Dominick Paoloni, CIMA®

CIO & Founder

Portfolio Manager, IPSAX

Adjunct Professor, University of Denver & University of Colorado

Over the years I have written many articles on the good, the bad, and the ugly of annuities. As I always point out, there are many kinds of annuities, and the terms can vary widely depending on the individual contract. In the mid-1990’s IPS Strategic Capital was one of the first financial firms to recommend an annuity product known as an equity indexed annuity. This type of annuity allows investors to participate in a portion of stock market returns, while eliminating downside risk when the market declines. Through the 1990’s our clients benefited from a portion of the high market returns; then when the markets turned in the 2000’s their annuities held value as the markets slid.

A big problem with equity indexed annuities today is the continual decline in the opportunity potential on the upside. It’s not uncommon to see an equity indexed annuity boasting 100% of the market gain but have a 3 to 5% annual cap. This is a far cry from the indexed annuities of old, which provided clients with 50% to 90% participation and unlimited upside. Clients often ask why insurance companies gave such great opportunities in the late 1990’s but have offered such poor value today. Are insurance companies just getting greedy?

While we all agree that the insurance companies are greedy (and always have been), the reduction in the value proposition of equity indexed annuities can partly be attributed to the current low interest rates but not all the issues can explain the poor value they deliver today.

Hugh D. Berkson points out in his article¹ “Fixed Indexed Annuities: New Name, Same Scam” In theory, Fixed Index Annuity (FIAs) are investment products that produce only positive returns. But in execution, FIAs often fall short of that result. FIAs are so complicated, and their prospectuses so opaque, complex, and riddled with definitions, cross-references, and crucial omissions, that even agents and advisors who sell them don’t understand how they work. You, the customer, could have no hope of understanding what you were buying, even if you attempted to absorb the issuer’s indecipherable disclosures. Thus, what a customer understands about FIAs generally is limited to what the advisor chooses to emphasize. It is estimated that 69 billion a year is sold in fixed index annuities mostly in-light-of-the-fact the products pay very high commissions.

Indexed Products

Insurance companies were the original creators of the equity indexed annuities. Due to the popularity of these investment instruments, banks began building index products calling them structured products, which allows for return participation of an underlying asset while giving complete or partial downside protection.

IPS recognized the value in these innovative structured products and began using them in client accounts in 2010. In order to better meet our client’s needs, IPS is now building custom structures for our clients in house, eliminating the third-party insurance company or bank. Because we engineer these structures at IPS, the value proposition to our clients can exactly match a client’s time frame and risk profile.  Structured products can be built around essentially any index, so clients who want exposure to gold, silver, US equities, foreign currencies, or any other volatile asset class can participate in the asset’s gain without fear of drastic losses.

Deconstructing Indexed Products

With equity indexed annuities, many clients understood that the insurance company would protect their original investment while giving the client an opportunity to receive a percentage of the market gain. No, like the investor, the insurance company has zero market risk in equity indexed annuities. How is this possible?

The core of an indexed product is a fixed income asset like a bond or dividends that generate income. All the risk lies in the ability of the underlying asset to pay off. If the bonds pay interest or the stock pays dividends, the risk to downside losses is reduced or eliminated. Many structured products blew up in 2008 because the banks create structures anchored with mortgage-backed securities. However, when the mortgages collapsed the structurers blew up.

Consider the following basic example of how a structured product works. A client wants to invest in the market because CDs are not returning enough interest to cover taxes and inflation, resulting in a real negative return. However, investing in the market significantly increases the potential downside risk and she is therefore hesitant.

IPS can solve this problem by building a structured product. For example, IPS could build a structured note with less than a 1-year maturity.

This note captures 76% of the upside while protecting the first 20% of the downside. If the market was up 20% the note would capture 15.2%. If the market should drop more than 20% by maturity the portfolio will capture only ½ of the loss of the market below 20%.  For example, if the markets were down 30% at maturity the portfolio will be down 5%. The note protects the first 20% and only captures ½ of the next 10% which would be 5% total loss when the market is down 30%.

IPS Strategic Capital is a quantitative driven long volatility firm that specializes in building hedge solutions for companies, pensions, endowments, and individuals. It is the goal at IPS to create a mathematical asymmetrical return that is not driven by any view of the markets.  If you are interested in learning more about how IPS Strategic Capital can help you implement a long volatility hedging solution for your situation don’t hesitate to reach out.

IPS Strategic Capital designs low-cost hedging strategies that define tomorrow’s risk today. For more information on our strategy solutions please visit our website at investsps.com or call 303-697-3174

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Managing Principal and Chief Investment Officer of IPS Strategic Capital, Dominick Paoloni has served the investment community for over 35 years. Dominick received his Certified Investment Management Analyst (CIMA) through the Wharton School of Business and completed the College for Financial Planning’s CFP certification program.

Dominick is the portfolio manager for IPSAX as well as an Adjunct Professor at the University of Denver, and the University of Colorado Denver, he is a published author in a plethora of financial magazines including an academic white paper published through the Journal or Financial Consultants. Dominick frequently lectures throughout the country and internationally on the real-world use of derivatives in risk-defined money management.

Disclaimer: The information in this article should not be misconstrued as an offer, nor a solicitation, to buy or sell securities. Any past performance of any investment(s) does not necessarily indicate the future performance of any investment(s). No client, current or prospective, should assume the future performance of their investments will be profitable based on historical performance. Any backtest charts and data presented are purely hypothetical and do not represent the performance of accounts managed by IPS Strategic Capital. The results were obtained by applying a rules-based investment process to historical data. All investments have the potential for profit and the potential risk of loss. Changes in investment strategies, contributions, or withdrawals may cause the performance results of one’s portfolio to differ materially from the reported composite performance. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s portfolio. One should always consult an investment advisor before making any investment decisions.

One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges, and expenses carefully before investing or sending money. This and other important information about the Strategy is available upon request.

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Work Cited Page

¹Fixed Indexed Annuities: New Name, Same Scam 03/07/12 by Hugh D. Berkson