Fixed Indexed Annuities: Dissecting Performance Expectations

Abstract

In today’s low interest-rate environment, fixed income securities will not be able to deliver returns of the past. As structured solutions to the principal protection problem, fixed indexed annuities (FIA) can be effective bond replacements in a retirement portfolio through an efficient risk transfer. In this paper, we compare the performance expectations of common FIA structures and present practical comparisons given different market conditions. Simulating the various structures over time, we find that participation rates should be preferred to cap rates except in low and range-bound equity markets, which historically have been less common. We also show that volatility-controlled or 'vol-controlled' indexes should be preferred to non-vol-controlled indexes under most conditions. In either case, an FIA should be expected to considerably outperform comparable bond exposures in a range-bound or expected increasing rate environment like we have today. Finally, we show that vol-controlled FIA performance is essentially independent of the vol-control target because increasing option prices offset expected improvements in performance.

Keywords: fixed indexed annuities, retirement security, retirement income

JEL Classification: G10, G11