Hidden pitfalls could lead to indexed-annuity disappointment

As the market shows increasing signs of fragmentation, investors need to bear a few important details in mind

Hidden pitfalls could lead to indexed-annuity disappointment

For the investors behind the rise of indexed annuities, the appeal is clear: the products provide a minimum amount of interest, as well as potential additional interest based on the price change of a financial index. The calculation of additional interest typically also involves complex indexing features such as participation rates, interest-rate caps, and spreads.

But more recent buyers of such annuities could be in for disappointment, thanks to a change in the calculation of their contract’s interest rate. “For many years, indexed annuities were linked to widely followed stock market indexes like the S&P 500 Price Index,” wrote David Allison, CFA, CIPM, and vice president and founding partner at Allison Investment Management, in a blog post for the CFA Institute. “But that has changed.”

Citing data from US-based financial data provider Moore Market Intelligence, Allison said that only 52% of indexed annuity sales in Q3 2018 were for S&P 500-based products. Looking at the rest of the indexed annuity products sold during that period, the Nasdaq 100 was the only other index that got more than a 1% share of the market — with a 1.8% share.

“Many of these [annuity-indexing] options do not represent any market or market segment and can be downright esoteric,” he said. “More than 50 exotic or ‘volatility-controlled’ indexes are available in today’s indexed annuity universe.”

With that in mind, he referred to a few important details about such indexes that investors should watch out for:

  • Volatility-controlled indexes typically maintain a set volatility target by tracking rules-based trading strategies that are designed to manage asset-class exposures. These strategies are formulated to de-risk during times of volatility, which reduces hedging costs for insurance carriers. Because of that, such carriers can offer more enticing interest-crediting features, such as higher interest-rate caps, along with volatility-controlled indexes.
  • Investors who are accustomed to more straightforward indexes may not anticipate the twists that arise in the return calculations of volatility-controlled indexes. Those include the fact that performance is often calculated net of a certain servicing cost and based on an excess return over a specified reference investment. Also muddying the water is the fact that some of the indexes include ETFs with their own internal costs.
  • Most volatility-controlled indexes are also created based on simulated performance track records. Those simulations are conducted using back-tests that can include decades’ worth of historical returns data. “[L]ive and simulated returns may be conflated in annuity illustrations and marketing material,” Allison said.

Citing a study by Vanguard, he said that index-based financial products with back-filled data tend to attract more assets, but the superior back-filled performance tended to not persist after the indexes went live.

“There are now more than 70 times as many indexes as there are stocks globally,” Allison said. “Now more than ever, investors need advisers who will help them decide whether index-linked financial products are built to sell or built to last.”