The ABCs of Structured Annuities
October 26, 2018 by Scott Stolz
Today, registered index-linked annuities, buffered annuities, index-linked variable annuities and structured annuities are all used to describe a single product. Given the many names for this relatively new annuity structure, I suspect there is some confusion as to what these products are and when they should be recommended.
I refer to these products as structured annuities because the insurance industry based the design on structured notes offered by most broker-dealers. Structured notes are bank debt obligations that return principal plus interest linked to underlying markets while still providing some downside protection. Structured annuities are similar to structured notes, but offer the potential for tax-deferred growth.
How do they compare to other annuities? Let’s start with what they are and what they are not. Like an indexed annuity, the return during the selected period is tied to a particular index, such as the S&P 500 or the MSCI EAFE.
However, structured annuities allow the policyholder to capture much more of the upside of the index than an indexed annuity. Of course, this can’t happen without a tradeoff. Unlike an indexed annuity, a structured annuity merely protects some of the downside and can cause a policyholder to lose money, similar to a variable annuity.
When initially investing in this product, all structured annuities require the policyholder to make three choices that are essentially the same as an indexed annuity: 1) The duration of the interest crediting segment, typically from one to six years; 2) the index used to determine account value performance (e.g., S&P 500, MSCI EAFE, etc.); and 3) the crediting method, which entails the following:
A cap on earnings: Performance is limited to a certain amount of the underlying index return. For example, with a 95% cap on performance, policyholders will receive positive returns up to 95% over the life of the product. So if the index returned 60%, the policyholder would receive 60%, but if the index returned 110% over the life of the product, the policyholder would receive 95% (the cap).
A trigger or step rate: Policyholders receive a specific, predetermined return if the underlying index is either up or unchanged from its initial level. For instance, if the trigger or step rate is 6% and the client selects the S&P 500 index, then the client will receive 6% as long as the S&P 500 is not lower than its initial level during the selected term.
A spread or annual fee deducted to calculate the final return: Like an indexed annuity, some structured annuities offer options that have higher participation rates in exchange for an annual fee or spread. This additional cost is deducted from any gains. The idea behind this approach is to provide more upside in the years where the index performs well above historic averages.
Policyholders essentially pay for this privilege by accepting lower returns in the years where the index is positive but below historic averages. For instance, with a 1.25% annual fee or spread on any gains, if an underlying index returned 5%, the policyholder would receive 3.75% of that gain. If the index returned 20%, the policyholder would receive 18.75%.
Over the long run, back testing would indicate the fee or spread options should provide a boost on the overall average return depending on the index performance. (Please note: past performance is not an indication of future results.) However, it will also lead to a wider expected range of possible returns.
The actual return will be based on the selected index over the selected time period, subject to the limit on the upside, just like an indexed annuity.
Types of Downside Protection Unlike an indexed annuity, though, structured annuities require the policyholder to choose the amount and type of downside protection. The more downside protection the policyholder elects, the less potential upside they will receive. Typically, structured annuities will offer two methods of limiting downside exposure.
1. “Buffer” against a loss. Structured annuities typically offer a “buffer” of 10%, 20%, or 30%. This percentage represents the total amount of downside protection.
For example, if the policyholder selects a 10% buffer, then the policyholder is protected against any loss as long as the chosen index does not decline more than 10%. To elaborate, if the index over the selected period returned -15%, the policyholder would incur a loss of 5%. Similarly, if the policyholder selects a 20% buffer, then no loss occurs unless the index returns a loss of more than 20%. Not surprisingly, the larger the buffer, the lower the upside potential.
Actual pricing may look as follows, though the scenarios and information described herein are hypothetical in nature and are not indicative of the performance of any particular investment or annuity. They are for illustrative purposes only and should not be considered as the sole basis for any investment decision.
- Example 1: 3 years; S&P 500 index; 10% buffer; 35% cap on index performance over 3 years.
Example 2: 6 years; S&P 500 index; 10% buffer; 95% cap on index performance over 6 years.
Example 3: 6 years; S&P 500 index; 25% buffer, 65% cap on index performance over 6 years.
2. “Guard Strategy.” With this option, the policyholder is exposed to the percentage loss up to the guarded amount, but is protected against any loss after the guard percentage. Therefore, this method works the opposite of the “buffer” method.
For example, if the policyholder selects a 10% guard, then he or she is subject to a loss of up to 10%. If the index over the selected period of time generates more than a 10% loss, then the insurance company covers the loss beyond the 10%.
The smaller the guard selected by the policyholder, the greater the exposure for the insurance company. As a result, the client will get less upside potential. Actual pricing may look as follows in one example: a 1-year product tied to the S&P 500 index with a 10% guard could have a 10.75% cap on performance over a 1-year term.
When Should You Consider a Structured Annuity? In my view, structured annuities are not an alternative to fixed and indexed annuities. Rather, these annuities may offer an alternative to variable annuities. People who buy fixed annuities want full downside protection and want to know they are going to receive a positive return. Index annuity holders are comfortable with an unknown return each year — even a 0% return on occasion — but like the fixed annuity policyholders, they want to protect their principal.
While structured annuities often provide an option that completely protects principal, the pricing is typically inferior to that of an indexed annuity, and, hence, is rarely an attractive option. Because the most competitive aspects of a structured annuity do not fully protect the downside, they are not the best solution for the most risk-averse client.
However, with more upside participation in exchange for more downside exposure, structured annuities could fill the need solved by a variable annuity. These products may provide much of the upside that could be captured with a variable annuity (without a living benefit), while still protecting the client from a significant market correction.
Structured annuities could be particularly attractive to clients who currently own variable annuities and/or mutual funds and would like to take some risk off of the table without fully exiting equity markets.
Accumulation, Not Income Because annuities may not be right for all clients, there are many things to consider before making a recommendation. First and foremost, you must determine the role of the annuity: Is it to fill an income need or an accumulation need?
If the purpose of the annuity is to provide either current or future income, then you would likely recommend either an immediate annuity (SPIA), deferred income annuity (DIA), or an annuity with a living benefit rider. Structured annuities, to date, do not offer living benefit riders and are typically priced under the assumption that the policyholder only holds the policy through the surrender charge period. While policyholders can annuitize structured annuities, these products are not about income, and should not be considered an income solution for clients.
However, structured annuities may be able to fulfill the accumulation need. By offering a means to capture some of the market upside while protecting some or much of the market downside, these products are “designed to provide some stability in an unpredictable endeavor — investing,” as described by Brighthouse Financial.
Therefore, I believe these products are best suited for clients who indicate they want to either gain or maintain some exposure to equity markets but are more concerned with losing money than making money. I describe this typical structured annuity client as a “chicken equity investor” — the client who says they want to be in the market, but you know is going to panic if the market goes through any significant correction (or maybe even one that is not so significant).
Take a look at your clients’ goals, objectives, and risk tolerances. For those “chicken equity investors” who want some upside market participation and some downside protection in a tax-deferred wrapper, you may consider exploring structured annuities.
Scott Stolz is Senior Vice President, Raymond James Private Client Group Investment Products and Wealth Solutions.