Product manufacturers in the fixed index annuity (FIA) world seem to be broken down into two groups.

Those who believe, build, and use exotic indices and those who don’t.

The latter warn about the dangers of back-tested results. They’ll say things like, “have you ever seen a bad back-test?” Surely, you haven’t.

(Related: Know Your Clients. Well.)

And I believe most advisors are aware of the risks associated with the newest flavor of the month index birthed by some of the brightest numerically oriented minds within the insurance industry towers. However, more intriguing is the total disregard to a much bigger fault or risk associated with back-tested results, which is present in traditional and exotic indices.

Here’s the two common components of back-testing in FIA’s:

  1. How the index would’ve performed during previous time periods prior to the index’s existence; and,
  2. The amount of an index’s growth a FIA would’ve participated in prior to the FIA’s existence.

In regard to the first component, this only applies to indices too newly formed to have historical data to reference. I believe most advisors understand the risks associated with these back-tests, so I will move on without discussing this further. The risks of the second component are much less understood and seemingly never discussed.

The second component applies to freshman indexes as well as indexes of tenure, like the Dow Jones Industrial Average or the S&P 500. What’s the danger to back-testing an FIA’s would have been growth, for a period when it didn’t exist, using actual historical performance of either of these mammoth of banality indices? Simple, crediting rates are susceptible to changes within an insurer’s overall book yield.

Maybe this isn’t a glaring error. A few years ago, at a home office event, a seasoned producer proclaiming, “an FIA will do better than the market.” To prove his point, he showed that company’s marketing piece, which illustrated an FIA outperforming the S&P 500 over a specific 10-year period. Obviously, this wasn’t intended to implicate this product would outperform the S&P 500 every 10-year period, or even most, but that’s the way he took it. That’s also the way he presented it to his clients.

As a side note, I’ve always wondered if they rescinded his contract due to a clear lack of understanding of their products.

Is this mistake too egregious to contemplate any advisor north of the industry median committing? Yes, but many advisors are making a similar mistake.

Recently I saw a FIA illustrated with a high enough annual participation rate (it also had a spread) to give an annualized rate of return of around 90% of the S&P 500’s gains over the last 40 years, although its only be in existence for the last few.

The advisor was very confident in this illustration. It showed nearly 40 years, both good and bad. Thankfully, in this case, it was an easy conversation with the now current client. I simply asked, “do you really believe you can get 90% of the good with none of the bad?”

He didn’t and neither do I.

Let me back up a bit. We’re 10 years into the longest bull market in U.S. stock market history. Can we agree, at some point, whether in two months, two years, or X number of years that the stock market will stumble out of bull territory and head into Timothy Treadwell’s bear sanctuary? Of course, at sometime the shoe always falls. So, what will happen to FIA crediting rates when the market changes its heading?

What normally happens during periods of negative, or poor, economic production? Do interest rates go up or do they typically go down? They go down. The Federal Reserve will try to use monetary policy to spur economic growth by trying to lower the Federal Funds Rate. A lower Federal Funds Rate leads to lower lending rates, which in turn are should increase economic output.

Said differently, after a period of poor economic output, we expect the Fed rates to decline, which would result in a reduction to an insurers’ yield on new policies. This is what happened in previous down-turns.

As more of an insurer’s overall book (meaning their total assets) is invested at a lower yield, the overall book yield is reduced. Think of it this way. If I have an entire bowl of salted, buttery popcorn, the overall yield is delicious. But as I add more and more unsalted, unbuttered popcorn, the deliciously appetizing yield of my bowl is decreased. It’s less and less savory.

As the overall yield declines, the carrier, often, reduces current rates on new products and slowly adjusts the rates on existing policies (the book). Combined, these actions bring the carrier’s spread (difference between yield and costs) back to the desired margin.

Another side note, this is why existing policies renewal rates are less influenced by increased yields than new policy rates because the overall book yield adjusts more slowly than the current yield.

Let’s make this simple, when the economy goes bad, the fed will slash rates, when they slash rates an insurers’ overall book yield will decline and as a result, they’ll lower renewal rates. So, although an FIA might have X% cap or X% participation rate, illustrations using current rates back-tested against historical returns of a known index should be a big warning sign.

For example, imagine utilizing say a 50% annual participation rate in the S&P 500. Back-testing could show several periods where the FIA would outperform the S&P 500. However, these back-tested results assume a static, consistent indexing rate. And isn’t it fair to assume the largest annual gains of the S&P 500 are likely to come after the largest annual losses? Aren’t these the very years our economy is likely to be in contraction rather than expansion? And isn’t it likely that during periods of economic contraction, that the Fed will use monetary policies that negatively affect FIA index crediting rates?

One plausible argument to this would be that back-tested years have higher average book yields than we currently have. Therefore, while book yields are reduced, their overall yield is still greater than that of today. Interesting, but it ignores other pricing factors like agent compensation. For example, if higher crediting rates are needed to drive FIA growth, then why are FIA sales at all time highs? Doesn’t this mean, the consumers are satisfied with the index crediting rates? Therefore, any positive long-term yield increase could result in greater carrier margins and agent compensation before an increase to FIA index crediting rates.

This being said, if you’re using an FIA for accumulation, then I’d strongly suggest you use a short surrender schedule. If the FIA has a X% participation rate, then prepare clients to receive X% while things are good, 0% for the few years while things go bad and level out, and then the minimum participation rate (or cap, or whatever) while things start their uproar from their subterranean low point. The longer the term of the FIA, the less you should focus on the current index crediting rates, since the longer the FIA is held, the more likely it will be held during a period of negative economic output. And when things go bad, the Fed will… Well, you get the point.

Before we end this, can I ask you one simple question? If an insurance company presented you with a new product and showed you back-tested results which were sub-par, negative, or materially lagging the products’ sub-segment, then would you as a consumer purchase it?

Here’s a better question, would you as an advisor, recommend it? In either case, NO! Therefore, either knowingly or unknowingly, we’ve asked for provocatively illustrated back-tested results. But, back-tested illustrations are like a dating site photo, or a job applicant’s resume. They’re the best version you’ll ever see. In fact, it’s probably something you’ll never personally witness because it’s a reflection of what was, not what will be.

— Read 8 More Dave Ramsey Myths Debunked on ThinkAdvisor.


Michael J. Markey Jr. (Photo: MM)

Michael Jay Markey Jr. is a co-founder and owner of Legacy Financial Network and its associated companies. He has been a member of the Million Dollar Round Table member and a winner of Court of the Table and Top of the Table honors.