How effective is your method of managing portfolio risk? We compare and contrast different approaches – including fixed income, managed futures, low volatility equities, and tactical – to explore the relative protection they can deliver versus the return drag they can create.
Month: May 2016
What is an Indexed Annuity?
In recent conversations with current and potential clients, we have seen an uptick in the use of indexed annuities as a tool for risk management.
For the uninitiated, Fidelity succinctly described an indexed annuity in a recent blog post:
“An indexed annuity is a contract issued and guaranteed by an insurance company. You invest an amount of money (premium) in return for protection against down markets; the potential for some investment growth, linked to an index (e.g., the S&P 500® Index); and, in some cases, a guaranteed level of lifetime income through optional riders.”
The rules that govern the performance credited to an indexed annuity account tend to be relatively simple and intuitive. A hypothetical example would be something like this:
- If the S&P 500 loses value over the policy year, the account is credited 0%.
- If the S&P 500 gains between 0% and 5% over the policy year, the policy is credited with the S&P 500’s gain.
- If the S&P 500 gains more than 5% over the policy year, the policy is credited with 5%.
In this example, the 5% figure is referred to as the “cap.”
While these rules may be simple and intuitive, the trade-offs inherent in such a contract are less clear.
Recently, I’ve been stealing the following phrase from my co-PM, Corey, quite frequently: “Risk cannot be destroyed, it can only be transformed.” I think this concept is especially applicable to indexed annuities.
Fortunately, indexed annuity-like payoff structures can be created with stocks, bonds, and options. By evaluating these replicating portfolios, we can start to develop a more complete cost/benefit analysis and perhaps better understand how these types of products may or may not fit into certain client portfolios.
For those not interested in the details, the takeaways are quite simple:
- Indexed annuities depend on interest income to finance investments in the equity markets.
- When interest rates are low, there is little capital available to make these equity investments.
- Limited capital means either (i) low equity participation rates or (ii) low caps that restrict potential upside.
- Low participation rates and/or low caps on index participation are a recipe for muted returns, which may make it difficult to stay ahead of inflation.
In short, indexed annuities suffer from many of the same problems that plague traditional asset classes in low interest rate and high valuation environments.
Example #1: Stocks and Bonds
Say we have $1,000,000 to invest. We want to invest it for ten years. We’d like some equity upside, but want to guarantee that we will get back our $1,000,000 at maturity. How might we go about doing this?
It’s not all that complicated. We just need to make two investments.
- Buy a Treasury STRIP that matures 10 years from today with face value of $1,000,000. Today, this would cost approximately $834,000.
- Invest the remaining $166,000 in the S&P 500 (or any other equity strategy).
10 years from now, the Treasury STRIP will be worth $1,000,000. As a result, we will breakeven even if we lose our entire equity investment. If equities end the period flat, we will have $1,166,000 – an annualized return of 1.55%. If equities appreciate over the next decade, our return will exceed 1.55%. The chart below plots the annualized portfolio return for various S&P 500 scenarios.
So where is the risk?
The portfolio consists of a 83.4% allocation to a zero-coupon Treasury bond and a 16.6% allocation to equities. For those familiar with indexed annuity lingo, this 16.6% is the participation rate. This is essentially a very conservative asset allocation model. It may be low risk, but it is certainly not risk-free despite the fact that the portfolio will be worth at least the minimum $1,000,000 in 10 years.
First, the value of the account can dip below $1,000,000 prior to maturity. Suppose that over the next year interest rates are unchanged and equities crash 50%. The account value will be $932,277, a 6.8% loss. On a side note, I actually think this may be one of the key benefits of an indexed annuity product: helping investors maintain a more optimal investment horizon by masking over short-term fluctuations.
Second, the go-forward appeal of this strategy will be highly dependent on interest rates. Higher interest rates will make the strategy relatively more attractive. Why?
Higher interest rates –> Lower STRIP prices –> More money to invest in equities
If 10-year STRIP rates were 5.00% instead of 1.83%, the STRIP would only cost approximately $614,000, leaving a $386,000 to invest in equities. Now instead of a 16.6%/83.4% stock/bond split, we get a 38.6%/61.4% split while still taking no risk of a 10-year loss.
Below, we plot what our hypothetical indexed annuity replicating portfolio would have looked like historically over different interest rate regimes.
