Have indexed annuities become too complicated?

The emergence of several "exotic" indices within indexed annuity contracts have arguably made these products more complex than they need to be

Dec 16, 2016 @ 10:30 am

By Greg Iacurci

Fixed indexed annuities are becoming more complex.

To a certain degree, the product evolution driving that complexity is inevitable, as insurance companies seek to stand out and grab a bigger piece of a market whose annual sales have been growing for about a decade and are on pace to have their best year ever.

However, some analysts and industry executives argue indexed-annuity design has grown too convoluted, to the detriment of advisers and their clients.

They point specifically to the uptick in new, “exotic” indices used by insurers, as well as a broad number of mechanisms used to determine the interest credited to an investor.

“They are complex, unnecessarily so, if you ask me,” said Sheryl Moore, president and CEO of Moore Market Intelligence, who tracks indexed annuity products.


The basic structure of an indexed annuity is actually more complicated than the product's name suggests. An indexed annuity doesn't operate like an index mutual fund, which buys a mix of securities to mirror a stock or bond index.

Rather, insurance companies direct the majority — roughly 90% to 95% — of a policyholder's premium to fixed-income investments such as bonds, with the remainder used to buy options on a market index. That sliver of options is what delivers variability in returns.

Over the past few years, insurance companies have introduced indexed annuities tied to what Ms. Moore calls “exotic” indices, which differ from well-known types such as the S&P 500, Russell 2000 or Barclays U.S. Aggregate Bond index.

They are what Wink Inc., a market research firm, dubs “hybrids,” many of which have some sort of volatility management or multi-asset characteristics. Recently launched examples include the UBS Market Pioneers index, JPMorgan ETF Efficiente 5 index and the Barclays All Caps Trailblazer 5 index.

Insurers have seized on such indices as a way to make their products more attractive, but in reality they don't offer much benefit beyond traditional indices and only serve to confuse advisers and investors, analysts and executives say.

Some of the asset management firms sponsoring these hybrid indices, especially the investment banks such as Goldman Sachs, Morgan Stanley and Merrill Lynch, charge an additional fee (roughly 50 basis points) to investors to manage the index, whereas an S&P 500 index doesn't cost extra, according to Ms. Moore.

That could complicate a sale under the Labor Department's conflict-of-interest rule coming into force in April. Known as the fiduciary rule, which governs investment advice in retirement accounts, the regulation requires advisers to recommend products in customers' best interests, and is expected to put a laser focus on fees.

It may prove more difficult for advisers to recommend a product with a hybrid index that carries an additional cost, if the index doesn't add much value beyond a traditional index, Ms. Moore said.


A popular sales pitch for indexed annuities is “market upside with no downside,” because insurers can't credit less than 0% interest to the policy over a given time period. Many policies have a “cap” to the upside, so there's a maximum amount of interest an insurer will credit in the event the market goes gangbusters.

Persistently low interest rates have caused insurers to lower caps on their products, but hybrid indices provide a way for insurers to offer “uncapped” versions.

One of the most effective ways for insurers to differentiate is to say a product can provide more interest, in theory, than competitors, according to Scott Stolz, senior vice president of Private Client Group investment products at Raymond James & Associates Inc.

“From a marketing point of view, if you can say your strategy is uncapped, doesn't that sound better?” Mr. Stolz said. “In reality, they put enough restrictions on it that it's not formally capped, but it really is.”


Use of hybrid indices has swelled the past few years. In 2013, six hybrid indices were available for indexed annuities; today, there are 47 unique hybrid indices, according to Wink data.

“Really, it's alarming how quickly this trend has been picking up,” Ms. Moore said.

They've grown to be the second-most popular index choice on products sold, behind the S&P 500, representing 30% of indexed annuity sales in the third quarter this year, according to Wink. That's up from 22% in the same quarter last year.

The majority use an uncapped strategy.


Allianz Life Insurance Co. of North America, the biggest seller of indexed annuities, offers two such indices: the Bloomberg U.S. Dynamic Balance Index and PIMCO Tactical Balanced Index.

The purpose of both is to manage and stabilize volatility, according to Matt Gray, senior vice president of product innovation at Allianz. The PIMCO index, for example, which launched this year, manages for interest-rate movements by managing allocations daily among the S&P 500, cash and a bond component with a duration overlay.

The reason hybrid indices can be coupled with uncapped strategies is simple: Putting a cap on an S&P 500 indexed annuity helps insurers control volatility and risk exposure, but that volatility management device is already built into hybrid indices.

Some volatility-controlled indices move beyond “simple” underlying asset classes (stocks, bonds, cash) and use more esoteric ones such as commodities, emerging markets and precious metals, according to Mr. Gray, who said Allianz doesn't allocate to such assets.

“That could be good in the right circumstances, but you have to look at what's the point of it,” he said.


For advisers and investors, the complexity of hybrid indices derives from unfamiliarity and not having an easy way to track them, analysts and executives said.

“It's difficult to explain, when a client asks at the end of the year 'How did you calculate what I got?'” said Mr. Stolz of Raymond James.

Judson Forner, vice president of investment marketing at ValMark Securities Inc., an independent broker-dealer, shared that sentiment.

“I think it can add to the complexity, because you may not know what that index is,” Mr. Forner said. “You can't turn on Bloomberg and look at the different indices.”

Some firms, such as Wells Fargo Advisors, have turned away from them.

“We don't allow for those esoteric indices that the general public never heard of and would find it hard to track,” Bernie Gacona, director of annuities at Wells Fargo, said. “I believe in complete transparency and simplicity and that's how we built our index annuity platform 2½ years ago.”

Ultimately, the bells and whistles seem to be all flash and not much substance. Raymond James has analyzed the available indices, Mr. Stolz said, and “our fundamental view is they'll all return about the same thing.”

Quantified, that's about 1.5% more than on a traditional fixed annuity, today equating to around 4% to 4.5% over a 10- to 15-year time frame, he said.


Of course, exotic indices aren't the only complication with indexed annuities.

There are currently 12 ways insurers can calculate interest on an indexed annuity contract, Ms. Moore said.

Annual point-to-point crediting is the most popular method, where an insurer credits interest to a policy on the contract's anniversary based on where an index value starts and ends over the year. But there are also methods such as monthly point-to-point, term end point, and daily and monthly averaging, among others.

There are additional ways to control interest credit, through use of “spreads” and “participation rates.” Uncapped annuities are often paired with one of these mechanisms.

A spread of 2% means the insurer will keep the first 2% of returns and credit the remainder to the annuity. A participation rate of 70% would provide an investor with 70% of the contract's upside over a given period.

And more indexed annuities are being purchased with living benefit riders, which provide a guaranteed income stream. Such riders are popular with variable annuity contracts, but are known for having nuances that can prove complex.

Of course, not all parties view these additional features as a bad thing. Some such as the Insured Retirement Institute argue proprietary indices and new crediting strategies represent market innovations that provide more flexibility and choice, which help advisers cater to broad financial situations of their clients.

“As with all innovation across the industry, adviser training and education will have an important part in ensuring the strategies' features and mechanics are fully understood and can best be incorporated into a plan,” Cathy Weatherford, IRI's president and CEO, said.

Ultimately, though, executives such as Mr. Stolz and Mr. Forner suggest their advisers use an S&P 500 index with a cap, crediting interest using an annual point-to-point method, to keep it simple.

“Whether it's too complex is open to debate. They're certainly more complex than they used to be,” Mr. Stolz said.


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