Indexed products: Why so popular and what are the downsides?

Senior Editor John Hilton interviewed Sutton White, head of Annuity Product at Life Innovators, during the recent NAFA Annuity Leadership Forum to discuss how indexes work and why indexed products resonate so well with consumers. But threats lurk, mainly from regulators who want to crack down on proprietary indices.

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Interview Transcript:

John Hilton:

Welcome, everyone. My name's John Hilton. I've been an editor with InsuranceNewsNet and covered the financial services industry for the past eight years. I'm here today at the NAFA Annuity Forum, and I have with me Sutton White from Life Innovators. Welcome, Sutton.

Sutton White:

Thanks, John.

Hilton:

Why don't you describe a little bit for our audience what you do and what Life Innovators does?

White:

My background, I've been in the industry over 20 years. I started on the distribution side with Wachovia. That's how long ago that was. Went through the Wells Fargo merger. I then left and went down to Atlanta to run the annuity platform at SunTrust, their broker-dealer. I then left there in 2014, moved back to Charlotte to work for MetLife. So I went from the distribution side to the manufacturing side. Immediately started working on the spinoff with Brighthouse. Went through the spinoff, and then in 2018, moved over to Jackson National and ran their fixed indexed and RILA product development over there.

In 2021, I had an opportunity to come to Life Innovators with Bobby Samuelson, and I'm the head of annuity product. We're a turnkey product development shop, but we do more than just product development. We do consultations with holding companies that are looking to get into the industry, offer turnkey services around standing up insurance carriers all the way from the IT stack to product development to distribution. So we kind of cover the gamut on that. So we've been doing that it'll be two years next month.

Hilton:

And how are things going? I know annuities are selling way beyond record numbers, so I mean, you picked a good time to jump into a new venture like that. I mean, how are things going?

White:

It's always better to be lucky than good, right? So we certainly timed it right. I think we were trying to be at or near capacity at a year. We were there about six months into it. We since hired three people, couple of actuaries and a sales and marketing head, and we continue to get new contracts. So we've got five products in market now. We're looking to have a sixth probably later this year, and a seventh the first of 2024. So we're extremely busy.

Hilton:

Let's take advantage of some of your wealth of experience here, and we're going to talk about indexed products today, specifically indexed annuity products. So talk a little bit about... I mean, these products are some of the best selling products on the market, so talk about why that is. Why does everyone want an indexed product?

White:

I think there are a couple reasons. So 2022 was a record year for FIA. It was a little over $79 billion in sales, which was an all-time record for fixed indexed annuities.

We think the drivers are for a couple reasons. One, the protection of principal, right? So as folks are moving from the accumulation stage in their retirement or pre-retirement to retirement, they're much more sensitive to being able to have principal protection and not have to go through some of the market corrections and volatility that they may have gone through in the past, right? And obviously, as you get closer to retirement, the time to recover your portfolio gets much shorter. So being able to protect principal with still having some upside growth is certainly important. So that's been the primary driver.

I think there's some secondary drivers such as a flight to safety. Not only principal protection, but being able to allocate amongst different index options or even a fixed account. So it gives you a lot of flexibility inside of one contract. So those are a couple of the reasons we've seen for FIA and why they've continued to take off.

Hilton:

Yes, and even though interest rates have climbed to heights we haven't seen in quite some time, indexed products continue to sell well. I saw you recently in Utah at another conference, and you mentioned registered index-linked annuities continue to sell very well. So are these products immune to not only interest rates, but economic conditions as they seem to be?

White:

No, they're definitely not immune. I think the rise in interest rates actually help FIAs more than they do RILAs. As you've seen interest rates go up, you've actually seen cap rates go up because the options budget that the carriers have to spend is actually larger in a rising rate environment.

So it's interesting the dynamics of what we've seen where engineered indices or proprietary indices had garnered the lion's share of the market for the past few years, driven mainly because interest rates were so low, it was hard to offer a competitive cap on an S&P or another traditional index. What we saw last year was the allocations to engineered indices went down from about 60% to about 38%, and the rise in S&P, as well as a rise in allocation of fixed accounts.

So I think what we're seeing is probably a correction in terms of historically FIAs, the engineered indices were not quite as prevalent as they have been in the low interest rate environment. As interest rates continue to rise or level off and stay high, I think we'll continue to see more folks allocating to the S&P and other traditional indices, and maybe not quite as much allocation to the engineered indices. Yeah.

