Beware of Backtested RILA Performance
For the analysis, options are priced using the Black-Scholes model with a constant implied volatility of 25% (both over time and across strike prices), where dividend yields and 10-year government bond yield data obtained from Robert Shiller’s website, for terms of one, three and six years.
Participant Rates on a 20% Buffer RILA by Term: January 1871-October 2022
Source: Robert Shiller’s website, author’s calculations
We can see that the participation rates for the respective terms would have varied significantly over time and that current participation rates are relatively low. While the participation rate on a 6-year term 20% buffer RILA in the model is estimated to be around 100% today (consistent with available products), the historical median participation rate is closer to 170%, which would result in significantly more upside.
The historical variation in participation rates creates a significant “point in time” issue when evaluating RILAs, since backcasting the attributes for a product available during a specific period (e.g., today) could result in outcomes that are materially different compared to when participant rates were unusually high (e.g., the 1980s) or unattractive (the year 2020).
Capturing Current Market Factors
The primary reason participation rates (as well as caps, if that was the primary upside level) are so much lower today (vs. the long-term historical average) is the relatively lower bond yield environment. Lower bond yields result in less revenue available to generate the upside (i.e., purchase the OTM call options), and to the extent bond yields exceed dividend yields can also negatively impact options pricing dynamics.
The change in the composition of returns for S&P 500 historically is also important to be aware of, because dividend yields were historically a much larger portion of the total returns of the stock market, and individuals who purchase RILAs only receive the price return.
Overall, this analysis suggests care should be taken when analyzing RILAs. An analysis that uses historical returns and today’s features is likely to dramatically understate the potential upside of the product and yield dubious results. Therefore, forecasted returns that accurately capture today’s expected return environment should be used in any kind of analysis.
For readers interested in learning more about the economics behind RILAs, and the potential benefits of the approach, I’d recommend reading something I put together for the Alliance for Lifetime Income, which is available here.
David Blanchett is Managing Director and Head of Retirement Research for PGIM DC solutions, an Adjunct Professor of Wealth Management at The American College of Financial Services, and a Research Fellow for the Retirement Income Institute.
