Why Advisors Shouldn't Dismiss Index-Linked Annuities

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.