The Performance and Returns on Index Interest

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Hopefully, in the near future, Index Interest will have its own category in a portfolio and will receive recognition as such, in the overall world of asset allocation and portfolio management. Until that time, it is important for investors to know when and which traditional investments for which they are good substitutes. Let’s start with index annuities, since they’re more homogeneous in their structures across a wide variety of companies. We will reference a study published by the Wharton School of Business Financial Institutions Center, the real historical returns that investors earned on index annuities from 1997 to 2010. This is the most comprehensive study to date on index annuity historical performance and is aptly titled “Real World Index Annuity Returns” (4). See the chart below.

While the range of returns (column 5) showed a variance from less than 1% to over 12% due to the differences in contracts and crediting methods, none of the contracts showed a loss even when the underlying index posted negative returns.  This is exactly what’s supposed to happen.  But more importantly, when evaluating index annuities as a whole, is the average return of the group over each five-year period (column 3).  As you can see, the typical five-year return was somewhere between four and six percent.  Not bad when compared to the returns of the actual stock index over the same five-year periods (column 2).  What you should notice from the data is that when the market index performed well, the index annuities studied also performed well but the returns weren’t as high.  When the market index performed poorly with low or even negative returns, the index annuity still produced moderately positive returns due to locking in gains.  This is exactly what index interest is designed to do and what should be expected.  However, this clearly presents a dilemma when trying to shoehorn index interest into one of the existing asset categories.  During extended bull markets, it performs more like the stock market, but during extended volatile or bear markets, it performs more like bonds.  So, which is it more similar to?  Neither.

In the infancy stage of index annuities, many advisors and investors alike wrongly viewed annuities with index interest as a replacement for stock market investments. They were and are designed to produce average returns that are approximately 1% to 3% higher than prevailing fixed interest rates over the same period of time.

Let’s look now at index CDs . Unlike index annuities, which will sometimes stay the same for many years, a new offering of index CDs comes out monthly with different terms and different calculation methods.  However, there are usually several that go off of the major stock market indices and are very similar in terms and methods every month.  Therefore, in lieu of a study, we will have to resort to the next best thing which is taking an actual index CD and plugging in the index numbers to see what the returns would have been.  While this is not perfect by any means, it should at least give us a rough idea. Let’s use the following index CD, linked to the S&P 500 and plug it into different historical time periods to see what returns it would have produced.

XYZ National Bank Index CD 5 year maturity

Linked to S&P 500 Point to point with a cap of 60%

Minimum Return = Principle

Maximum Return = 160% of amount invested

The chart below takes this index CD and shows how it would have performed if it had been available during different time periods in recent market history.  It starts with April of 1980 and goes through April of 2006 in two-year increments, showing both the change in the index level and the resulting index CD return with the 60% cap.

 

 

 

 

 

 

 

 

 

So, how did the index CD do?  Overall I would say, “Not too bad.”  In the five-year periods looked at; the index CD captured the majority of the index gains in all except two (1982-1987 and 1994-1999).  It should be noted that the 1980’s and 1990’s were the period of one of the greatest bull markets in stock market history.  So, let’s look at the same period of time, using the same index CD but going off an October start in the odd numbered years.

 

 

 

 

 

 

 

 

 

So, to summarize, out of the 27 different time periods we looked at, an index CD with a 60% cap would have missed out on some large gains in five periods, would have avoided substantial losses in five, and would have captured all or most of the gains in the other 17.

Let’s go one step further with this data and look at it in terms of annual returns.  The following chart combines the data from the previous two charts of five-year returns and looks at what annual compounded rate of return it would have taken to duplicate the returns of the index CD over each of the periods looked at.  For instance, a 60% return over a five-year period would have required a fixed interest investment yielding 9.86% and compounding annually to achieve the same growth.

 

 

 

 

 

 

 

 

 

 

Looking at the data in this format, it seems a pretty daunting task to draw any conclusions, even though you may have noticed a few trends.  Let me give you some key numbers derived from this set of data that should help clarify it a bit.  For the time periods looked at:

  • The average five-year return for the index was 54.01% for a compounded equivalent annualized return of 9.02%. The average five-year return of the index CD with a 60% cap was 37.71% for a compounded equivalent annualized return of 6.61%.
  • The average of the annualized index CD returns shown in column three was 6.08%.

It should be remembered that this set of data is not meant to be a comparison between investing in an index mutual fund and investing in index interest CDs, due to certain limitations.  With this in mind, let’s go one step farther with the data and split the time periods into two groups; one group looking at the predominantly bull market of 1980- 2000 and the other looking at the bearish or sideways market of 2000-2010.  First, let’s look at the bull market data.

 

 

 

 

 

 

 

 

 

Here are the numbers for the overall bull market of 1980-2000: The average five-year return for the index was 88.48% for a compounded equivalent annualized return of 13.51%.

The average five-year return of the index CD with a 60% cap was 55.42% for a compounded equivalent annualized return of 9.22%. The average of the annualized index CD returns shown in column three was 9.19%.

Now, let’s examine the bear market data.  Keep in mind that the S&P 500 index hit a high point of around 1500 in 2000, subsequently dropped, and as of 2011, it was still hovering a little above 1300 having yet to rebound past its previous high.

 

 

 

 

 

 

Here are the numbers for the overall bearish market of 2000-2011.

  • The average five-year return for the index was 1.86% for a compounded equivalent annualized return of 0.37% due to the negative return periods.
  • The average five-year return of the index CD with a 60% cap was 10.33% for a compounded equivalent annualized return of 1.99%.
  • The average of the annualized index CD returns shown in column three was 1.88%.

The index CD would have actually performed much better than the S&P Index during this time period due to it not experiencing any losses but still capturing all of the upside gains.  This is a case where the averages don’t present as clear of a picture as looking at the individual data.

CONCLUSION
In bullish markets, the typical annual return over a five-year period for the index interest products looked at was between 8% and 10%.

In bearish markets, the typical annual return over a five-year period for the same index interest products was between 2% and 4%, with some 0% returns for the index CD due to the longer reset period.
To put it another way, we have an investment product that produces returns similar to a balanced mutual fund in bull markets, and produces returns more like a short maturity bond fund or money market account during bear markets.  So, if we try to put index interest into an existing asset class, during good stock market years, it should be classified as an equity investment, and during bad market years, it should be classified as bonds or cash.  As you might imagine, trying to factor into a portfolio an investment that keeps playing asset class musical chairs has proved frustrating for advisors and investors alike.  As mentioned before, most of the die-hard adherents to modern portfolio theory have either ignored this chameleon of an investment or tried to tear it apart with inaccurate and unfavorable comparisons.  But what if we took a different approach?  What if we treated index interest as its own asset class?

J.R. Thacker
is President and Founder of Thacker & Associates Inc. and President of Center Street Securities, Inc. He has worked in the financial services industry since 1996. Thacker founded his own firm specializing in retirement planning. His unique approach to retirement investing quickly became popular, and the firm was voted “Best Financial Planner” for six years in a row. He can be reached by e-mail at info@indexinterest.com or jrthacker@thackerandassociates.com.

 


J.R. Thacker is President and Founder of Thacker & Associates Inc. and President of Center Street Securities, Inc. He has worked in the financial services industry since 1996. Thacker founded his own firm specializing in retirement planning. His unique approach to retirement investing quickly became popular, and the firm was voted “Best Financial Planner” for six years in a row. He can be reached by e-mail at info@indexinterest.com or jrthacker@thackerandassociates.com.

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