Math on annuity returns misstates the picture

I sold an equity-indexed annuity (EIA) to a doctor in August 1996. He put $470,000 into a contract linked to the S&P 500. His annuity value in August 2008 was $940,000, a 6 percent annual return. Had he invested in the index directly, his return over the same period would be about

3 percent a year.

I took $150,000 out of the market in October 2007. Had I left my money in the market, the value today would be around $90,000. I just received my EIA summary, and the value is $180,000.

The EIA was such a "lousy" investment that I gained $30,000 over two years instead of losing $60,000.

I agree that some EIAs were misrepresented and a number of agents were not properly trained. You seem to think that the Securities and Exchange Commission would do a much better job of overseeing EIA sales than the current insurance regulators.

Have you heard of Bernie Madoff? I bet most of his investors would love to have an equity-indexed annuity instead of the SEC-compliant Madoff scheme.

– P.H., by e-mail

As I understand EIAs, they are not properly compared to a pure equity investment because they are a fixed-income product with lower inherent risk and, in most investment periods, a lower return. But had you invested the same $470,000 over the period you mentioned, here is a comparison of what you would have had by investing in some major funds:

Vanguard Index 500: $933,216

Your EIA: $940,000

Fidelity Puritan: $1,057,278

American Funds American Balanced A: $1,093,325

Vanguard Wellesley Income: $1,245,291

Vanguard Wellington: $1,289,609

(Source: Morningstar Principia)

As you can see, the EIA would have beaten only the pure equity index over one of the worst investment periods in history — and by a small amount. The $933,216 figure for investing in a low-cost index fund includes reinvestment of dividends, an important part of investment returns that is lost in EIA contracts. Include dividends, and you'll get more than your 3 percent figure.

The EIA contract, however, would have trailed the performance of some very large, popular and liquid balanced funds, including two that would have paid the salesperson a nice commission. This is why I think investors are best served by having well-diversified portfolios with very low expenses.

History shows that we can't put much trust in either SEC regulation or insurance regulation when it comes to protecting individual investors.

What made you think Bernard Madoff was SEC-compliant? Madoff was undetected fraud, pure and simple.

I recently sold my business and am retired. As a pharmacist, I plan to do some part-time work to stay active. My wife and I are both 71. Our house, car etc. are all paid for. We don't carry a balance on our Visa account. Several years ago, I left the stock market, feeling I had too much exposure for what seemed like bad times coming.

I have $1.9 million in CDs, from 4.5 to 2.5 percent. I still have $12,000 in mutual funds, $375,000 in John Hancock Venture III and $139,000 in Equitable Accumulator 99 annuities.

Knowing that interest rates on CDs are not going to get any better, what do you recommend for safe investments in the stock market?

– R.G., by e-mail

There is no such thing as a safe investment in the stock market. That doesn't mean you should avoid it. It just means you have to know that it is possible to lose money as well as make it.

Long term, investing in a broad index of common stocks tends to provide a higher return than other alternatives — although that idea is getting a bit hard to swallow with no return on domestic equities for the past 10 years.

International equities are still selling at lower valuations than domestic equities, so you could start by making commitments to broad indexes like the iShares MSCI EAFE exchange-traded fund (ticker: EFA, expense ratio: 0.35 percent). Recently, it was yielding 2.75 percent. Similarly, the Vanguard Emerging Markets exchange-traded fund (ticker: VWO, expense ratio: 0.20 percent) recently offered a yield of 3.1 percent.

In domestic equities, the Vanguard Value exchange-traded fund (ticker: VTV, expense ratio: 0.1 percent) recently had a yield of 3 percent. Those yields are all in the ballpark with typical yields on five-year CDs.

Questions about personal finance and investments may be sent via e-mail to scott@scottburns.com.