages such as 70 and 75, the payouts from the SPIA dominate the guaranteed payouts from the EIA for single lives, as they should, although they are quite close for joint lives.
Needless to say, the table is just a snapshot in time for a few companies, so it’s difficult to make general statements about the exact ages at which one option dominates the other, but this does happen, especially for joint lives.
Rational Explanation
The reason an EIA can guarantee a lifetime payout that is higher than a SPIA for younger females and/or a longer delay period, is partially due to the assets backing an EIA versus a SPIA and partially because of the unisex and lapse-supported nature of the EIA + GLB pricing.
SPIAs are sold and priced based on more conservative assets and with the unique age and gender of the annuitant, while EIA + GLB are more loosely organized into pricing bands and are not priced to be gender specific. Moreover, the insurance companies assume that some policyholders will surrender their EIAs before they ever convert them into income, which allows them to offer just a wee bit more to the rest. Add this all together and you find that younger females might get more, relative to a SPIA which is priced with zero lapsation and calibrated to an exact age.
And remember, the numbers in the table are only the guaranteed payouts for the equity-indexed annuity. If the underlying (S&P 500) equity index moves up at the right time and at the proper speed—no matter how remote you gauge the probability—the guaranteed lifetime income will be higher.
Here is the bottom line. If you strip out the shady sales practices and the 15-year surrender charges, underneath it all is an intriguing insurance proposition for advisors who are willing to understand and wade into a (potential) minefield.
Now, I want to be crystal clear here, lest readers suspect that I was hit on the head with a hockey stick and am suffering from an intellectual concussion. I am not saying that an equity-indexed annuity is better than a variable annuity with a GLWB. That is an apple to pineapple comparison. My point is rather modest. Sometimes insurance pricing can be weird. Take advantage of it. So, before you pull the trigger on an irreversible life annuity for a younger client—especially if you are piling on refunds, period certain and guarantees—you might want to run a quote for an EIA + GLB. Like me, you might be surprised.
P.S. No. Mom didn’t get the EIA.