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May 09, 2023 at 09:19 AM
What You Need to Know
- Recent lawsuits around annuities using custom indexes have sparked debate about sales practices and tools available to demonstrate performance.
- Backtesting can introduce unintended consequences if the results are framed as expected performance of the product.
- Custom indexes have a vital role to play in an annuity, but they do not guarantee the best possible outcomes in all instances.
The wish to offer attractive principal-protected products while in a low-interest-rate environment prompted the proliferation of custom indexes and their inclusion in insurance products over the last decade. Most notably, in fixed indexed annuities (FIAs) we saw a persistent shift of premium allocations from benchmark indexes such as the S&P 500 to custom risk control indexes.
With the increased use of these novel, sometimes complex indexes, there are still misperceptions concerning how they work.
Recent lawsuits around annuities using custom indexes have sparked debate about sales practices and tools available to demonstrate performance and understand the functionality of these indexes, on their own and within annuity products. The roles and responsibilities of index providers, insurance carriers, advisors and ultimately end clients enter the discussion as well.
As a contribution to this debate, let’s take the opportunity to try to dispel some misperceptions concerning not only custom indexes themselves, but more importantly, their role when used in FIAs.
No Active Management, No Fiduciary
The first point to make is that a custom index is fundamentally different from an actively managed fund. With a custom index, there is no portfolio manager making decisions regarding composition, allocations or weightings through time.
Instead, a custom index is calculated according to a predetermined set of rules. The index provider sets these rules at the inception of the index and ensures the rules are followed thereafter. So, a custom index is in essence non-discretionary.
The index provider does, however, have a high-level responsibility to ensure that the index continues to meet its objectives over the years. To this end, index providers reserve the right to step in and exercise discretion to fix problems. But the index provider is not a fiduciary, and a custom index is not actively managed.
However, because the index is rules-based, the investment process is, in principle, fully transparent, meaning it can be replicated. This is in contrast to an actively managed fund, which is often opaque with no insight into the actions of a portfolio manager.
Another significant distinction is the absence of “style drift.” The way an index selects and allocates to different assets and asset classes is solely driven by the index rules. For example, if you chose an index because it selects low-volatility stocks, you will always get that, and never highly volatile growth stocks.
One potential source of confusion may be that many indexes are provided by large asset managers and banks that have asset management operations. But a custom index from such a provider is not to be confused with any fiduciary asset management services they may offer.
