In part two of my blog posts on structured annuities, I would like to discuss the benefits and detriments of the asset class, and then compare/contrast the two examples that I presented in our last post. In the financial marketplace, structured annuities are known by different stripes, including buffered annuities, indexed variable annuities, and index-linked variable annuities. Over the past nine years, structured annuities have grown to $12 billion in annual issuance.
First, let’s discuss some of the benefits of structured annuities. In my view, the number one benefit of these strategies is that when picking a segment, the investor knows what exactly they are getting into and it is perfectly defined at maturity. To better illustrate this, let’s go under the hood on a structured annuity that has a one-year 10% buffer with a cap of 7% on the S&P 500 as an example:
- The investment will mature in one year;
- It is based on the S&P 500;
- If the price return of the S&P 500 declines by less than 10% than you receive your full principle back, but you incur losses if the S&P 500 declines more than 10% on a 1:1 ratio. For example, if the S&P 500 price return over the year is down 20%, then the investment will lose 10%; and
- The investment captures full returns up to the 7% maximum return but does not capture any gains above that level.
Another benefit of structured annuities is that these products are very flexible allowing you to decide what is your perfect allocation of exposure. For example, you may want a 20% buffer instead of a 10% buffer and that simply means that you can become more aggressive or less aggressive in regards market participation. That’s why this is such a “category killer.” It fits right in between fixed indexed annuities, that have 100% principal protection but less upside and variable annuities, which take on full downside risk.
Now, let’s talk about some of the detriments to investing in the asset class. I think detriment number one is that the fact that investors do not capture a dividend will loom large within the five-year maturity product.
Detriment number two is that because there’s no real liquidity you’re stuck in these products. So, it’s hard to get out early, especially when product characteristics become stale due to a large market move (note 2019).
Detriment number three involves stale characteristics again (we’ll discuss this a little bit more within the five-year segment) but essentially these strategies are not dynamic. Since they’re passive (set-and-forget) this can be a detriment. Now, let’s remember that the insurance company issuing the annuity is neutral on whether you choose a one-year segment or a five-year segment. In fact, they have you in this type of product either way because of the contract.
Let’s get into one-year versus five-year and the way we should approach this via a “bear case” scenario, in which the one year is a clear winner. Why? Well both the one-year and five-year give you a 10% first loss protection level via the buffer. However, for the one year it’s over a one-year segment and for five years you have the same amount of protection but for a way longer period. So, if the market goes down 10% in the first year you’ve protected everything you need with that one year. On the other hand, with the five-year you still have another four years to go with no further protection.
It’s important to remember that you do not capture the dividends in these products. Well that means that the first one-year segment has 8% protection rather than 10%, assuming a 2% dividend for the S&P 500. The five-year annuity is not protected at all over five years and you capture 10% of dividends regardless of where the S&P 500 goes (Please note my recent blog where I provide guidance to stay away from the 5-year 10% bugger for that reason: Looking Under the Hood of Structured Annuities Pricing and Construction). In a scenario where the total return of the S&P is down 40%, it means the price return is down 50% and you have 10% worth of protection. It’s important to understand that in the five year you’re not really getting much protection with that buffer, however in the one year you’re getting material protection. So, in a bearish scenario the one-year wins.
Now, let’s discuss the bullish scenario. The one-year segment has a 7% cap. That’s low in most bullish scenarios since you’re capturing way more than 7% on an annual basis. So, you’re leaving a lot on the table for the protection level. Now that we’ve established that you have a higher protection level, I believe that you’re still leaving a lot there on the table.
The five-year has a 90% participation right; you participate on a 100% of the upside up to that 90% gain again without the dividend but you’re going to capture most of the upside. So, in this case the five-year wins.
In conclusion I think that investors must fully understand how structured annuities are built. I believe this is the only way to truly understand the risks and rewards of these products.
This content is also available in video format on Catalyst Insights: Options Manager Looks Under the Hood of Structured Annuities, Part 2.