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Structured Annuities Soften Downturns

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Historically, individual investors who wanted to protect against the possibility of big market drops would boost their fixed-income allocations at the expense of equities.

While that approach has held up reasonably well in some downturns, it has not served investors as well in others — particularly the last major selloff in 2007-2008, when historical correlations broke down and bond gains didn’t come close to offsetting equity losses.

A recent research paper from S&P Global examined this period, along with the stock market crash of 2000-2002, and compared traditional equity/fixed-income allocations to an alternative de-risking option — use of risk control structured annuities that protect against dramatic market losses while providing exposure to upside index gains. These products are gaining widespread attention as more and more baby boomers begin focusing on the transition from the wealth accumulation phase of their lives to the distribution phase. Individuals nearing retirement become more cognizant of sequence of returns risk—the danger of a market downturn as they prepare to draw from their hard-earned nest egg.

(Related: Analysts Grade Variable Annuity Issuers’ Stormproofing)

The paper’s findings support our view that risk control annuities belong in many retirement portfolios and can provide a useful hedge against downturns, particularly the big drops that can take an investor’s breath and dollars away. At best, these sharp drawdowns give savers anxiety and, at worst, cause them to make impulsive, irrational investment decisions in times of stress.

The Long Haul

The study first looked at performance over a 22-year period ending in 2017. It found that a portfolio allocated half to a “moderate” 65/35 stock/bond mix and half to a risk control annuity performed almost as well as a traditional 60/40 stock/bond allocation (6.7% annual return for the portfolio with risk control, versus 7.4% for the traditional stock/bond mix), with a similar Sharpe Ratio.

What struck the S&P research team, however, was the marked improvement in the maximum drawdown (the peak-to-trough decline of a portfolio over a set time period) on the risk control portfolios, with 17% for the moderate risk control portfolio versus ‑23.4% for the traditional stock/bond mix. “As expected and by design,” the researchers wrote, “risk control portfolios provided better downside protection for market participants.”

Market Dislocations

After observing the drawdown dampening effect of risk control portfolios over the entire 22-year period, the S&P researchers focused their lens more closely on two events during that time, the stock market crash of 2000-2002 and the 2007-2008 global financial crisis.

They found that during the 2000-2002 crash, a traditional 60/40 stock/bond allocation outperformed (with a -9% total return for the period) the various allocations to risk control annuity products (including the moderate risk control portfolio with a -14.8% return). Maximum drawdown was -17.7% for the risk control portfolio, versus -15.9% for the traditional 60/40 allocation. The researchers attribute the relatively strong performance of the straight stock/bond portfolio to a flight to quality that occurred during the crash, where investors fled stocks and purchased bonds.

That same phenomenon did not occur in the credit market-inspired global financial crisis of 2007-2008, however, and the risk control portfolios provided generally superior results. Total return for the moderate risk control portfolio was -17.1% during the period of the financial crisis, versus -23.5% for the traditional 60/40 allocation. Their maximum drawdowns were -22% and -30.6%, respectively.

The ‘Sleep at Night’ Factor

It is unsurprising that different time series produced different outcomes for the various allocations S&P looked at in their study. The old standby of 60% equity and 40% bond mix held up quite well indeed during what was a classic stock market correction in the first few years of the new millennium.

However, it is instructive to see that risk control portfolios provided generally better protection against drawdowns over the entire period of the study. When markets got really bad in 2007-2008, virtually every asset class seemed to be correlated and plummeting down, yet risk control delivered significantly better protection.

Of course, that doesn’t even speak to the “sleep at night” factor. During either period, investors in risk control products would have likely experienced more confidence in knowing potential losses in the risk control component of their portfolio were finite. Sure, a traditional 60/40 stock/bond allocation may hold up reasonably well in some types of future downturns, but the stress and anxiety likely experienced during volatile times by those who haven’t controlled risk can feel almost infinite.

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Photo: CUNA Mutual

David Hanzlik is vice president of annuity & retirement solutions at CUNA Mutual Group a company that serves clients of financial institutions.