Last year was a nice reminder that both the stock and bond markets can have down years – sometimes at the same time. This year hasn’t exactly been peachy either. Volatility has increased as mixed data and economic sentiment have made the markets difficult to navigate.
For younger investors with long timelines, this volatility may not matter. But for pre-retirees and those in their golden years, surging volatility can subject themselves to a sequence of withdrawal risks and enhance the risk of running out of money in retirement.
And that’s why a new kind of annuity, one with a buffer could be a good choice. Registered index-linked annuities (RILAs) are quickly gaining popularity. And it could just save your retirement.
Rising Volatility and Risks
Historically, diversification is supposed to help a portfolio during bad years. When equities are falling, fixed income is supposed to pick up the slack. But 2022 showed that the relationship doesn’t always work. In 2022, the S&P 500 managed to sink by over 19%. At the same time, the portfolio’s main buoy managed to fail investors as well. The Bloomberg U.S. Aggregate Bond Index managed to generate a total return, which included those steady coupon payments, of negative 13%.
So far, results for stocks and bonds have been a bit mixed as well. Bonds have basically been flat, while stocks have performed well; albeit, with surging volatility.
For investors, this poses a big issue – for some investors anyway. Those with long timelines can ignore the noise. But for those near or in their golden years, losses and surging volatility creates some nasty headaches – chief of which is sequence risk.
Sequence risk has to do with the timing of withdrawals from a retirement portfolio. It turns out that the first few years of retirement are critical to building a lasting nest egg. Starting retirement in a downward trending market impacts the ability of a portfolio to fund a full retirement. In a downward market, investors in retirement are essentially locking in losses, and those losses get compounded even if the market rebounds over the next few years.
It’s a significant issue and one that derails retirement and causes investors to outlive their money.
Finding a “Buffer”
With sequence risk once again on the table, investors and their advisors have been searching for solutions. One might now exist in a new kind of annuity.
A registered index-linked annuity, or RILA, is an annuity that offers upside through market participation of an index like the S&P 500 or MSCI EAFA. Here, portfolios are allowed to grow. The kicker is that RILAs also include a buffer or floor that limits the downside. This provides investors with growth potential, while limiting losses and sequence risk from their portfolios.
In practice it works like this: An investor buys an RILA tied to the S&P 500. If the market rises by 15%, the value of the annuity will grow by a similar percentage net of fees. If the market loses, the buffer or floor kicks in.
Buying a RILA with a floor sets the maximum percentage loss amount an investor is willing to take. If the RILA floor is set at 10%, and the index loses 8%, then the value of the annuity would go down by 8% since the floor was not reached. If the index loses 15%, then the value of the annuity would only drop by 10% since the floor was breached.
Buffers work a bit differently and it is the amount of loss that the insurance company is willing to absorb. An RILA with a buffer of 10% means that the insurance firm will eat any loss less than that amount. Using the numbers above, if the index loses 8%, then all the losses go to the insurance firm and the annuity’s value stays the same. If the index loses 15%, then the annuity’s value would drop by only 5%.
Why use a RILA?
Ultimately, a RILA looks to bridge the gap between regular indexed/variable and fixed annuities.
Variable annuities are just that – variable. So, losses can occur and sequence of withdrawal risk is there. At the same time, many traditional indexed products cap upside potential. On the other hand, fixed annuities offer no loss guarantees. However, upside is limited to whatever crediting/interest rate investors buy. Right now, that’s not such a bad thing. But a few years ago, with interest rates at effectively zero, fixed annuities weren’t really a good deal.
A RILA potentially eliminates these issues and allows investors to still find needed growth, while providing a lifejacket in the case of a major drawdown or prolonged economic slump. It allows investors to potentially plan downward scenarios as well. Advisors can literally say “ok, if the markets do go to heck, this is the minimum we’ll have to work with.”