Hilton:

So let's get into these indices. Now, I've been told that 15, 20 years ago, there were maybe a handful of indices, and now there's over 150. And the growth is obviously in proprietary indices with fancy names like Mosaic. So can you talk a little bit about why? Why does everyone want their own index, and what are some of the problems with these?

White:

It's a great question. I would say yeah, the amount of what we call engineered indices, some people call them smart beta indices, proprietary indices. Basically it's an index that's created maybe not just for the purpose of being in an indexed annuity product, but they might have this index live and it's in a fee-based platform or some other platform other than annuity. Some are created specifically for the annuity. But like I mentioned earlier, the interest rate environment is really what drove the proliferation of it, because it was just impossible to get a competitive cap rate on the S&P. Even two years ago, we were seeing caps on the S&P at 4%, 3.5%, where you can offer a proprietary engineered index and have a much higher cap, a cap that's stable, but generally you'll see participation rates, and they'll have very high participation rates.

The trade-off with these indices is generally that they have some kind of vol control. And what vol control does, or volatility control does, is it allows the index provider to have guardrails. So they're going to kind of know where the return is going to be, and if all gets really high, they don't have to worry about the return getting super high. If the return is low, they don't have to worry about necessarily a huge downside. So it gives them kind of a corridor to operate, which allows them to keep options prices steady, which also allows for them to provide steady cap rates and participation rates. Which from a consumer standpoint is very helpful, right? I think we've seen certainly in the last year, with where interest rates have gone, where volatility is, renewal rates have not been as competitive as people would've expected them to be.

This kind of helps that conversation, the fact that for some of these engineered indices, your cap or par rate is going to stay steady. That's mainly because of the agreement between the hedging partner and the carrier or the counterparty. They have a fixed options cost on these.

The downside is there's not really a huge market for the options. So if you're offering a proprietary index, you're kind of beholden to whoever your counterparty is. So it can get a little tough for a carrier if they were wanting to go out and have a competitive bid on options prices, they're not able to do that, right? So that in turn leads to is it competitive, is it not. And with the vol control component, it makes it even a little bit less transparent around how these indices actually work and what the returns are.

My concern with the proprietary indices is... So you mentioned the proliferation of proprietary indices. I think the last number I heard was around 180. Excuse me. We track about 160. And I was actually going through those numbers recently, and last year, 2022, the number of those out of 160 indices, there were seven that were positive. So I think going back to the allocation to these proprietary indices, a lot of folks that kind of got whipsawed in this high volatility period in 2022 are looking at these proprietary indices and going, "Well, okay, I thought this was supposed to sort of levelize my return, and even if the market is bad, I might get a slight return." And I think what we saw was that it didn't necessarily help in terms of counterbalancing the overall market.

And even going into 2023, looking at it, there's a lot of indices that are positive, but they're nowhere near the S&P, right? So if you're looking for an equity-like return on these products, that's not really what these products are built for, right? So I think a lot of it goes to does the client understand what they're buying, does the producer understand what they're selling, and if they're okay with middle-of-the-road type returns and they're not looking for equity returns, then they're probably okay. But I think some people go into these products thinking, "A hundred percent downside protection and equity-like returns, what could go wrong?" And I think 2022 was kind of a reckoning for that, where it was like, "Okay, well, now I understand better that these are going to be more fixed income type returns than equity type returns."

Hilton:

You just mentioned the problem there. Only seven out of 180 or so are really returning a profit. So clients end up disappointed. So that leads us to our next topic. They end up disappointed because they were shown an illustration of, to quote one lawsuit I recently covered, 6%. So they're connected, right?

White:

Yes.

Hilton:

So indexes lead to illustrations. What are the problems with illustrations?

White:

I think that is probably the number one concern for these engineered indices. They don't have any actual historical data. Most of them don't. So when a carrier launches or offers a proprietary index, they're counting on backcasted or backtested returns, which essentially is if this index had been around in 2008, this is how it should have performed based on the rules of the index.

Now, the problem with that is there's no actual data to be able to say yes, it did perform or it didn't perform that way. So you get into a little bit of an illustration problem where carriers are illustrating these backtested results and saying, "Hey, this index would've averaged 11% over the last 20 years." The problem is you don't know what it would've actually done. So when a client buys it and expects an average of an 11% return in something that's principal protected, generally you're setting yourself up for disappointment, right?