Unsurprisingly, the performance of the hypothetical indexed annuity tends to lag in strong equity markets and shine when equity markets crash. That being said, the simulated performance is quite compelling on a risk-adjusted-basis.
The picture changes, however, when we re-run the historical simulations using today’s interest rates. The average annual return drag increases from just 1.05% with historical rates to a whopping 6.40% with current rates. 6.40% of drag vs. equities is especially problematic once we factor in low expected equity returns and inflation. While the risk of capital loss may be effectively mitigated, we have just substituted it for the risk that we fail to meet our growth objectives.
Once again, risk cannot be destroyed, it can just be transformed.
Indexed annuities are not immune from the low interest rate malaise currently gripping the markets.
I think it’s also important to consider the appropriate benchmark for this type of investment. In my view, ending the 10-year period with $1,000,000 is not “breaking even.” In our initial example, we could have avoided equities entirely and used all of our capital to buy a Treasury STRIP. Today, our $1,000,000 could purchase approximately $1,199,000 notional of these bonds. In other words, if we stick to our 10-year investment horizon, then we can guarantee that our account is worth $1,199,000 10 years down the road. This equates to a 1.83% annualized return. This is our benchmark.
When we plot the simulated performance (assuming today’s interest rates) vs. this breakeven benchmark, we see that performance did in fact slip below 1.83% for investor’s that initiated their investment between October 1998 and January 2001. These investors would have struggled because they experienced both the popping of the tech bubble and the global financial crisis. Lo and behold, risk exists. In essence, the replicated indexed annuity is investing the future interest to be earned on the STRIP investment in equities. If this investment isn’t profitable, the investor would have been better off sticking the Treasuries.
Example #2: Options and Bonds
One way we can deal with the low equity participation rates caused by low interest rates from our first example is to introduce leverage. Specifically, we can do so by using equity index options.
Again assume that we have $1,000,000 to invest for ten years. We still want to impose a $1,000,000 floor on our account value at the end of the period, but now we want 100% participation with equity gains (at least up to some cap).
How would we go about doing this?
We start by buying $1,000,000 of 10-year Treasury notes at par. Today, the interest rate on this investment would be 1.88%. Treasury bonds pay interest semi-annually and so the investment will generate $9,400 in interest payments every six months.
To get our equity participation, we will use this cash flow to buy at-the-money call options on SPY that expire in six months. Let’s say each of these options costs $10, so we can buy 940 options. This is problematic. We want 100% participation in equity gains. To get this at SPY’s current price of around $206, we need to buy 4,854 options ($1,000,000 divided by $206).
940 options gives us a participation rate of less than 20%, not too much different than our portfolio in Example #1 above.
Fortunately, we can solve our issue with a bit of financial engineering. Say that call options with the same expiry and a strike of $209 (about 1.5% out-of-the-money) are trading at $8. If we sell one of these options for each $206 strike call we buy, we have created a bullish call spread. These call spreads only cost $2 each, allowing us to buy the 4,854 units we need.
We now get 100% participation in equity gains. However, we have paid a price for this. Namely, we only get 100% participation for gains up to 1.5%. We have sold the rights to any gains in excess of 1.5% in order to finance our call purchases. We have “capped” our six equity return at 1.5%.
At the end of six months, we will re-invest any option payoffs into Treasury notes/bills. As a result, we may have slightly more than $9,400 to buy options for the next six-month period.
We continue this process for ten years (or 20 six-month periods). Even if the worst case scenario plays out and the market goes down each and every period, we will still receive our $1,000,000 principal back from the 10-year Treasury note investment.
Below, we again simulate how such an approach would have hypothetically performed relative to the S&P 500.
When we use historical interest rates, the results are once again pretty compelling. On average, the simulated indexed annuity trails the S&P 500 by less 1% per year, while providing nice downside protection.
Unfortunately, when we repeat the simulation using today’s interest rates, we see that this simulation has the same shortcomings as our first one.
When interest rates are low, our Treasury bond position throws off very little cash. With low cash flow, we aren’t able to buy very many at-the-money call options. As a result, we need to sell calls with strikes that are quite close to today’s equity prices in order to finance our at-the-money call purchases. This effectively sets our cap very low and puts strict limits on how much equity upside can be realized. The annualized drag to the equity markets is now nearly 5% per year.
Once again, risk has not been eliminated. Our “reward” for buying the Treasury bond is the interest payments. We use these interest payments to get leveraged market exposure through options. If the market declines, the options will expire worthless and we have lost our interest payments.
