Exotic Indexes: Built to Sell or Built to Last?

By David Allison, CFA, CIPM Posted In: Alternative Investments, Drivers of Value, Economics, Performance Measurement & Evaluation, Portfolio Management, Standards, Ethics & Regulations (SER)

Investors have been piling into indexed annuities with the hope of participating in rising financial market indexes. But they might be disappointed — even if markets scale to new heights.

Indexed annuities are unique among annuity products: They promise investors a minimum amount of interest plus potentially additional interest based on the price change of a financial index in conjunction with complex indexing features, such as participation rates, interest rate caps, and spreads.

A record amount of money poured into indexed annuities last year despite their complexity. According to LIMRA, indexed annuity sales for 2018 rose 27% year over year, to a record $69.6 billion. The products sold especially well in the volatile fourth quarter, setting an all-time quarterly sales record of $19.5 billion.

But recent buyers of indexed annuities may face an unexpected wrinkle in how their contract’s interest rate is calculated. For many years, indexed annuities were linked to widely followed stock market indexes like the S&P 500 Price Index. But that has changed. In the third quarter of 2018, only about half of indexed annuity sales (52%) were for S&P 500-based products. The only other index whose share exceeded 1% was the NASDAQ 100, with a 1.8% share.

Not Your Parent’s Index

Today’s indexed annuity buyers often choose among several indexing options when evaluating interest-crediting strategies. Many of these options do not represent any market or market segment and can be downright esoteric. More than 50 exotic or “volatility-controlled” indexes are available in today’s indexed annuity universe.

There are a few important details about these indexes that investors need to keep in mind:

Volatility Control: Volatility-controlled indexes generally track rules-based trading strategies designed to manage asset class exposures as a means of maintaining a set volatility target. Their built-in volatility-control mechanisms are designed to de-risk during volatile periods, reducing hedging costs for insurance carriers. This way, these carriers can offer more sellable interest-crediting features, such as higher interest rate caps, along with volatility-controlled indexes.

Fees and Excess Returns: The return calculations of these indexes have twists that investors accustomed to more straightforward indexes wouldn’t expect. Performance is often calculated net of a servicing cost and on an excess return basis. For example, one such index’s returns are determined on an “excess return basis over the sum of (i) a notional cash deposit at Fed Funds, compounded daily and (ii) a daily index cost of 0.5% per annum (accruing daily).” Moreover, some of the indexes contain exchange-traded funds (ETFs) that have their own internal costs.

Simulated Performance: Most volatility-controlled indexes are created with simulated performance track records. For example, one index went live on 31 March 2015 but charts returns going back to 30 April 1999. So live and simulated returns may be conflated in annuity illustrations and marketing material.

Do Index-Linked Annuity Illustrations Measure Up?

It’s hard to believe the average indexed annuity buyer understands how volatility-controlled indexes work given their complex investment strategies, return calculation methods, and back-filled performance data.

How volatility-controlled indexes are sold may add to the confusion. Though sometimes referred to as “market indexes” in marketing materials, these indexes are not designed to track any market or segment of the market. Moreover, some annuity illustrations link actual index returns with backtested index returns and might unintentionally mislead investors who fail to read the fine print or aren’t well-schooled in such backtesting pitfalls as overfitting. A Vanguard study showed that index-based financial products with back-filled data attract more assets, but the superior back-filled performance tends not to persist after the indexes go live.

A National Association of Insurance Commissioners (NAIC) working group proposed doubling from 10 to 20 years the minimum amount of time an index or its constituents must exist for it to be used in annuity illustrations. In a letter to the NAIC’s Annuity Disclosure Working Group, an industry representative pointed out that this proposed standard would eliminate many of the volatility-controlled indexes available today.

But even this reform may not give investors enough clarity. The GIPS recommendation is that practices for presenting model, hypothetical, and backtested performance be considered — this one in particular: “Performance should only be provided to clients, prospects or consultants who are sufficiently experienced and knowledgeable to assess the relevance and limitation of theoretical performance of the financial product.

Built to Sell or Built to Last?

Money flows suggest that investors have grown to trust index-linked products. But we are a long way from the traditional concept of indexing. There are now more than 70 times as many indexes as there are stocks globally. Traditionally conservative financial products — annuities and CDs, for example — are now tied to exotic indexes with back-filled return data. 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.

What is your take on the way financial products linked to exotic indexes are being sold to individual investors?

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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