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Michael Finke

Retirement Planning > Retirement Investing

Why Advisors Shouldn't Dismiss Index-Linked Annuities

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What You Need to Know

  • Sales of protection-focused annuities, mainly RILAs, have outpaced sales of other annuity types.
  • Advisors shouldn't dismiss investments that limit downside (and upside) as inefficient gimmicks.
  • Annuity wrappers can be useful for deferring short-term gains until after retirement.

Sales of protection-focused annuity products were higher in the fourth quarter of 2021 than the combined total of accumulation and income-focused annuities, according to data from the Secure Retirement Institute. 

In fact, the sales of registered index-linked annuities (RILAs) have led the protection annuity charge with sales more than doubling from $4.3 billion in the second quarter of 2020 to $8.9 billion by the end of 2021. 

What’s driving the appeal of protection products offered within an annuity wrapper? Why would any investor want a complex financial product that promises protection at the expense of significant upside? And why choose an annuity when similar products exist as ETFs?

In a new white paper written for the Retirement Income Institute, fellow American College Professor Wade Pfau and I take a deeper dive into a collection of financial products that offer varying loss protection and compare them to outcomes from a traditional investment portfolio.

How should advisors think about protected annuities? 

First, they shouldn’t dismiss them as an inefficient gimmick. In a series of detailed articles written while he was head of retirement research at Morningstar, David Blanchett lays out the complex economics that underlie the potential benefits of financial products that use a combination of fixed income investments, equities, and financial options to create a customized distribution of outcomes. 

Why might a retiree prefer an option-controlled retirement investment to a traditional long-only portfolio of stocks and bonds?

According to Nobel laureates Robert Merton and Myron Scholes, financial options can be used to construct investments that “can be used by investors to produce patterns of returns which are not reproducible by any simple strategy of combining stocks with bonds.” A retiree may prefer this altered distribution of possible returns to a conventional portfolio.

Limiting Risk

Consider a 60-year-old baby boomer who is five years away from retirement. The market has performed well over the last decade, and they have $500,000 invested today in the S&P 500 and $500,000 in bonds to fund the lifestyle they hope to lead. 

The distribution of bond returns over the next five years is relatively narrow. The distribution of the overall portfolio is wider and depends primarily on five-year stock returns.

If we run a Monte Carlo analysis on the S&P 500, we can see how much their future wealth can vary by the time they retire at age 65. At the 10th percentile, they will have $410,000. At the 1st percentile, stocks will fall to $265,000. A lucky retiree at the 90th percentile will have over $1 million. 

In five years, they should be able to withdraw about $22,000 from the portion of their portfolio invested in bonds (of course this is a simplification and ignores the potential risk of bonds, which can be significant as we’ve discovered recently).

If the retiree gets lucky and achieves the 90th percentile of returns, they’ll be able to withdraw $47,200 from their stocks based on the 4% rule. If they get unlucky at the 10th percentile, they’ll only be able to withdraw $16,400.  

Is the retiree willing to accept the downside risk of spending $38,400 each year in order to achieve the potential upside of $69,200 if they get lucky? At lower percentiles the potential downside and upside become even more extreme (as low as $32,600 at the 1st percentile). Is this a risk the client is willing to accept?

An alternative is to give up some of the upside to cut off some (or all) of the downside risk. In a low interest rate environment, products with floors offer less upside potential and more closely resemble fixed income investments.

However, unlike the intermediate-term fixed income investments that constitute the bulk of an insurance company’s general account portfolio, products such as fixed indexed annuities (FIAs) won’t fall in value if interest rates spike.  

In practical terms, the distribution of FIA outcomes in a low interest rate environment over five years ranges from 0% at the 1st percentile to 7% at the median to about 12% at the 95th percentile.

Growth is similar to expected growth on safe bonds but without the potential downside of term and credit risk. It should be noted that any attempt to position 0% floor products as “upside with no downside” is disingenuous since the upside is lower at the 95th percentile than a bond fund.

Purchasing a RILA with a -10% floor allows an investor to increase the potential upside to 19% at the 90th percentile. The upside is limited to the call options budget available to capture modest growth after the insurance company invests in bonds to guarantee returning 90% of principal.  A -10% floor allows a bigger options budget than a 0% floor.

Buffered RILAs

RILAs with a buffer allow an investor to accept a greater range of potential upside and downside outcomes. Buffered annuities are an interesting concept because they seem to be tailor-made for loss-averse investors. Why? The insurance company protects against the first 10% of losses, preventing small losses that often result in a big emotional response. However, investors are on the hook for losses beyond -10%.

For example, a -10% buffer would turn the -37% return from the S&P in 2008 into a -27% return. Big negative returns are far less common than small negative returns with a bell-shaped return distribution. Investors are completely protected against most losses and buffered against large ones.

Of course, there is a cost. The insurance company needs to employ an options strategy to provide the buffer. This will limit the upside potential of a RILA distribution. For example, at the 90th percentile a buffered annuity will have a 31% return over five years and taxable stocks will have an 87% return.

At the fifth percentile, a buffered RILA has a -8% return and stocks a -26% return. At any return below the 25th percentile, the buffered annuity provides a higher return than stocks and the difference increases toward the tail, resulting in significant downside protection.

Another Option

Another interesting protection annuity that performed well in our analyses is a variable annuity with a so-called guaranteed minimum accumulation benefit (GMAB).

The product used in our analysis offers a true five-year floor of -10%, resulting in a lower extreme downside than a buffered annuity. GMABs also provide more modest protection than RILAs against smaller downside outcomes with a -10% return at the 10th percentile and a 1% return at the 25th percentile. 

The upside of a GMAB, however, was far higher than a buffered annuity with a 53% return at the 90th percentile and a 66% return at the 95th percentile. 

For an investor who wants to get rid of any possibility that they will have to cut back significantly on spending if they get unlucky with their stock investments over the next five years while giving up only the more extreme upside outcomes if they get unlucky might find the GMAB product more attractive than an unprotected stock investment.

Deferring Gains

An additional advantage of holding nonqualified assets in products that use financial options to tailor an investment portfolio in an annuity wrapper is the ability to defer short-term gains until after a worker has retired.

This is particularly valuable when a worker is in a significantly lower tax bracket after retirement. Of course, gains could be further deferred if the annuity is turned into lifetime income using an immediate annuity that benefits from the exclusion ratio where only a portion of each payment is subject to income taxes.

The insurance companies who manage these products provide value by managing option trading on behalf of the advisor and providing guarantees that insulate a client from volatility swings that could increase option prices. 

Option-protected portfolio strategies aren’t new, but the outcomes they produce appear to be increasingly popular among investors nearing retirement.

This shouldn’t be surprising since many retirees base their decisions about when to retire on the lifestyle they can generate from the investments they hold today. A negative return shock can result in a delayed retirement, or an unacceptable drop in lifestyle that could have been eliminated by cutting off some upside.