Like other annuities, RILAs have tax benefits with interest and returns tax-deferred until withdrawal. Moreover, many insurance companies will allow investors to convert or annuitize a RILA into lifetime income payments. Those payouts are tax advantaged as well, with a portion of the income being return of capital.
For investors near or in retirement, moving a portion of their savings into an RILA could add peace of mind and provide just the right tool to help limit sequence risk.
Adding a RILA
Despite being created in 2010, it wasn’t until recently that RILAs have started to be widely used. According to industry group LIMRA, RILA sales have jumped from just $1.9 billion in 2014 to over $41 billion last year. Already, 2023 is shaping up to be even bigger 1. Given the benefits, it’s easy to see why.
Things to think about are choosing between a buffer or floor-styled RILA. As we described in the example, the difference can be striking. Additionally, some insurers flip-flop the names, so you need to understand exactly who is taking the losses beyond a certain point. As with all annuities, investors need to be cognizant of fees, costs and surrender charges. Adding these buffers and downside protection is not free. Making sure you are not paying too much is critical.
While the number of insurers offering these products are growing, few are from credible insurers.
RILA Issuers
These issuers are selected based on their credit rating.
| Insurer | Credit Rating (A.M. Best) | Option of Indices & Funds |
|---|---|---|
| Allianz | A+ | S&P 500 | Russell 2000 |
| Prudential | A+ | S&P 500 Index | Russell 2000 Index | MSCI EAFE Index | Nasdaq-100 Index | Dimensional International Equity Focus Index | AB 500 Plus Index |
| Nationwide | A+ | S&P 500 Index | Russell 2000 Index | MSCI EAFE Index | Nasdaq-100 Index |
| AXA Equitable | A | S&P 500 Price Return index | Russell 2000 Price Return Index |
| Brighthouse | A | S&P 500 Index | Russell 2000 Index | MSCI EAFE Index | Nasdaq-100 Index |
| Lincoln | A | About 30 different active mutual funds |
If the idea of a buffer interests you, but you’re not sure you want to go the annuity route, an alternative exists in the 120 (or so) buffer ETFs that are on the market. These offer similar exposure – albeit, not the same – as a buffer RILA.
Actively Managed Buffer ETFs
These funds were selected based on YTD total return, which range between 7.5% and 12.5%. They have expenses between 0.79% to 1.05% and have AUM between $280 mn to $1.9 bn. These ETFs do not usually pay any dividends.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| POCT | Innovator U.S. Equity Power Buffer ETF - October | $430M | 12.5% | 0% | 0.79% | ETF | Yes |
| FJAN | FT Cboe Vest U.S. Equity Buffer ETF - January | $325M | 10.8% | 0% | 0.85% | ETF | Yes |
| XDEC | FT Cboe Vest U.S. Equity Enhance & Moderate Buffer ETF - December | $362M | 10.4% | 0% | 0.85% | ETF | Yes |
| FDEC | FT Cboe Vest U.S. Equity Buffer ETF - December | $280M | 10% | 0% | 0.85% | ETF | Yes |
| BUFR | FT Cboe Vest Fund of Buffer ETFs | $1.86B | 9.7% | 0% | 1.05% | ETF | Yes |
| PNOV | Innovator US Equity Power Buffer ETF - November | $654.2M | 8.6% | 0% | 0.79% | ETF | Yes |
| PDEC | Innovator U.S. Equity Power Buffer ETF - December | $682M | 7.6% | 0% | 0.79% | ETF | Yes |
In the end, a RILA or similar styled buffer fund can provide the needed downside protection, while still offering growth opportunities. For investors near or in retirement, this is a lifesaver.
The Bottom Line
Last year showed us that stocks and bonds don’t always go up. With that in mind, finding some downside protection via a registered index-linked annuity (RILA) could be the answer. Thanks to their price floors, or buffers, investors can have their downside and sequence of withdrawal risks limited.
1 LIMRA (July 2023). Record-High Sales of Registered Index-Linked and Fixed Indexed Annuities Drive Overall Sales Growth in the Second Quarter 2023