In a previous blog entry I described the basic mechanics of structured note variable annuities (SNVAs). The products’ partial or complete downside protection plus potential to participate in investment index-linked returns are proving popular with investors and sales continue to grow.

The presence of structured notes adds complexity to VAs, which can already be quite complicated. Investors must consider index selection (if multiple indexes are available), segment and segment duration, performance caps and buffers in addition to the usual VA-features and benefits.

SNVAs have attracted criticism, as well. Advisors considering the products for clients should review a recent Journal of Retirement article from Fairfax, Virginia-based Securities Litigation and Consulting Group (SLCG), a financial economics-consulting firm. (You can download the article, Structured Product-Based Variable Annuities, and view a video discussing the research.)

Here’s a high level summary of the paper’s approach and key findings. The authors demonstrate how capped and buffered structured notes can be decomposed into a portfolio of four financial assets:

1) a zero-coupon bond;

2) a short European put option with a strike price equal to the buffer level;

3) a long European at-the-money call option, and

4) a short European call option at the cap level. It sounds complicated but the article’s diagrams illustrate how those assets replicate a structured note’s payoff profile.

It’s possible to price each component at the VA’s issue date by using formulas like the Black-Scholes option model. These formulas include assumptions about the index used, volatility, dividend yield and interest rates, among other factors. Using these models, the authors ran pricing backtests with various caps, buffers, assets and segment lengths.

The tests’ goal was to calculate the fair cap rate for each month from January 2005 through April 2013; they define a fair cap rate as one that results in a contract value equal to the premium paid minus a1 percent fee. In other words, it’s the rate that produces a combined option and bond position—i.e., the four financial assets—that’s worth 99 percent of the premium paid.

In case this sounds like too much rocket science, recall a standard present value calculation. If you know the term, present value, cash flows and future value, you can calculate the “fair” interest rate that equates the cash flows and future value to the present value. It’s the same idea with this analysis: given the contract’s features and assumptions used in the pricing models, you can calculate a fair cap rate.

SLCG found that SNVAs’ cap rates are often set below fair value. In other words, investors are getting a sub-optimal deal: “Our analysis suggests that fair cap levels are often very high; any lower cap would imply a premium charged to the investor.

Although traditional variable annuities must recoup high sales commissions through charges and penalties, spVA (structured product VA) issuers can recoup those expenses by setting the cap. This may explain why the three spVAs currently in the market differ in regards to their surrender charge schedules. An issuer could offer a product with a lower surrender charge or lower annual fee but select lower caps on its spVA segments to maintain profitability.”

The paper is not light reading so it’s worth watching the video discussion. Even if you disagree with the assumptions and conclusions, however, it’s helpful to encounter an analytic, non-marketing perspective on SNVAs.