Page 18 - Investment Advisor October 2022

ANNUITIES UPDATE

By Michael Finke

Why Advisors Shouldn't Dismiss Index-Linked Annuities

Investments that limit downside (and upside) aren’t “inefficient gimmicks.”

ales of registered index-linked FIA outcomes in a low interest rate envi-
annuities (RILAs) have more than ronment over five years ranges from 0%
Sdoubled from $4.3 billion in the at the 1st percentile to 7% at the median
second quarter of 2020 to $8.9 billion to about 12% at the 95th percentile.
by the end of 2021. What’s driving the Growth is similar to expected growth
appeal of protection products offered on safe bonds but without the potential
within an annuity wrapper? Why would downside of term and credit risk. Still,
any investor want a complex financial any attempt to position 0% floor prod-
product that promises protection at the ucts as “upside with no downside” is
expense of significant upside? And why disingenuous since the upside is lower
choose an annuity when similar prod- at the 95th percentile than a bond fund.
ucts exist as ETFs? Purchasing a RILA with a -10% floor
First, they shouldn’t dismiss them as an allows an investor to increase the poten-
inefficient gimmick. In a series of detailed retire at age 65. At the 10th percentile, tial upside to 19% at the 90th percentile.
articles written while he was head of they will have $410,000. At the 1st per- The upside is limited to the call options
retirement research at Morningstar, David centile, stocks will fall to $265,000. A budget available to capture modest
Blanchett lays out the complex econom- lucky retiree at the 90th percentile will growth after the insurance company
ics that underlie the potential benefits of have over $1 million. invests in bonds to guarantee returning
financial products that use a combination In five years, they should be able to 90% of principal. A -10% floor allows a
of fixed income investments, equities, and withdraw about $22,000 from the por- bigger options budget than a 0% floor.
financial options to create a customized tion of their portfolio invested in bonds RILAs with a buffer allow an inves-
distribution of outcomes. (of course this ignores the potential risk tor to accept a greater range of poten-
Why might a retiree prefer an option- of bonds). If the retiree gets lucky and tial upside and downside outcomes.
controlled retirement investment to a achieves the 90th percentile of returns, Buffered annuities are an interesting
traditional long-only portfolio of stocks they’ll be able to withdraw $47,200 from concept because they seem to be tai-
and bonds? According to Nobel laure- their stocks based on the 4% rule. If lor-made for loss-averse investors. The
ates Robert Merton and Myron Scholes, they get unlucky at the 10th percentile, insurance company protects against the
financial options can be used to construct they’ll only be able to withdraw $16,400. first 10% of losses, preventing small loss-
investments that “can be used by inves- Is the retiree willing to accept the es that often result in a big emotional
tors to produce patterns of returns which downside risk of spending $38,400 each response. However, investors are on the
are not reproducible by any simple strat- year in order to achieve the potential hook for losses beyond -10%.
egy of combining stocks with bonds.” upside of $69,200 if they get lucky? At For example, a -10% buffer would
Consider a 60-year-old baby boomer lower percentiles the potential downside turn the -37% return from the S&P in
who is five years away from retirement. and upside become even more extreme 2008 into a -27% return. Big negative
The market has performed well over (as low as $32,600 at the 1st percentile). returns are far less common than small
the last decade, and they have $500,000 Is this a risk the client is willing to accept? negative returns with a bell-shaped
invested today in the S&P 500 and An alternative is to give up some of return distribution. Investors are com-
$500,000 in bonds to fund the lifestyle the upside to cut off some (or all) of pletely protected against most losses
they hope to lead. The distribution of the downside risk. In a low interest and buffered against large ones.
bond returns over the next five years is rate environment, products with floors Of course, there is a cost. The insur-
relatively narrow. The distribution of the offer less upside potential and more ance company needs to employ an
overall portfolio is wider and depends closely resemble fixed income invest- options strategy to provide the buffer.
primarily on five-year stock returns. ments. However, products such as fixed This will limit the upside potential of a
If we run a Monte Carlo analysis on indexed annuities (FIAs) won’t fall in RILA distribution. For example, at the
the S&P 500, we can see how much their value if interest rates spike. 90th percentile a buffered annuity will Adobe Stock
future wealth can vary by the time they In practical terms, the distribution of have a 31% return over five years and

16 INVESTMENT ADVISOR OCTOBER 2022 | ThinkAdvisor.com