If anything good came to the annuity industry from more than a decade of historically low interest rates, it’s the innovation that this environment compelled upon product development.
With options budgets shrunken to extreme levels last year, the “upside potential” of traditional indexes and crediting strategies like the long-suffering annual point-to-point S&P 500 index seemed a bit of an oxymoron if you agree that 2%-4% hardly seemed like upside.
The result of this innovation was an enormous proliferation of custom index choices that shared one common trait. They stretched options budgets to create more palatable upside potential during the secular low-rate environment, which it seems is finally history after 40 years of declining yields.
Since custom index volatility is typically about one-third that of the S&P 500 price return index, those tiny options budgets a year ago had a chance to produce much better returns than the S&P indexed accounts. Whereas the best you might expect from the S&P capped indexed accounts might have been 3%-4% in a year, the custom indexes often came with no caps or at least with caps much higher than the S&P.
The good news (and bad) of rising rates
What a difference a year can make. Now, with corporate spreads broadening and the 10-year Treasury about double where it was not long ago, these new indexes are sporting eye-popping participation rates (for multiyear crediting strategies in particular), such as those that credit every two years or every five years. I am talking about rates that provide 200%, 300% or even 400% in some cases, of the upside performance of the underlying index.
That is simply jaw-dropping if you do the back-of-the-napkin math on potential crediting outcomes. The fact that these remain inside an annuity wrapper that is not a security, and thus not subject to market risk, bends what otherwise seem like the immutable laws of settled financial principles, such as that more reward can only come with more risk.
But tempering the excitement about those big participation rates is the recent performance.
Paradoxically, the key contributing factor to the high par rates — the rise in interest rates — is also the main driver of perhaps the worst performance any of these indexes have ever experienced in their relatively brief (less than a decade for most) existence. Over the past six to 12 months, many of these indexes are down 5%-10%. This might not seem much compared with the 20%-30% declines in equity markets, but for low volatility indexes, that is outlier-level poor performance.
The recent poor performance has greatly depressed compound annualized returns over periods of up to five years. For instance, the HSBC AI Powered Multi Asset Index has a performance of -10.80% for the year to date through mid-July. That has, in turn, greatly depressed one-year, three-year and five-year numbers: -9.93%, -0.41% and 3.08%, respectively.
No matter what your par rate is, those numbers don’t inspire confidence for many. Of course, 10-year numbers look much better at almost 6% annualized. (The index inception date was Jan. 26, 2021, so all performance prior to that date is back-tested.)
Which brings me to the key point here. The window of high participation rates is now open, and nobody knows how long it will last. If the Federal Reserve finishes its inflation-fighting efforts sooner rather than later and markets stabilize, index performance should improve, but there is no guarantee that participation rates for new money will remain as attractive as they are today.
Strike while the iron is hot
But why wait for performance to improve? Why not strike while the iron is hot? Lock in those high par rates today and, given today’s entry points (stocks and bonds are already beaten down, volatility is already high), the future may be brighter than it seems at first blush.
Here is an example: Athene’s Accumax is a fixed indexed annuity that offers the AI Powered Multi Asset Index in a FIA with a five-year surrender charge period. In exchange for that relatively short time commitment, the product offers to credit interest once at the end of five years and provide the owner with participation of 260% of the five-year total performance of the index. Some data to ponder on the potential of this product:
1] With only one crediting period five years in the future, there is plenty of time for the index constituents and design to produce reasonable performance that may be as good as or better than the past five years of just over 3% annualized.
2] Even if the next five years do produce only a 3% average annualized return similar to the five-year period ending June 30, 2022 (which reflects the year-to-date double-digit decline), that would translate into a total return of $15,927 for every $100,000 of purchase amount at the end of the period. Apply a 260% participation rate to that and total interest at the end of the five-year period swells to $41,410.
3] Applying a compound annualized growth rate to growing $100,000 to $141,410 in five years results in about 7.25% return. That is simply an astounding performance for a product free from market risk.
4] Compared with an indexed annuity product using a traditional annual S&P crediting strategy with, say, a 9% cap (about as good as it gets today for non-advisory annuities), the stars would need to be just about perfectly aligned for that to beat this custom index strategy at even a lowly 3% raw index annualized return.
Laurence Black is the founder and principal of The Index Standard, a custom index analysis service based in New York. He has built a business that is not unlike the service Morningstar pioneered decades ago in parsing the thousands of mutual funds available.
“I saw the proliferation of these indexes over the last decade and knew that there was an opportunity to improve the way in which information on these indexes is made available. With increasing product complexity and growing pressure to meet compliance and fiduciary standards, we aim to provide unbiased index ratings and forecasts that are designed to improve decision-making.”
The Index Standard produces a fact sheet on each index, with information on type, region, inception, ticker, carriers that offer the index, and underlying holding categories. More important, as the front of each fact sheet states, they “run thousands of simulations using the consensus market return expectations, along with critical index characteristics to generate forecasted annualized 10-year return expectations.” In doing so, they come up with Conservative (25th percentile), Moderate (50th percentile) and Strong (75th percentile) forecasts.
In addition, the fact sheet includes a section attributing the components of historical index performance, performance — including both the underlying assets (equity, fixed income) — and the design of the index.
For example, the AI Powered Multi Asset Index fact sheet, as of July 1, has a Conservative 10-year return forecast of 4.71%. (The Moderate and Strong are 5.84% and 6.94%, respectively.) According to the report, the index is well diversified with around 18% exposure to equities, 3% to gold and 50% to fixed income. It has some momentum exposure and its dynamic mechanism that rotates through asset classes may deliver an extra ability to outperform (called alpha).
That high index design attribution may be of some comfort to those who place little faith in equities or fixed income to perform well in the next decade — they may not need to for this index to deliver.
Using the Conservative forecast of 4.71% with the AI Powered Multi Asset Index, $100,000 produces $25,875 of growth at the end of the fifth year. Multiply that by 2.6 (to reflect the 260% participation rate offered by the carrier’s fixed indexed annuity), and the index growth is amplified into interest crediting of $67,275. That is the equivalent of a five-year compound annualized growth rate of 10.84%, with zero fees.
You could be forgiven for thinking any product with the potential to return double-digits annualized over five years and with no additional fees while exposed to no market risk was at best highly improbable if not impossible. But indeed, a very rational case for it can be made, as the bar is low for high performance thanks to the annuity innovation available today.