As the annuity marketplace evolves in reaction to the Department of Labor fiduciary rule, more and more insurance carriers are jumping onto the buffer annuity bandwagon as the popular products continue to gain traction with clients. 

While this is clearly the case, it’s more important than ever that advisors take a step back and evaluate these products carefully to ensure that they really meet the client’s financial needs. The relatively new product offers an appealing cross between an indexed annuity and a variable annuity that clients clearly want, but advisors should look before they leap in order to avoid surprise liability (and potentially unhappy clients) down the road.

Buffer Annuity Basics

A buffer annuity is a cross between both variable and indexed annuities.  Rather than investing clients’ premiums primarily in mutual funds, buffer annuity sub-accounts are typically invested in complicated structured products (such as options contracts).  This feature is attractive to many clients because structured products often provide the potential to offer higher returns.  However, they also carry more significant risks than the traditional mutual fund investment because of the types of underlying investments involved (which often include emerging markets and REIT index options).

Buffer annuities, as a result, do not protect (or claim to protect) completely against the risk of investment losses.  Most products only offer a degree of downside protection (they provide a “buffer” against market losses).  For example, when a buffer annuity offers a 10 percent buffer against losses, the insurance company that sold the product will absorb the first 10 percent of losses.  The investor himself 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 percent and the cap is 6 percent, 6 percent will be credited, but if the gain was 1 percent, the client would receive the 1 percent credit because it is less than the cap amount).  Buffer annuities usually offer caps of around 8 to 9 percent.

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.

Recent Negative Attention

While buffer annuities may initially seem like a glowing solution to the concerns of still-risk adverse clients, the complexity of the products makes it difficult for even the experts to understand—in some cases leading to unpleasant surprises for clients who have relied on the advice of these experts.  In fact, FINRA has been handling several complaints that have been made about buffer annuities in recent months.

While it is possible that clients who have recently lost money through a buffer annuity investment may be able to recover some of their losses, using a lawsuit as an avenue for recovering losses is unappealing to most clients.  Because buffer annuities focus on accumulation value, rather than providing stable income during retirement years, buffer annuities may not be suitable for clients who are looking for the typical security offered by an annuity.

These clients need to understand that unlike most annuity products, where principal is entirely protected or income is guaranteed, a buffer annuity investment can produce a loss depending upon market performance.

Conclusion

Buffer annuities can provide an attractive investment for clients who understand and accept the risks associated with the product—but because the product still carries the term “annuity,” advisors should use extra caution in ensuring that the client fully understands those risks—and that the product is different than the annuities the client may be familiar with.

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For previous coverage of annuity product planning in Advisor’s Journal, and for in-depth analysis of the various types of annuity products, see Advisor’s Main Library.

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