The commonsense benchmark for this portfolio is just a 10-year Treasury bond. The 3/31/16 rate that was used in the simulation was 1.78%. This 1.78% is our benchmark. We see below that the simulated indexed annuity barely beats out this benchmark in most cases.
A Word About Dividends
Research Affiliates estimates that U.S. large-cap equities have a 10-year expected return of 1.3% after inflation. On a nominal basis – or adding back in inflation of 2.0% – this number becomes 3.3%. Of this 3.3%, they believe that inflation will contribute +2.0%, dividends will contribute 2.2%, and growth will contribute 1.3%. But, this adds up to 5.5%. What gives? Research Affiliates believes that equity valuations will gradually revert back to historical norms. They estimate that this will be a 2.2% annualized drag on performance.
As you can see, dividends are a crucial part of equity returns. If we remove the 2.2% dividend yield, the above expected return number drops from an already meager 3.3% to only 1.1%.
This is problematic for indexed annuity investors, since credits are often based on price, not total, return of the equity index.
To test the impact of this, we can perform some Monte Carlo simulations using the Research Affiliates capital market assumptions. We compare a 20/80 S&P 500/Barclays Aggregate portfolio to the following indexed annuity (note: we took this structure from a popular product in today’s market):
- 4% bonus on initial investment
- 100% participation rate on S&P 500 with a cap of 2.5%
- S&P 500 return is measured using the annual, point-to-point methodology (i.e. we compute the return using just the beginning of year and end of year S&P 500 values)
We performed 10,000 simulations of 10-year periods. The following histogram plots the annualized out/underperformance of the 20/80 portfolio vs. the indexed annuity over 10-year periods. Positive numbers mean the 20/80 portfolio outperformed. Negative numbers mean the indexed annuity outperformed. All returns are annualized.
On average, the 20/80 returned 3.45% per year over a 10-year period. The indexed annuity returned 1.89% per year. The 20/80 portfolio beat the indexed annuity in 88.8% of the simulations.
Indexed annuity proponents may point to the risk management benefits of the product in trying to reconcile these statistics. There are a few problems with this argument.
First, the 20/80 portfolio isn’t all that risky to begin with. It only lost money over 10-years in 1.1% of the simulations. And this is using today’s capital market assumptions where both U.S. stocks and bonds are overvalued and therefore offer low future expected returns.
Second, and much more importantly, we have to consider inflation. To see why, consider the simplest form of risk management, holding cash. This will guarantee that you protect your capital, until you wake up a decade later only to realize that inflation has eroded your purchasing power.
If we deduct 2.0% of inflation per year, the “risk management” scoreboard changes dramatically. The 20/80 loses money on an inflation-adjusted basis in 15.9% of the simulations, while the annuity fails to keep up with inflation 59.9% of the time! In our experiment, you are more likely to lose money than make money with the annuity over a decade. Hardly risk-free!
Conclusion
Risk cannot be destroyed, it can only be transformed. Warren Buffett famously said, “If you’ve been playing poker for half an hour and still don’t know who the patsy is, you’re the patsy.” The same idea holds true with any financial product. There is always risk somewhere. If someone selling a product says otherwise, then be very, very suspicious.
For indexed annuities, the main risk is that potential returns are severely limited when interest rates are as low as they are now. High interest rates are the fuel that may allow these products to deliver equity-like returns with less downside risk. Without high interest rates, however, you are going nowhere fast. Going nowhere fast is a problem when inflation is always nipping at your heels. Downside risk management is great, until it restricts your growth so much that your purchasing power erodes over time.
Data Sources and Disclosures
Data comes from the Federal Reserve, Research Affiliates, CBOE, and Morningstar. Calculations were performed by Newfound Research.
Index annuity guarantees are subject to the credit of the issuing insurance company.
All returns are hypothetical and backtested and reflect unmanaged index returns. Returns do not reflect fees. Past performance does not guarantee future results. Results are not indicative of any Newfound index or strategy. Hypothetical performance results have many inherent limitations and are not indicative of results that any investor actually attained. An investor cannot invest directly in an index. Index returns are unmanaged and do not reflect fees and expenses.
For the options analysis, we use historical VIX levels with a 20% premium applied to reflect the higher implied volatility typically associated with longer-term options.
