A new type of annuity product that offers a cross between an indexed annuity and a variable annuity has begun gaining attention in the investment world—and not all of this attention has been positive. While the buffer annuity has strongly appealed to investors in a post-recession market who wish to participate in the equity markets while still obtaining downside protection, many of these clients have lodged complaints about the products with FINRA in recent months. (See Middle-Income Retirees Least Likely to Prefer Annuities: EBRI.)
It is therefore important that advisors gain a complete understanding of these products before recommending them to interested clients—and this means knowing the good, the bad and the ugly of the buffer annuity. (see State Crackdown on Annuities Sharpens Suitability Issues for Advisors).
Buffer Annuity Defined
A buffer annuity is essentially an annuity that incorporates traits of both variable and indexed annuities. Rather than investing clients’ premiums primarily in mutual funds, buffer annuities’ sub-accounts are typically invested in complicated structured products (such as options contracts). Structured products often provide the potential to offer higher returns, but also carry more significant risks than the traditional mutual fund investment because of the types of underlying investments (including emerging markets and REIT index options, which can be inherently more risky).
Buffer annuities, as a result, often do not protect completely against the risk of investment losses—most products only offer a degree of downside protection (i.e., they offer a “buffer” against market losses). For example, when a buffer annuity offers a 10% buffer against losses, the insurance company offering the product will absorb the first 10% of losses associated with the product. The investor herself experiences the remainder of the loss.
Although these products are riskier than indexed annuity products (that typically protect against any loss of principal), they can offer higher “caps” than most indexed annuities. A cap, as the name suggests, serves to cap the client's credited interest at the cap amount (for example, if the market gained 10% and the cap is 6%, 6% will be credited, but if the gain was 1%, the client would receive the 1% credit because it is less than the cap amount).
Buffer annuities usually offer caps of around 8% to 9%.
Because of this, the client is able to more fully participate in market gains, which is appealing to many clients who feel that annuities create opportunity losses when the markets are strong. However, clients looking for income protection during retirement should think twice about the risks involved with buffer annuities. (See Lincoln Financial, AIG Launch Fee-Based Annuities: Top Portfolio Products.)
Most of the negative attention buffer annuities are receiving involves the product’s complexity. Much of this complexity arises simply because structured products are a much more complicated investment than mutual funds—meaning that clients are less likely to fully understand the risks associated with these products.
Clients who are looking to accumulate assets as an investment may be drawn to buffer annuities because of the greater potential to participate in market gains, but those looking to secure reliable income during retirement should be wary of this type of investment. Because buffer annuities do not entirely protect against the risk of market losses, it is possible that clients can lose a portion of their principal investment.
It is therefore important for clients to understand the concept of the buffer—which is different than the “floor” that is a common annuity feature. While the floor provides a limit below which the product earnings are guaranteed not to fall, a buffer only reduces the amount that the client can lose by a set percentage. Serious investment losses can cause the product to lose more than the buffer will protect against.
Because the buffer annuity is only a few years old, it is especially important for advisors to become educated in the product to ensure that interested clients are getting a suitable product that they understand fully in order to prevent unpleasant surprises down the road.
See these addtional blog posts by Professors Bloink and Byrnes:
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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