A Counterintuitive Annuity Strategy That Can Reduce Risk

What You Need to Know

The majority of advisors choose a structured annuity strategy with the primary objective of avoiding a negative return.
Maximizing growth is a secondary goal once the desired level of protection is chosen.
One-year indexed terms with annual resets can provide more protection over the entire surrender charge period.

According to a 2021 LIMRA study on structured annuities, almost half of all structured annuity sales utilized a strategy term of five or six years. The other half was broken down between one- and two-year indexed terms.

So why are so many advisors choosing to make their clients wait five or six years before interest gets credited to the policy? It’s my opinion that the majority of advisors choose a strategy with the primary objective of avoiding a negative return. Maximizing growth is a secondary goal once the desired level of protection is chosen.

If my assumption is true, then longer term strategies make perfect sense. After all, if I go out six years and combine this with a 10% buffer, there’s a slim chance that a client will experience a loss six years later. But how slim? Fortunately, SIMON from iCapital’s annuities platform can help answer that question.

Let’s take a look at an example of a structured annuity with a six-year point-to-point strategy with a 500% cap rate and 10% buffer on the S&P 500. Using SIMON, we can view the hypothetical performance metrics across six-year indexed terms between Jan. 2, 1958, and July 7, 2023. We find that during this period, the index dropped in price more than 10%, only 4.5% of the time over any rolling six-year period, and the average six-year return based on a 500% cap rate would have been 61.6%, or 8.33% per year.

Take another example of a structured annuity with the same six-year point-to-point strategy, but with a 350% cap rate and 15% buffer on SPX. During this same period, the hypothetical performance metrics show the percentage of negative returns falls to just 1.91%. And how much upside do we give up? None. In fact, we actually gain upside by choosing the higher buffer with the lower cap rate. Why? Because the SPX has never increased in price more than 243.11% over any rolling six-year period.

Therefore, unless we experience a historic bull market, both the 350% and 500% cap rates are effectively uncapped options. By eliminating some of the negative returns with the higher buffer and lower cap rate, we actually slightly increase historical average returns to 61.76%, or 8.35% per year.

From these examples, we can observe with six-year indexed terms, a buffer of at least 10% does indeed provide a great deal of protection.

Comparing Indexed Terms

The next question we must ask is, how does a six-year indexed term compare to a one-year indexed term?

Let’s first take a look at an example of a structured annuity with a one-year point-to-point strategy with a 19.5% cap rate and 10% buffer on SPX. Again, we will go to SIMON to analyze the hypothetical performance.

Using SIMON, we find that across one-year indexed terms between Jan. 7, 1958, and July 7, 2023, the best possible one-year return is obviously equal to the 19.5% cap rate, and the average one-year return would be 8.36%, slightly better than the 8.33% per year generated by the six-year point-to-point strategy with a 500% cap rate and 10% buffer on SPX.

But then we see the worst possible one-year return of -38.82%. That means there was a one-year period where SPX fell 48.82%, leaving a negative return of 38.82% after the 10% buffer. Not a good outcome for the client.

In addition, the 10% buffer would have failed to fully protect the client in 13.61% of the time period. In other words, in one out of every eight years an advisor would have to tell the client that, while it could have been worse, the value of their structured annuity dropped during the year.