So that's where the proprietary indices get into a little bit of an issue. And again, it goes back to understanding what's being bought and what's being sold. If you understand that a proprietary index might offer a good non-correlated asset to the market, or that it provides some diversification in your portfolio, then it's a hundred percent going to do that for you. But if you're expecting 11 or 12% average return on something that has a vol control and is a non-correlated asset, it's probably not realistic, right?

I think the other place where illustrations run into an issue is some illustrations illustrate backtester performance, some are illustrating income riders or death benefit riders. That's where it gets also a little concerning because if you're illustrating an income rider, and depending on how the income rider is structured, it might depend on strong market returns to provide some astronomical income amount. And when the performance isn't there and the income amount isn't there, it tends to upset the client because they're like, "Well, I thought I was going to have a million dollars a year to retire on. I have $200,000. What's the deal?" Right? So I think illustrations can be a handy tool, but they should definitely be a tool and not necessarily the primary selling option of an annuity.

Hilton:

So that leads us to the regulators. And insurance, of course, regulated at the state level, and the State Association of Insurance Commissioners have been targeting these illustrations for some time now. They have settled on AG 49-B right now, and I listened to one speaker recently say there could be an AG 49-C as they continue down this road. What are your thoughts on... I guess these are kind of patches, let's call them. So what do you think will happen and what are your thoughts on this kind of patching they're doing?

White:

Yes. And AG 49-B and potentially AG 49-C are really offshoots from the IUL illustration. So indexed universal life. Which to me is a little bit different from a fixed index annuity in terms of an illustrated rate on an IUL can become a problem because of cost of insurance that's embedded in the indexed universal life contract. So if performance doesn't meet a certain threshold, you actually could wind up either losing money because of cost of insurance or even having your policy lapse. So the performance on the illustration for an IUL, much more important in terms of how the policy's going to behave than with the fixed index annuity. The fixed index annuity, the worst case you're going to have is zero, right? Unless you have some type of rider or something on there that's deducting a fee, your principal is always protected.

So that being said, and going back to what we were talking about, I would foresee some type of regulation coming down for FIA illustrations. Maybe not quite as arduous as AG 49-B or C, but something that puts in some level of parity of what's being illustrated versus what a realistic return is, whether it's comparing the backcasted results to a benchmark indices or to a 60/40 portfolio or something like that. I do think it's important to offer transparency to the client and the producer to be able to accurately benchmark, "Here's what the backtested results are, but here's a more likely case of what it might look like," right? If for nothing else, to help facilitate that conversation between the producer and the client to level set the expectation on it.

Hilton:

Recently you were in Salt Lake City for another conference and talking a lot about registered index-linked annuities, and you're bullish on RILAs continuing to perform very well. Could you maybe summarize, and I don't know if there's any updates in the couple months since then, but could you summarize why you feel that way?

White:

I think since RILAs really came out in 2010, and when they started to get a lot of traction in 2014, the question has always been, "Well, that's great, but what happens when we have a market correction? Or what happens when interest rates rise and FIAs become more competitive and maybe RILAs aren't quite as the shining star?" Right? Because part of the reason RILAs gain popularity, and there's multiple reasons, but one of the reasons is because they could offer much higher cap rates than an FIA could in a time of low interest rates. That's mainly due to the fact that RILAs are priced a lot on volatility, and that there's some downside participation. So that allows you to offer a higher upside.

In 2022, I was actually pretty pleased to see that RILAs were only up 6% year-over-year. I would've anticipated RILAs would've been down, as we saw FIAs have a record year, and even fixed annuities like MYGAs. But the fact was that RILAs still continued to see growth even as FIAs had a record year, even as fixed annuities had a record year, even as interest rates rose. So to me, it's an indicator that the RILA category is certainly a permanent category.

I think the other thing is that as we see some regulations start to kind of ease a little bit on the requirements for filing RILAs, I would anticipate seeing more carriers get into the market, which is why I'm still pretty bullish. I know there's a lot of carriers that want to be in the market, but feel like the filing requirements are a little bit arduous and just aren't willing to do that.

So it's certainly, I think, was good news for RILA that 2022, they continued to see growth, and they're still showing moderate growth this year as well. So I think not that 2022 was the ultimate test, but it certainly was a test and one that I feel like RILA, the category, passed pretty well.

Hilton:

As I cover some lawsuits on FIA sales gone bad, disgruntled clients, customers, the companies come back to the disclosures. You signed this. It was in bold even. Do you feel the disclosures are effective in these cases or in general?

