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.
HYBRID INDICES
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. 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.
'DOESN'T THAT SOUND BETTER?'
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.”
GROWTH
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.
WHY COMPLEX?
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.
DIFFICULT TO EXPLAIN
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.
CALCULATING INTEREST
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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