A Framework for Evaluating Fixed Indexed Annuities

A Framework for Evaluating Fixed Indexed Annuities

SOLUTIONS & MULTI-ASSET|PORTFOLIO SOLUTIONS GROUP|INVESTMENT INSIGHT|MAY 2020

A quick search on the internet reveals some troubling statistics about the current state of U.S. individual retirement plans:

? One in three Americans have nothing saved for retirement1

? Only 12% of individuals 55-64 years of age have what they need for retirement2

? Social Security will be cut by 23% over the next five years even though one-half of U.S. retirees currently depend on it for 50% of their income3

? 76% of baby boomers with the ability to save do not believe they can accumulate enough money to see themselves through retirement4

AUTHOR

Needless to say these figures are very alarming.

In this article, we will provide an introduction to Fixed Indexed Annuities (FIAs) and describe their potential to

PATRICK REID, CFA

Managing Director Morgan Stanley Investment Management

See p. 4 for important disclaimers

1 A survey conducted in 2018 by personal finance site GoBankingRates found that 56 percent of Americans had only $10,000 put away for retirement and one in three have nothing saved at all.

2 As of December 31, 2019

3 As of December 31, 2019 basicfact-alt.pdf

4 As of December 31, 2019 Investment Research Institute

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improve investment outcomes for retirees. We will also present a framework that investors may use to evaluate the range of FIA offerings that are available to them.

Introduction to Fixed Indexed Annuities

An FIA is a tax-deferred, long-term savings vehicle issued by an insurance company that combines principal protection with the opportunity for asset growth based on the performance of an index or set of indices. For certain investors, FIAs may be an attractive option because they have low correlation to many other traditional investments. In addition, they mitigate the effects of broad market swings. In some cases FIAs also provide guaranteed income at retirement.

Not all FIAs, however, are built alike. Important differences include:

? Underlying indices

? Participation rates (i.e., the degree to which an investor benefits from a rise in an underlying index)

? Fees

Choosing the most appropriate FIA, determining how much to invest in it and understanding how it may interact with other investments in a portfolio is challenging. Unfortunately, in our view, the tools and information that investors need to tackle these issues are inadequate.

To help investors make informed decisions about FIAs we have developed a simple framework to evaluate these issues. The structure is as follow:

STEP 1: Examine indices on a standalone basis

STEP 2: Evaluate indices in relation to the FIA

STEP 3: Consider the FIA in the context of a broader investment program

We believe that this framework can help investors determine whether FIAs are a good choice for them, understand which indices might work best for them and, importantly, become more confident about their retirement-related financial decisions.

Applying the Framework

STEP 1: EXAMINE INDICES ON A

STANDALONE BASIS

While insurance companies structure and distribute FIAs, the underlying index or indices are generally designed and managed by third-party firms. Key questions that investors should seek answers to include:

1. WHO IS THE INDEX PROVIDER? Is it a reputable, well-known firm? Does the firm have expertise in this area of investing? Is the firm respected as a steward of capital or a fiduciary?

2. HOW HAS THE INDEX PERFORMED?

What is the track record of the index over different time periods? How has it fared in both favorable and unfavorable market environments?

3. DOES IT SEEM LIKE A SENSIBLE LONG-

TERM OPTION? Is the index designed to respond and adapt to future market developments?

4. DOES THE PRODUCT DESIGN MAKE

SENSE? What is the risk profile of the index and how does this align with the investor's risk tolerance? What asset classes or geographies does the index provide exposure to? If the index contains multiple asset classes, how do they work together to enhance or detract from the FIA's growth potential. Are the exposures to the different assets classes fixed or will they change over time? If the latter, what are the driving factors behind the changes and how often do the changes occur?

These are questions investors have the right to ask and that their advisors or sales representatives should be comfortable addressing.

STEP 2. EVALUATE INDICES IN RELATION TO THE FIA

The list of questions below is not exhaustive but may help investors develop a fuller picture about the investment.

1. HOW DOES THE CHOICE OF THE INDEX IMPACT THE FEES ASSOCIATED WITH

THE FIA? Fees are often expressed as a "spread" which is the percentage of return that is deducted from the performance of the index embedded within the annuity. Investors should be aware of how the spread will impact the growth potential of their capital.

2. WHAT IS THE PARTICIPATION RATE?

What level of exposure would an investor get to the selected index? Does the participation rate change over time?

3. HOW DOES THE STRUCTURE OF THE FIA ALIGN WITH THE INVESTOR'S TIME

HORIZON? Given the investor's age, is the expected volatility of the index appropriate? Does the FIA and index provide adequate protection?

4. IS THE GROWTH POTENTIAL OF THE INDEX SUFFICIENT TO MEET INCOME REQUIREMENTS IN RETIREMENT?

5. HOW FLEXIBLE IS THE FIA IN TERMS OF

INDEX EXPOSURE? Can the investor choose from a menu of index options? Can the investor change the index that they have exposure to?

6.WHAT IS THE SURRENDER RATE OF THE FIA?

These are questions all reputable insurance providers and sales representatives should be able to answer for a prospective policy holder.

STEP 3: CONSIDER THE FIA IN THE CONTEXT OF A BROADER INVESTMENT PROGRAM

If investors are considering FIAs as part of a broader portfolio, they will need to understand how those allocations might interact over time. This, of course, would

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A FRAMEWORK FOR EVALUATING FIXED INDEXED ANNUITIES

impact what assets could be available during retirement. Understanding the FIA's exposures and how they may behave relative to the rest of a portfolio can help an investor anticipate or avoid future problems. Being aware of the insurance and capital preservation benefits of the FIA may make an investor feel more comfortable taking risk in other areas of their investment program and hold less cash that is exposed to inflation risk.

Conclusion

FIAs have many attractive benefits. The features of the individual FIA and the indices chosen will impact the investor experience differently. We believe FIAs should be considered as part of an overall asset allocation when planning for retirement. Making trade-offs among FIAs, stocks, bonds and should be done consistently and prudently. We

encourage investors to inform themselves about FIAs and underlying indices with the goal of gaining confidence in retirement planning.

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