By: Dominick Paoloni, CIMA
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 different 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 over the last several years 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 5% annual cap. This is a far cry from the indexed annuities of old, which provided clients with 50% to 80% 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 recently. 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 be attributed to the current low interest rates.
Equity indexed annuities were the earliest structured investments used by pension funds, endowments, and individuals. Due to the popularity of these investment instruments, banks began building structured products, which allow 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 2009 through the banking institutions. 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. Was the insurance company assuming the risk of loss if the market crashed? 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 (bond), such as US Treasuries, corporate bonds, or even mortgages. All the risk lies in the ability of the underlying bond to pay par at maturity. As long as the bond matures at par and does not default, the risk to downside losses is reduced or eliminated. Many structured products blew up in 2008 because the banks creating the structured products anchored the investments with mortgages. However, when a quality fixed income instrument is used and the term is short, the risk of default can be mitigated.
Consider the following basic example of how a structured product works. A client wants to invest in the market because CD’s are not returning enough interest to cover taxes and inflation, resulting in a real negative return. However, investing in the market significantly increases her potential downside risk and she is therefore hesitant.
IPS is able to solve this problem by building a structured product. For example, IPS could build a diversified portfolio of investment grade corporate bonds with a 2.5 year maturity with approximately 90% of the client’s funds. These bonds are the risk within the structured note. If any of the investment grade bonds should default in the 2.5 years, the client would show a loss, but as long as the bond matures at par and does not default, the client will receive the bond principal plus interest accrued. In addition to the return from the bond, the rest of the 10% of the client’s funds were invested in index options. If the index options expire worthless in 2.5 years, the bond would mature at the value equal to the original investment. However, if the index option matures with intrinsic value due to a gain in the underlying asset that value is added to the full maturing bond, allowing for market participation (see Fig 1).
What is the Advantage of a Custom Structure?
Within an equity indexed annuity, insurance companies and banks typically charge estimated internal fees between 7% – 10%. In comparison, IPS only charges our typical annual management fee to build custom structures in house. By eliminating the high fees charged by the large institutions, IPS can deliver a much better value proposition as well as a structure that meets your time frame and risk profile.