Crazy Annuity Indexes

Indexes available in an annuity are a material part of any contract you might analyze.  It does, after all, translate to how much money can be made and what type of expectations are reasonable.  Several years ago the options were very simple and each contract usually had just a few options.  As more companies entered the market and product options were expanded, every company slowly but surely added “proprietary” indexes, created and managed by investment institutions.  It was a competitive edge for a company to have an index to itself that performed well.  So everybody ended up doing the same thing.

Newsletter November 27,2020: Index Annuities Have Evolved

It used to be simple so I like to keep it that way.  Standard indexes like the S&P 500, Dow Jones, Russell 2000 and NASDAQ are easy to understand and easy to track.  The new ones not so much.  Some of them have ticker symbols and are traded publicly but many are managed privately and in-house at the financial institution that created them.  Tracking is always possible but not as easy when you are dealing with a proprietary index.

It’s not to say this is a bad thing but I’ve seen too many overoptimistic illustrations based on a brand new index that’s only been around for a couple of years.  Some of these have had good years and I’ve recommended them in the past but the sales claims based on absolutely no legitimate data drive me crazy.  Most of the people who call saying they regret a past purchase were expecting a brand new index to follow backdated performance from a time when it didn’t exist.

Newsletter March 24, 2023:  BS Annuity Illustrations

Risk Control Mechanisms

These new indexes are a blended mix of equities, commodities and always have a fixed component of bonds, treasuries or cash to reduce risk.  The basic idea is to reduce exposure to down markets, kind of like regular investment management.  The tradeoff is that by reducing risk, the upside is somewhat limited as well.  If you have “ABC Daily Risk Control 5%” index, then you have an index that is rebalanced daily to maintain a volatility target of 5%.  Many people see that and think it’s something like a cap rate but it bears no indication of what type of yield you can expect.

The Chicago Board of Exchange Volatility Index (VIX) is an index that measures relative risk in the markets.  The indexes in annuities use this to determine the percentage of assets that are exposed to equities markets.

A 5% volatility target is easy to understand if explained properly but many agents fail to do so, or just don’t understand it themselves.  If the VIX is at 20% then a 5% risk control index would only have a quarter of its assets exposed to the market so if the market rises, the index would only get a very small piece of the gain.  Since the VIX has been well above average for the past few years, most of these indexes have not been keeping pace with the market.  Risk control indexes will offer volatility targets up to 12%, which gives significantly more growth opportunity but comes with larger swings between the top and bottom.

The other issue is the cash component in these indexes.  If only a portion of the index is allocated to equities or commodities, the remainder is placed in cash, bonds or treasuries, depending on the rules of the index.  Performance of that part of the index can also be affected positively or negatively with changes in interest rates.  If rates rise, cash-based assets lose value and the index drops.  If rates drop, cash-based assets increase in value and the index can rise, even when the overall stock market has dropped.  The balance between equities and safe assets in a blended index must be understood to explain performance over a period of time.

Blended indexes will do just fine if rates stay steady, volatility is low and the market climbs.  When there’s lots of volatility and rates are all over the place you’re likely to see some lackluster performance.  It’s really no different than a lot of managed portfolios.  Blended indexes can do very well at certain times but don’t expect them to repeat past performance.  The past 15 years have mostly seen steadily decreasing rates, except for 2018 and 2022.  With continually falling rates, a backtested index with 5% risk control would have a cash component that added a healthy boost to overall performance.

Over the past couple years, rising rates along with a flat stock market has created dull performance in blended indexes.  Some have done fine but most have been flat at best or declined a fair bit at worst.  Most of the contracts that I’ve seen do well were allocated to standard indexes like the S&P 500.  Going forward I think that’s the prudent approach as well, with a little bit of money tied to a blended index in case the market drops and rates decrease.

These indexes are not all bad, it just takes specific circumstances to achieve reasonable performance.  And it’s no place to chase fads.  Now when someone tells you about some brand new index with great numbers, you’ll know exactly how to analyze it.  What is the equity component comprised of?  What is the target volatility level?  What type of cash instrument is used for risk control?  Read this over again and you’ll be ahead of most agents trying to sell it.  Just because the past ten years won’t be like the last doesn’t mean you can’t achieve good results but at least you know when a crazy annuity index is worth using and when it’s not.

Have a great weekend…


Watch The Podcast Episode: Crazy Annuity Indexes

Last Updated on September 21, 2023 by Bryan Anderson