Diversify fixed indexed annuities with custom indices

You know not to “put all your eggs in one basket.” Instead, you want to give your clients a choice of baskets with varying characteristics, risks and return potential that could help shield them from wide, unpredictable market swings as they make steady progress toward their financial goals.

In the same way, your clients may benefit from diversifying inside of their annuities. If they’re interested in protection from market loss and participation in market gains that a fixed indexed annuity (FIA) offers, having a variety of benchmark and custom indices to choose from can help limit volatility and provide long-term diversification benefits, according to research conducted for Athene by The Index Standard.

The benefits of diversification

Spreading allocations across multiple custom index options may provide smoother, risk-managed returns, especially if the indices are not correlated — in other words, the less their fluctuations match, the better. 

Here’s an example using returns from custom index options over three years.

Both indices have average annual returns of 10 percent. Index B is more volatile (8.2%) than Index A, but they move in opposite directions. In other words, they aren’t correlated.

Now let’s put the two custom index options together in the same basket. Your client has equal exposure to each. Here are the combined returns for each year.

The average annual return is the same: 10 percent. But the combined volatility is much lower (4.6%). That’s because the indices’ fluctuations offset each other, creating a smoother overall return.

The S&P 500^®: a benchmark index not built for FIAs

So what if your client had a FIA with two different indices selected — one tracking a standard benchmark index, the other global stocks? They would have some diversification and the potential for more satisfactory returns.

Nearly all FIAs include interest crediting strategies tied to the S&P 500^® index, which is widely used to represent the overall equities market. But it wasn’t designed to meet the needs of FIA owners. That’s because even though the S&P 500^® historically has returned approximately 10 percent a year, short-term returns can vary widely.

Since 1957, when the modern S&P 500^® was born, returns over any 1-year period ranged anywhere from a loss of almost 50 percent to a gain of almost 75 percent. For any 10-year period, you would expect returns to be more stable, and they were — between a loss of 6 percent and increase of 17 percent a year.

That 10-year number is important, because it’s the typical time horizon for many FIAs. If your client owns a FIA, they likely value the security and stability of the product. And they might not find the potential to lose 6 percent a year on the FIA’s underlying index a suitable risk, since it means a 0 percent credit.

Controlling risk in custom indices

But if you apply a custom index to a FIA, you’re adding diversification to the basket. Custom indices use a rules-based mechanism instead of a human asset manager to control volatility. 

The custom indices within FIAs target a desired level of volatility. When the underlying index becomes more volatile, the mechanism shifts the allocation from the high-risk asset to a stable asset (like cash). When the custom index becomes less volatile, the opposite occurs. 

No matter what’s happening in the market, however, the custom index’s volatility control mechanism seeks to limit volatility to a preset “target” level. As a result, your client might not enjoy all the gains when the market rises, but they’re better cushioned against major drops, leading to potentially smoother returns.

You could consider a FIA that includes both a custom index and the S&P 500^® to increase the diversity of a client’s portfolio. You have a lot of options for custom indices today: they can be based on U.S. equities only, global stocks, and a mix of stocks, bonds and other types of assets. When the two indices are combined within the FIA, the amount of combined fluctuation decreases, generally smoothing out returns.

For clients seeking principal protection from market loss and growth potential, modern FIAs with custom indices as well as benchmark indices provide more diversification. Determining the appropriate FIA and custom index selection needed for a client's "basket" can help them build a more secure retirement.

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