Despite sharing the same basic structure, all fixed indexed annuities (FIAs) are not created equally. While the S&P 500® is the most popular benchmark index for FIAs, a growing segment of the market is made up of annuities that track custom indices.
The distinction is critical: Although FIAs do not make direct investments in the markets, their performance is linked to an underlying index or indices. By tracking custom indices, FIAs can target specific return characteristics while also potentially generating greater value for investors than annuities that use the S&P 500® as their benchmark.
Know these five important index features as you evaluate FIA options
1. Specific objectives or strategies
Custom indices are often structured to suit a specific strategy. For example, an index may track an equity index or it may target a specific sector (say, only utilities stocks) or a geographic region (such as international versus U.S. equities). Likewise, an index may be composed of assets with low correlation to the S&P 500®, which only tracks equities for 500 of the largest U.S. companies. However, an index consisting of mixed assets that aren’t highly correlated to the S&P 500® may generate greater client value depending on economic conditions.
An index’s objectives can help individuals who are attempting to target specific strategies within their overall savings plan and can offer diversification benefits alongside a portfolio that already has significant exposure to the S&P 500®.
2. Custom blends of asset classes
Many FIAs feature custom blends of several underlying indices, with the goal of reducing risk through diversification. This flexible approach allows the indices to vary their exposure to a mix of asset classes using proprietary methodologies to determine which constituents offer the best risk-reward profiles for current market conditions.
3. Tactical rebalancing and reweighting
The frequency with which an index’s components are rebalanced and reweighted can affect an annuity’s performance. For example, the composition of the S&P 500® changes relatively infrequently, meaning that annuities tracking this index have little opportunity to generate performance that’s substantially different from the U.S. stock market.
By contrast, custom indices might be rebalanced and reweighted at the end of every month, or perhaps even every trading day, making them more responsive to changes in the financial markets. This strategy can result in more consistent performance that follows a different path than using benchmark indices.
4. Risk control mechanisms
Many indices in a FIA use a risk control feature that seeks to manage performance to a particular volatility level. These indices rely on dynamic asset allocation — including an allocation to cash — that is adjusted based on market conditions. If markets are stable, the annuity typically is fully exposed to the index’s mix of assets, such as stocks, bonds, and commodities. However, if the market shows signs of volatility, the risk control feature reduces exposure to the index and increases exposure to cash, cushioning against sharp declines.
These risk control features have a rules-based approach to avoid very high positive returns and very low negative returns, with the goal of more predictable, stable performance. And by narrowing the range of both positive and negative performance, annuity providers can offer greater participation rates which provide more value to the client.
5. Crediting strategies
The combination of being guaranteed against losing money due to market downturns and growth opportunities based in part on the upward movement of an index is part of a FIA’s appeal. While it’s possible to earn no interest in any given crediting period, interest credits will never be less than zero, and once they’re earned, they are locked in. In exchange for the guarantee, crediting strategies limit participation in the underlying index generally as a cap rate, participation rate or spread fee. Multiple crediting options with 1- or 2-year periods allow clients to have more options to grow the value of their annuity over time.
Translating design features into potential FIA performance
Understanding the components that go into custom indices can help you assess how a FIA might perform in various market conditions, as well as the potential value of a product. That way, you are better prepared to steer clients toward the FIA that best suits their portfolio, goals and appetite for risk.
FIA sales continue setting records with 2023 end of year expecting to grow up to 10 percent. Their design elements providing growth potential and principal protection, as well as a growing number of custom indices, are part of the reasons why.
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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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