Be Wary of Fixed Indexed Annuity Illustrations

Fixed indexed annuities, or FIAs, are having a moment. Sales are at an all-time high, driven by market volatility and higher interest rates. FIAs are a type of annuity in which the rate of return is based on the movement in a market index, such as the S&P 500.

Financial professionals selling FIAs typically provide potential buyers a visual representation, or an illustration, of how the annuity might perform under different circumstances.

Unfortunately, instead of providing clarity, illustrations often cause more confusion or mislead prospective buyers. Why? Because model regulations allow insurers to show projected returns using unrealistic assumptions.

This doesn’t mean that the actual products are necessarily a poor choice, as I wrote about in a recent paper. But I do think that the National Association of Insurance Commissioners should rethink indexed annuity illustration guidance.

Below I map out three reasons why these illustrations aren’t always reliable.

Past Performance Isn’t Indicative of Future Results

FIA illustrations—and indexed universal life illustrations, for that matter—use historical returns to project the future. According to the regulation, FIA illustrations must show three scenarios when depicting projected account values and index returns.

1. The first scenario assumes that the historical performance of the index in the most recent 10-year period repeats.
2. The second scenario is the “low” scenario. In this case, the illustrated index returns are based on the 10-year period, from the last 20 years, which resulted in the least index value growth.
3. The third scenario, the “high scenario,” is the same as the low scenario except that the 10-year period resulting in the most index value growth is used.

Assuming historical returns will repeat is not the best way to show how an FIA (or any product) may perform. The first scenario, for example, might show unrealistically high returns if the illustration is generated at the tail end of a bull market.

A better method would be to illustrate a variety of return scenarios based on the product manufacturer’s pricing projections (insurers do not assume historical returns repeat when pricing the product).

They Include Backtested Exotic Index Returns

The issue I described above is greatly exacerbated when an exotic index, or an index with nontraditional features, is used. Exotic indexes are increasingly popular with FIAs, and are often custom-built for the product by an investment bank or asset manager.

The methodology behind an exotic index is typically developed through extensive data mining. In other words, the index creator will test all kinds of rule-based trading strategies until satisfactory backtested returns are generated.

This matters because backtested returns are allowed in product illustrations. More specifically, the backtested index returns are included with the actual historical returns when projecting returns under the three scenarios I described above.

This can result in product illustrations with completely unreasonable return scenarios. For example, in one product illustration that I reviewed, the annualized rate of return for the “low” scenario was over 12%, and the annualized rate of return for the “high” scenario was about 17%.

At the end of the day, I don’t think that using an exotic index will lead to substantially better outcomes than a standard stock index. They may even lead to worse outcomes, as some FIA policyowners have concluded. Several have filed lawsuits over index performance.

They Assume Constant Cap and Participation Rates

Product illustrations assume that the current cap, participation rate, trigger rate, or other index rates stay constant in the projection. The reality is that the rates are only guaranteed for an initial period (often one year), and they are reset on a regular basis thereafter.

While insurers generally try to keep renewal rates consistent with the first-year rates, there are external factors that influence the rates. For example, if the cost to buy options increases substantially, the renewal rates are likely to be lower. Further, as noted by Wink, some insurers offer first-year teaser rates, which are rates designed to attract new business. Then, in the second year, the rates are reduced. Side note: It is very important to request renewal rate history before buying an FIA.

In any case, the key point is that cap, participation, and other index rates do vary over time. And instead of assuming constant rates in the illustration, I believe that a better approach would be to illustrate several scenarios where the index rates change. This would help consumers better understand the product mechanics.

FIA Return Expectations

I have provided several reasons why actual FIA returns may be lower than what is illustrated, but what is actually a reasonable return expectation?

In my recent paper, I found that a decent benchmark for an FIA with a guaranteed lifetime withdrawal benefit is a 20/80 portfolio. The appropriate benchmark for an FIA without a guaranteed lifetime withdrawal benefit may differ, but I do not expect it to deviate much from the 20/80 portfolio. It’s also worth noting that the appropriate benchmark ultimately depends on the specific product and credited rate method chosen.

The Bottom Line

FIAs are not necessarily a poor choice. I think they can serve as a fixed-income substitute. I also think that FIAs with a guaranteed lifetime withdrawal benefit can help certain investors that need or want more guaranteed income.

However, prospective buyers should not buy these products because of unrealistic return projections. Illustrated returns that appear too good to be true likely are.