White:

I'm not a lawyer, so it's hard for me to say one way or another, but I would say based on my experience, the disclosures are generally pretty thorough. Where I think the class action suits are focusing on and where the disclosures may not go is around the indices and the index performance, right? Generally when you see a disclosure, it's around the product, it's around suitability, it's around the core of what the client's buying. The index allocation isn't always part of that, because one, you can change index allocations at any time in most products. So having it as part of the core disclosure may or may not be effective if you allocate in the S&P and then a year later, you're allocating in a proprietary index. There's no real way to update a disclosure to provide anything to the client.

I think where some of these lawsuits have sort of dialed into is certain parts of the indices, and the one that I've seen personally is around excess return, right? And not disclosing the impact of what the risk-free rate does in an excess return index, right?

So for so long, the risk-free return rate was zero, right? Because interest rates were so low. Now all of a sudden, because treasuries have spiked up so high, the risk-free rate might be around 3, 4, 5% depending on when you're looking at it. So these excess return indices that are illustrated with a 0% risk-free rate are now performing in a market where it's a 5% risk-free rate, which means it creates almost a hurdle, right? A hurdle rate that the index has to get over before it starts to credit any positive returns. So when you look at it in an excess return world, that's created a lot of concern from the client saying, "Hey, this was never disclosed to me that if the risk-free rate or how excess return worked, or if the risk-free rate moved up, it would impact my returns on the index," right?

So I think it would be interesting to see where this all lands, because again, an illustration is just that, it's an illustration, and there's lots of caveats around past performance is not indicative of future results. So I think it's going to be interesting to see where the courts land in terms of yes, this wasn't disclosed specifically, but there is a buyer beware type caveat on most of these illustrations. And if you're buying this for index return or performance, it could turn into more of a suitability issue than a product functionality issue. Does that make sense?

Hilton:

We've seen these products evolve over the years. Is there anything coming next or what would be the next evolution of a indexed product?

White:

Yeah-

Hilton:

Annuity.

White:

I think we're certainly seeing some innovations on the product side in terms of the designs, right? There's new designs coming out, including one that we've actually helped design that actually allows you to open up floors in your gains to get higher cap rates and still comply with non-forfeiture and all the things that make it a fixed indexed annuity. So I think we're continuing to see innovation on the product side.

On the index side, we're also seeing a lot of innovation. I've kind of looked at it we're in the third... I would say proprietary index 3.0. Proprietary indices 1.0 were 10, 15 years ago, maybe they had a 5% vol control, but there wasn't a lot of counterbalance. And I think we saw that a lot in 2022 where clients got whipsawed where volatility was high, the index did what it was supposed to do, which was move them into cash or fixed income or some kind of asset other than equities, and then when equities bounced back, there wasn't enough time for it to move back and capture the upside of the equity. So they kind of got a lot of the downside and very little of the upside.

But I think what index providers have figured out is, "Hey, we can do things like intraday vol, right?" So there's indices that are coming out that have multiple looks at volatility, and we'll manage that volatility five to seven times a day versus weekly or monthly, which is what some of the initial ones did. And trying to stay within that vol control, right? So if it's a 5% vol control, I think what some of the studies have shown is it was actually a 2% vol control because it was moving in and out so quickly that it actually tamped the ball down too tightly. So having multiple looks at the vol during the day or during the week is something that we're seeing as a trend, which I think is going to help performance.

Also moving the vol control target up, right? That's due to higher interest rates. You have more options budget, so you can have higher vol targets. So I think 10, 12, 15% vol targets are kind of what we're seeing now, versus 5%, which was what was earlier.

And the types of IP, or intellectual property, that's going into the indices has gotten much more... It's gotten more complex, but it's also, I think, carrying a little bit more consumer value. We're seeing things like AI and ESG, which take or leave it, ESG is one of the hot dots in terms of category. So it's not just multi-asset 60/40 portfolio with a 5% vol control, there's actually new, different, and possibly more valuable intellectual property and ideas going into these indices to try to help replicate more market-like returns than what we've seen in the past.

Hilton:

Thanks for joining us.

White:

Yeah, thanks, John.

InsuranceNewsNet Senior Editor John Hilton has covered business and other beats in more than 20 years of daily journalism. John may be reached at [email protected]. Follow him on Twitter @INNJohnH.

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InsuranceNewsNet Senior Editor John Hilton has covered business and other beats in more than 20 years of daily journalism. John may be reached at [email protected]. Follow him on Twitter @INNJohnH.