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August 22, 2011 Letter to the Editor of the Journal of Financial Planning Re: The guest column in your August 2011 issue by Dr. William Reichenstein entitled “Can Annuities Offer Competitive Returns?” Dear Editor, The book “The Black Swan” by Nassim Taleb became very popular at the height of the recent financial crisis. It highlighted the difference between theory and reality. Its title comes from a prior belief of scientists in Europe. They believed that all swans were white. The discovery of black swans in Australia was the real-world reality that shattered their theoretical belief. In your article, Dr. Reichenstein uses a theoretical line of thought to dismiss the notion that indexed annuities could be competitive. He says: We do not need empirical tests to ensure that indexed annuities underperform their risk-adjusted benchmark portfolio’s returns. Because their structure prevents them from adding value compared to this benchmark return, they must underperform this benchmark return by the sum of their spread plus their transaction costs. Proof completed! In other words, Dr. Reichenstein is saying that what happens in the real world doesn’t matter because his philosophical argument makes the real world moot. But in the real world, over $30 billion per year of new money goes into indexed annuities annually, and only the most arrogant individual would believe all of those purchasers to be fools or that their real world returns and protections from market tragedy were “insignificant.” Moreover, Dr. Reichenstein says that in his 2009 article: I modeled hypothetical returns on 13 EIA contracts for 1957–2008…. None of these contracts could match returns available on one-month Treasury bills. Once again, we must consider the real world. Today, the yields available on one-month Treasury bills are 0.015%. Does Dr. Reichenstein’s assertion hold true going forward given today’s interest rate environment? Also if you remember that indexed annuities were first introduced in the mid 1990’s when three-fourths of the Dr.’s measurement period was over. One is only left to guess whether or not his theory will be replicated or not. And guessing is what those of us left in the real world want to avoid when buying a fixed indexed annuity. We KNOW we will be protected from negative markets. We KNOW we will earn a minimum interest. And, if the market is positive we KNOW we will earn additional interest as explained by the credible authors of Real World Returns, Dr. VanderPal, Professor Marrion, and Dr. Babbel. Also, while the entire article is arguably erroneous given the difference between the author’s theory versus the reality, even Dr. Reichenstein would agree that there is at least one glaring error in the article. In the article, he states, “They did not compare returns on EIAs to a 15 percent Treasury bill and 85 percent S&P 500 portfolio, which my study suggests would have been the risk-appropriate benchmark portfolio’s returns for a typical EIA.” The percentages are actually reversed, as in his 2009 article Dr. Reichenstein allocates 85% to one-month Treasury bills. But this does highlight a bias that many financial advisors have against indexed annuities, as they believe that the returns of indexed annuities should be compared to the returns of an S&P 500 portfolio. In reality, while many indexed annuities base their interest credits off of the S&P 500 index, they are designed to be far safer and provide valuable protections of principal, thus their returns are more appropriately compared to a portfolio consisting of much safer assets. I strongly encourage your readers to consider the article in the March 2011 issue of your magazine by VanderPal, Marrion, and Babbel. Their credentials are impressive and their real world results trump his theoretical argument. After all, the best way to refute a theoretical statement such as “indexed annuities cannot provide competitive risk-adjusted returns” is to show that in the real world, they do! Sincerely, Kim O’Brien, President & CEO The National Association for Fixed Annuities