Personality of the Year II: Sometimes complexity is necessary to achieve our purposes

The Personality of the Year Award will be presented to Professor Roger Ibbotson at the 2nd Americas Indexed Insurance Awards Ceremony, which will take place on the evening of Wednesday 19 September at The Embassy Club, Des Moines. Professor Ibbotson was chosen on the basis of receiving the highest number of votes from respondents to the 2nd Americas Indexed Insurance Awards Survey 2018.

In the second part of an interview, Professor Roger Ibbotson talks about the reasons behind the growing use of risk control underlyings in the US insurance market, the increased weight of indexed annuities in retirement portfolios and Zebra Capital's contribution to the market.

Another element that exemplifies the evolution of the annuities market beyond the protection element is the diversification of underlying indexes beyond generic benchmarks with the introduction of risk control and smart beta strategies on equity indexes, which have opened up new alternatives and added an extra layer of protection, according to Professor Ibbotson.

Zebra Capital joined efforts with the New York Stock Exchange (NYSE) in early 2017 to launch the NYSE Zebra Edge index, an index that incorporates behavioural finance research on high-turnover, or 'popular' stocks, with the goal of capturing higher returns with lower volatility.

"The NYSE Zebra Edge Index is based on our research which demonstrates the relationship between highly-traded stocks and returns," says Professor Ibbotson.

"The index allocates to an equal-weighted portfolio of large cap equities after removing both overly popular, or high-turnover stocks, and stocks with a higher level of volatility."

By removing the most popular and the most volatile stocks, you are left with less popular, less volatile stocks, which have historically provided higher returns with less risk, according to Professor Ibbotson.

The index incorporates a proprietary risk control overlay to target a specific level of portfolio volatility and leverages NYSE as the index calculation agent with widely-distributed index data feeds, according to Professor Ibbotson.

"This kind of index is ideal for insurance products because the products are designed to protect capital and provide a regular income based on market exposure, but you don't want a very volatile index because insurance companies would then have to offer less equity exposure," says Professor Ibbotson. "Risk control indexes continue to gain traction in the market and we have seen a notable growth over the last few years." In the first half of 2018, fixed indexed annuities (FIA) sales were US$32.1 billion, 14% higher than the first half of 2017. Fee-based FIA sales were US$67m in the second quarter, according to Limra Secure Retirement Institute (SRI).

In a recent whitepaper (Fixed Indexed Annuities: Consider the Alternative), Professor Ibbotson suggests that bond returns in today's historically low interest rate environment may be insufficient in meeting the anticipated retirement needs of US investors, potentially placing many at risk of outliving their retirement savings.

"The research concluded that, in simulation, uncapped indexed annuities outperformed long-term government bonds," says Professor Ibbotson, adding that FIAs are well-established as a specific investment tool for people approaching retirement in the retail market. "When people start approaching retirement they do need to take less risk as the earning power diminishes."

Historically, when yields were falling bonds would deliver capital gains, but with the current low interest rates, bonds actually represent a potential loss in a portfolio, according to Professor Ibbotson.

"Traditionally people relied on Treasury bonds but those instruments now have yields mostly below 3%, and when the yield rises you get a capital loss," says Professor Ibbotson. "We think these indexes are needed to manage people's money in a more efficient way, and by embedding them in annuities the characteristics of the product also improve."

Being an academic it should not come as a surprise that Professor Ibbotson believes education is key to addressing some of the pitfalls when going into FIAs, which include transparency, complexity, cost structure, and liquidity.

"All these potential problems can be mitigated when you deal with a trusted investment adviser and when you understand the risks you are taking," says Professor Ibbotson. "These are long-term investments and people should not expect short term gains."

The complexity of the products is innate to the fact that the products are seeking to address specific needs, according to Professor Ibbotson. "However, complexity does not mean risky, and sometimes complexity is necessary to achieve our purposes.

"This is actually very relevant to volatility controlled indices as they are not as risky precisely because the risk is controlled. Their lack of liquidity could also be seen as a risk element, but if you are a long-term investor this could be a safer way of investing."

People on their own would not be able to get into these products, and for the market to continue growing it needs innovative providers that design products that meet client demand but also provide value, according to Professor Ibbotson.

"[Product providers] need to educate end investors so that they understand that there are always elements to take into account around personal circumstance, risk appetite, etc.," says Professor Ibbotson. "There has to be a collective effort from manufacturers, advisors and supervisors to grow this market, and make it more transparent and bring the cost structure down. People should be able to see the value and feel that they are getting value for their money."

On the subject of regulation, Professor Ibbotson has mixed opinions.

"On one hand I think it is good that we have a framework with an overall principle that advisors and advice products act in the best interest of their customers, as opposed to the ones that merely make them more money," says Professor Ibbotson. "I do see the need to have a sustainable framework where everybody works in the best interest of end investors. However, overregulation can be counterproductive."

The 2nd Americas Indexed Insurance Forum 2018 will take place on September 18-19 at the The Embassy Club, Des Moines. The agenda and details of the conference are available at this link. For registration or information, please contact Helga Tirk at helga@structuredretailproducts.com