Fixed-indexed annuities may be the darling of the moment, but some of the illustrations detailing the way they are likely to perform in the future are misleading, Spencer Look, associate director for The Morningstar Center for Retirement & Policy Studies, says in a new research report.

Financial professionals selling fixed-indexed annuities (FIAs)—a type of annuity where the rate of return is based on the movement in a market index such as the S&P 500—typically provide potential buyers with an illustration that details how the annuity might perform under different circumstances, Look says in his report.

But in the case of fixed-indexed annuities, instead of providing clarity, illustrations often cause more confusion or mislead prospective buyers, Look said in an interview. The reason is model regulations governing the industry allow insurers to use projected and back-tested returns with unrealistic assumptions, according to his report.

“I think that plenty of consumers see the illustrated historical returns beating the stock market and that is their primary reason to buy these products. I think it is very important that consumers aren’t misled and expect 12% returns, which I've seen in my review of illustrations,” Look said. Companies used returns as high as 17% for the high-return scenario in illustrations, according to his study.

"I do think the National Association of Insurance Commissioners should rethink indexed annuity illustration guidance," Look added.

The NAIC did not respond to a request for comment.

Sales of fixed-indexed annuities have hit an all-time high, driven by market volatility and higher interest rates. FIA sales jumped 35% to $48.5 billion in the first half of 2023, according to LIMRA.

“FIA products offer an appealing combination of investment growth with principal protection. With cap rates nearing or exceeding 10%, there are few investment options that can offer a higher potential guaranteed return with full principal protection,” Todd Giesing, assistant vice president at LIMRA Annuity Research, said in a statement.

Look doesn’t think the products themselves are necessarily bad. In fact, he has shown in past research that they can benefit a retirement portfolio over time. “But I do think benefits can be overblown in illustrations,” he said.

Rather than assuming historical returns will repeat to show how an FIA may perform, which can show unrealistically high returns if the illustration is generated at the tail end of a bull market, a better method would be to illustrate a variety of return scenarios based on the insurer’s pricing projections. Insurers do not assume historical returns repeat when pricing the product—only when illustrating performance, Look noted.

Concerns over FIA illustrations “are greatly exacerbated” when an insurer uses an exotic index, which can be custom-built for the product by an investment bank or asset manager. The NAIC allows insurers to use back-tested returns that are generated by testing all types of trading strategies.

Insurers are able to combine historical and back-tested returns, which produces “completely unreasonable return scenarios. For example, in one product illustration that I reviewed, the annualized rate of return for the ‘low’ scenario was over 12%, and the annualized rate of return for the ‘high’ scenario was about 17%,” Look said.

“At the end of the day, I don’t think that using an exotic index will lead to substantially better outcomes than a standard stock index. They may even lead to worse outcomes, as some FIA policy owners have concluded. Several have filed lawsuits over index performance,” he added.

The FIA illustrations also assume that the current cap, participation rate, trigger rate, or other index rates, stay constant in the projection. The reality is that the rates are only guaranteed for an initial period (often one year), and they are reset on a regular basis yearly, Look said.

Some first-year FIA rates may be teaser rates that are reduced in the second year. “Rates vary over time and instead of assuming constant rates in the illustration, a better approach would be to illustrate several scenarios where the index rates change. This would help consumers better understand the product mechanics,” he said.

Look’s research has shown that a decent benchmark for an FIA with a guaranteed lifetime withdrawal benefit is a 20/80 portfolio.