Confessions of an Indexed Annuity Purist

Volatility-controlled indexes also have another important advantage. Since these indexes are designed to manage volatility within the index, hedging is much less costly than hedging the S&P 500, according to Barclays’ Index Pricing Model. In other words, the insurance company can buy more options with less money, given the lower cost of the options.

To better understand this concept, compare the cost of buying options on a relatively stable stock, such as IBM, to a highly volatile stock, such as Tesla: as volatility increases, the prices of options tend to rise.

Participation rates on these indexes have become very competitive relative to cap rates. As an example, consider an indexed annuity from Forethought Life Insurance Co., a Global Atlantic company. It offers a 195% participation rate on a one-year point-to-point on the PIMCO Balanced Index (PIMBAL). While this particular index doesn’t have as much history as the S&P 500, we can observe returns that would have been generated by a 195% participation rate back to the beginning of the century.

Using SIMON from iCapital’s Annuities Platform, we can view the hypothetical performance metrics across one-year indexed terms between Dec. 31, 2001, and March 10, 2023. The best return in any of those one-year indexed terms would have been 35.33%, the worst return would have been 0% and the average would have been 9.28%. It is also worth noting that 85.07% of the observed one-year indexed terms would have resulted in a positive return, while 14.93% would have resulted in a 0% return.

Historically, the current pricing on this strategy would have provided an average annual return of 9.28%, much higher than the 6.64% generated from the S&P 500 strategy with the 11% cap. In addition, this strategy would have provided significantly more positive one-year returns.

Some carriers now offer the option of paying an annual fee of 1.0% to 1.5% in order to add to the options budget and therefore increase the participation rate even further. For example, consider a fixed indexed annuity from Eagle Life Insurance Co., offering a 140% participation rate on a one-year point-to-point strategy on the Invesco Dynamic Growth Index (IIDGROW). In exchange for paying a 1.25% annual fee, the participation rate goes up to 220%.

Advisors should keep in mind that this is a true fee, therefore if the index does not increase in price by at least 1.25% during the year, the policyholder would get a negative return of up to … 1.25%. “Zero will no longer be your hero.”

How would these options stack up? Let’s review the data:

In reviewing the performance metrics, we can observe that paying the annual 1.25% fee would have led to more than a 4% greater annual average return per year. However, the tradeoff is that in 12.5% of the observed one-year indexed terms, the policyholder would have suffered a 1.25% loss. Is it worth the tradeoff?

The answer will depend on the individual client’s investment objectives and risk profile. However, it is definitely worth considering.

Regardless of whether you stick with the simple S&P strategy or venture into one of the many volatility-controlled reference indexes, the current interest rate environment provides an opportunity for investors to lock in attractive fixed indexed annuity rates while managing downside risk.

Scott Stolz is a managing director at iCapital Solutions.