So, why are they so hot?
by David Blanchett, PhD, CFA, CFP®
Mr. Blanchett is a fellow at the Alliance for Lifetime Income. He is currently Managing Director and Head of Retirement Research for PGIM DC Solutions. PGIM is the global investment management business of Prudential Financial, Inc.
There’s a new annuity in town that is receiving significant attention and garnering an increasing amount of annuity assets: the Registered Index-Linked Annuity (RILA). Given the hype, it’s important for advisors to consider these new products for clients—or at least be aware of how they work and where they could potentially fit within a retirement income plan.
What’s in a Name?
While RILAs aren’t technically all that new (they’ve been available for about a decade) they are relatively new as annuities go.
One emerging issue with the “newness” of RILAs is the various names used to describe the strategies across the industry. RILAs are also referred to as structured annuities, investment variable annuities, buffered annuities, etc. While these sound like very different things, the underlying strategy is generally very similar in that an insurance company uses financial options to gain a unique exposure to some type of market/investment (typically using a “buffer” or a “floor” approach).
While the industry definitely hasn’t settled on RILA as the general product name, it appears to currently be the front runner. Whether companies who already offer these products—or plan to in the future—is unclear. Therefore, it’s important to recognize that if a client (or potential client) asks about any (or all) of these, they could be referring to the same thing!
What is a RILA?
RILAs can be thought of as a riskier (or next-generation) version of fixed-index annuities (FIAs). With a FIA, the annuitant has virtually no downside risk, apart from the insurer’s default or inability to honor its claims-paying commitments, which applies to pretty much any annuity, and relatively limited upside (called the “cap rate”).
With RILAs, the investor can incur a loss (i.e., negative return) but can have significantly more upside, depending on the RILA structure. RILA strategies are generally categorized in two groups: buffers and floors.
With buffer products, the first amount of loss is absorbed by the product, based on the buffer level, and the investor would suffer any loss beyond that point. For example, if the buffer is 10% and the return of the underlier (such as the S&P 500) was -40%, the investor would lose 30%. If the return of the underlier is negative but greater than the noted buffer, the return would be 0%. For example, if the buffer is 10% and the underlier returns -5%, the investor return would be 0%.
With floor products the downside is limited to a stated percentage, such as 10%. For example, if the floor is 10%, you can’t lose more than 10% regardless of the return of the underlier (e.g., the S&P 500). A RILA with a 0% floor would have the same risk profile as a FIA.
The exhibit below contrasts the return profile of the S&P 500, a FIA, a 10% buffer product and 10% floor product.
The potential gains and losses are obviously very different across these four potential strategies. The return potential, both gains and losses, is the highest with the S&P 500. By forgoing some potential losses RILAs end up foregoing certain gains, but the nature of the gains and losses vary by strategy.
The differences in underlying exposures makes the risk of RILAs difficult to contextualize. Some recent research reveals that it’s possible to approximate the equity-like risk of these products based on the risk contribution of the strategies to a diversified portfolio.
For buffer strategies the equity-like risk can be generalized by taking 100 minus (4 * buffer level). For example, a 10% buffer product would be approximately 60% equity-like (100-(4*10)=60). For floor strategies, the equity-like risk can be generalized by multiplying the floor level by 4. For example, 10% floor product would be approximately 40% equity-like (10*4=40)
These estimates are important because they provide context about how to potentially source the funds to purchase the strategies, as well as how to potentially adjust a portfolio if one of these products are purchased, since the equity-like risk of a 20% buffer (relatively bond-like) is very different than a 20% floor (relatively equity-like).
Why Consider RILAs?
One thing you might be thinking is why even consider RILAs? In theory, an advisor could implement these strategies themselves using options (e.g., through buying and selling a series of call and/or put options). That’s definitely a possibility and a track I expect some advisors to take. However, there are specific benefits associated with implementing these inside an annuity (e.g., versus an ETF), in particular the illiquidity premium. Cap rates are likely to be higher inside an annuity.
In addition, there are some historical options pricing dynamics that make these strategies attractive, especially if the client is likely to have the same exposure to the underlying index (e.g., the S&P 500) in the portfolio regardless.
For example, an investor with an allocation to large cap has tail risk by virtual of owning equities. The question should then be if there is a more efficient way to gain the exposure, such as through a RILA.
We see this when we look at the historical prices of options. The implied probability of a significant negative return (based on options prices) has been much higher than the actual realized probability of a significant drop. This effect is depicted in the chart below.
For example, the historical probability of a return of the S&P 500 that is -30% or less has been around 2%. The implied probability of this happening based on options prices has been closer to 15%. Therefore, by selling these options (i.e., puts), it’s possible to capture some of this overpricing effect and potentially realize the benefits elsewhere (e.g., reducing the risk for other parts of the portfolio).
Where Do These Products Make the Most Sense?
Not all RILAs are created equal, and every client is different, so it can be difficult to generalize for whom and how RILAs can work best. However, RILAs can definitely improve portfolio efficiency in certain situations. Today, given where some of the key pricing components of these strategies are, I see buffer strategies (which are most common) as being generally more attractive than floor approaches. The one potential exception here would be for FIAs for someone with a relatively high-risk aversion level. Allocations to buffer RILAs tend to be highest among investors targeting a balanced risk level (say between 25% and 75% equities), who will not need to access the funds during the product term.
While annuities have been distributed largely by commission-based advisors historically, that’s changing given the rise of fee-friendly platforms. As financial advisors increasingly provide recommendations and advice on these products, it’s essential they understand how these strategies truly work and how they can benefit clients. RILAs aren’t going to make sense for every (or necessarily even most clients), but they are going to make sense for some, and advisors won’t really know who that is unless they know how they work.