The US Fixed Indexed Annuity market continues to attract interest and a variety of different offerings are available today. This sector combines structured product features to provide returns within an insurance wrapper.
With an ageing population and a need to save into retirement US insurance products remain popular and a relatively favourable regulatory regime has helped to see the market grow. The appetite for Fixed Income Annuities to be sold by brokers in large numbers has been further boosted by the Department of Labor (DoL) Fiduciary rule being withdrawn under the Trump Administration.
Conventional annuities accumulate at fixed rates each year and these vanilla versions were the first type of annuities sold. However as with most cash investments this concept has suffered enormously with falling swap rates and treasury yields. Meanwhile future retirees demand more from their annuities to fund later life particularly when savings may be stretched and a longer retirement anticipated. This is why alternative solutions have been sought.
Previous accepted wisdom had been for an accumulation period of earnings and investments followed by a simple fixed rate annuity to draw down. Indexed Annuities first appeared around twenty years ago to provide better solutions, particularly aiming to generate decent returns in a low interest rate environment.
First solutions for index linked
Since the horizons of Annuity products are typically 7 to 10 years the original Indexed solutions were “lock-in” or “point to point” products over the whole term. These used cliquet or participation payoffs, often with caps and averaging. This presents various problems, firstly Investment banks are unwilling to provide hedges for such long periods and accordingly assign high hedging costs and risk margin which makes the products less attractive. In turn Insurance companies suffer from a limited set of issuing parties and have to take long term credit risk of the Investment bank. Such solutions can also be inflexible in terms of reacting to market conditions such as interest rate movements over the medium term and do not always allow for surrenders at reasonable value.
Rolling annual products
Therefore in recent years there has been a change of product type to an annual accumulation construction based on a certain index participation level or cap. For example the investor may get 50% participation to an Index or have an annual cap of 7% with 100% participation up to that level. In general Fixed Index Annuities aim to provide a higher average return through equity participation than could be achieved by fixed interest.
Use of low volatility indices
Many of the underlyings used in Fixed Index Annuities are low volatility variants rather than benchmark indices, for example the S&P Low Volatility Index, the Goldman Sachs Dynamo Strategy Index and the Morgan Stanley 3D Index. The use of lower volatility indices allows higher participation or cap levels. However attention must also be paid to the choice of index, for example the Morgan Stanley 3D Index has only returned 3% p.a. over the last five years and despite its low volatility of 5.6% has a significantly lower Sharpe ratio than the S&P-500. Better optical terms are not good for investors if they are not backed up by performance.
Some annuities use a more aggressive strategy, for example the Symetra Trek Annuity linked to the PIMCO Equity Fusion Index allows for more growth potential but can lose up to 10% per annum if the index declines in any given year.
The returns from each year are re-invested into the next year which means that products roll from one year to the next. From a hedging perspective banks are providing a series of one year products rather than a single product over ten years. Therefore terms are fixed from year to year and therefore the cap or participation levels will vary each year. This is probably a better arrangement and means that the insurance provider can be more flexible and if necessary switch investors into different indices or product types.
In conclusion we see that the fixed index annuity market is offering a wide range of payoffs and underlying assets. This provides the sector with relatively complex products in comparison to simple alternatives but ones which if carefully chosen have the potential for good returns.
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