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Retirement Planning > Retirement Investing > Annuity Investing

Beware of Backtested RILA Performance

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What You Need to Know

  • Given the complexities associated with RILAs, advisors are increasingly looking at ways to better understand their risks.
  • The historical variation in participation rates creates a significant point-in-time issue when evaluating RILAs.
  • Backcasting the attributes for a product available during a specific period could result in outcomes that are materially different compared to when participant rates were unusually high or low.

Registered Index-Linked Annuities (RILAs) — also commonly referred to as index variable annuities, structured annuities, or buffered annuities — are an increasingly popular product.

RILAs can be viewed as an evolution of fixed indexed annuities (FIAs), to some extent. FIAs tend to be relatively one-dimensional, where the annuitant can’t lose money (i.e., the initial premium) but have limited upside. With RILAs, there is significantly more upside and downside potential, where the actual risk exposures vary notably by strategy.

Given the complexities associated with RILAs, the financial advising community is increasingly looking at ways to better understand their risks and where RILAs can potentially fit in a portfolio. One way to do this would be to simply apply the current RILA attributes (such as caps or participant rates) to historical market returns.

While this might seem reasonable, it can actually result in an incredibly flawed analysis.

The Problem With Historical Returns

RILAs are built using financial options (i.e., calls and puts). For example, a buffer RILA is built by selling an out-of-the-money (OTM) put option (at the buffer level), buying an at-the-money (ATM) call option, and selling an OTM call option. The higher the price of the OTM put option, the higher bond yields, and the lower relative cost of the OTM call option will all increase the potential upside of the product.

Understanding the pricing mechanics of RILAs is incredibly important when thinking about how the attractiveness has evolved over time and why you can’t simply use historical returns to backtest them. For example, right now, it’s possible to get a 20% buffer RILA with a 6-year term with an unlimited cap and 100% participation rate.

For those unfamiliar, participation rate is the percentage of the gains of the underlier that would be achieved for the respective term of the product. For example, with a 100% participation rate the annuitant would receive 100% of the gains of the respective index, up to the assumed cap, which for this analysis is assumed to be unlimited.

What’s not necessarily clear, though, is how the attributes of today’s RILAs compare to those that would have been purchased ten or twenty years ago. To provide some perspective on this, I put together an analysis where I estimate the participation rates for a RILA with a 20% buffer where the underlier is assumed to be the S&P 500 from January 1871 to October 2022.

For the analysis, options are priced using the Black-Scholes model with a constant implied volatility of 25% (both over time and across strike prices), where dividend yields and 10-year government bond yield data obtained from Robert Shiller’s website, for terms of one, three and six years.

Participant Rates on a 20% Buffer RILA by Term: January 1871-October 2022

Backtesting RILAs analysis Source: Robert Shiller’s website, author’s calculations

We can see that the participation rates for the respective terms would have varied significantly over time and that current participation rates are relatively low. While the participation rate on a 6-year term 20% buffer RILA in the model is estimated to be around 100% today (consistent with available products), the historical median participation rate is closer to 170%, which would result in significantly more upside.

The historical variation in participation rates creates a significant “point in time” issue when evaluating RILAs, since backcasting the attributes for a product available during a specific period (e.g., today) could result in outcomes that are materially different compared to when participant rates were unusually high (e.g., the 1980s) or unattractive (the year 2020).

Capturing Current Market Factors

The primary reason participation rates (as well as caps, if that was the primary upside level) are so much lower today (vs. the long-term historical average) is the relatively lower bond yield environment. Lower bond yields result in less revenue available to generate the upside (i.e., purchase the OTM call options), and to the extent bond yields exceed dividend yields can also negatively impact options pricing dynamics.

The change in the composition of returns for S&P 500 historically is also important to be aware of, because dividend yields were historically a much larger portion of the total returns of the stock market, and individuals who purchase RILAs only receive the price return.

Overall, this analysis suggests care should be taken when analyzing RILAs. An analysis that uses historical returns and today’s features is likely to dramatically understate the potential upside of the product and yield dubious results. Therefore, forecasted returns that accurately capture today’s expected return environment should be used in any kind of analysis.

For readers interested in learning more about the economics behind RILAs, and the potential benefits of the approach, I’d recommend reading something I put together for the Alliance for Lifetime Income, which is available here.

David Blanchett is Managing Director and Head of Retirement Research for PGIM DC solutions, an Adjunct Professor of Wealth Management at The American College of Financial Services, and a Research Fellow for the Retirement Income Institute.


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