Why Advisors Shouldn't Dismiss Index-Linked Annuities

What You Need to Know

Sales of protection-focused annuities, mainly RILAs, have outpaced sales of other annuity types.
Advisors shouldn’t dismiss investments that limit downside (and upside) as inefficient gimmicks.
Annuity wrappers can be useful for deferring short-term gains until after retirement.

Sales of protection-focused annuity products were higher in the fourth quarter of 2021 than the combined total of accumulation and income-focused annuities, according to data from the Secure Retirement Institute. 

In fact, the sales of registered index-linked annuities (RILAs) have led the protection annuity charge with sales more than doubling from $4.3 billion in the second quarter of 2020 to $8.9 billion by the end of 2021. 

What’s driving the appeal of protection products offered within an annuity wrapper? Why would any investor want a complex financial product that promises protection at the expense of significant upside? And why choose an annuity when similar products exist as ETFs?

In a new white paper written for the Retirement Income Institute, fellow American College Professor Wade Pfau and I take a deeper dive into a collection of financial products that offer varying loss protection and compare them to outcomes from a traditional investment portfolio.

How should advisors think about protected annuities? 

First, they shouldn’t dismiss them as an inefficient gimmick. In a series of detailed articles written while he was head of retirement research at Morningstar, David Blanchett lays out the complex economics that underlie the potential benefits of financial products that use a combination of fixed income investments, equities, and financial options to create a customized distribution of outcomes. 

Why might a retiree prefer an option-controlled retirement investment to a traditional long-only portfolio of stocks and bonds?

According to Nobel laureates Robert Merton and Myron Scholes, financial options can be used to construct investments that “can be used by investors to produce patterns of returns which are not reproducible by any simple strategy of combining stocks with bonds.” A retiree may prefer this altered distribution of possible returns to a conventional portfolio.

Limiting Risk

Consider a 60-year-old baby boomer who is five years away from retirement. The market has performed well over the last decade, and they have $500,000 invested today in the S&P 500 and $500,000 in bonds to fund the lifestyle they hope to lead. 

The distribution of bond returns over the next five years is relatively narrow. The distribution of the overall portfolio is wider and depends primarily on five-year stock returns.

If we run a Monte Carlo analysis on the S&P 500, we can see how much their future wealth can vary by the time they retire at age 65. At the 10th percentile, they will have $410,000. At the 1st percentile, stocks will fall to $265,000. A lucky retiree at the 90th percentile will have over $1 million. 

In five years, they should be able to withdraw about $22,000 from the portion of their portfolio invested in bonds (of course this is a simplification and ignores the potential risk of bonds, which can be significant as we’ve discovered recently).

If the retiree gets lucky and achieves the 90th percentile of returns, they’ll be able to withdraw $47,200 from their stocks based on the 4% rule. If they get unlucky at the 10th percentile, they’ll only be able to withdraw $16,400.  

Is the retiree willing to accept the downside risk of spending $38,400 each year in order to achieve the potential upside of $69,200 if they get lucky? At lower percentiles the potential downside and upside become even more extreme (as low as $32,600 at the 1st percentile). Is this a risk the client is willing to accept?

An alternative is to give up some of the upside to cut off some (or all) of the downside risk. In a low interest rate environment, products with floors offer less upside potential and more closely resemble fixed income investments.

However, unlike the intermediate-term fixed income investments that constitute the bulk of an insurance company’s general account portfolio, products such as fixed indexed annuities (FIAs) won’t fall in value if interest rates spike.