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.
The State of Risk Management
By Justin Sibears
On August 20, 2018
In Portfolio Construction, Risk Management, Weekly Commentary
This post is available as PDF download here.
Summary
I was perusing Twitter the other day and came across this tweet from Jim O’Shaughnessy, legendary investor and author of What Works on Wall Street.
As always. Jim’s wisdom is invaluable. But what does this idea mean for Newfound as a firm? Our first focus is on managing risk. As a result, one of the questions that we MUST know the answer to is how to get more investors comfortable with sticking to a risk management plan through a full market cycle.
Unfortunately, performance chasing seems to us to be just as prevalent in risk management as it is in investing as a whole. The benefits of giving up some upside participation in exchange for downside protection seemed like a no brainer in March of 2009. After 8+ years of strong equity market returns (although it hasn’t always been as smooth of a ride as the market commentators may make you think), the juice may not quite seem worth the squeeze.
While we certainly don’t profess to know the answer to our burning question from above, we do think the first step towards finding one is a thorough understanding on the risk management landscape. In that vein, this week we will update our State of Risk Management presentation from early 2016.
We examine eight strategies that roughly fit into four categories:
The Historical Record
We find that over the period studied (December 1997 to July 2018) six of the eight strategies outperform the S&P 500 on a risk-adjusted basis both when we define risk as volatility and when we define risk as maximum drawdown. The two exceptions are the equity collar strategy and the protective put strategy. Both of these strategies are net long options and therefore are forced to pay the volatility risk premium. This return drag more than offsets the reduction of losses on the downside.
Data Source: Bloomberg, CSI. Calculations by Newfound Research. Past performance does not guarantee future results. Volatility is a statistical measure of the amount of variation around the average returns for a security or strategy. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. The Tactical Equity strategy was constructed by Newfound in August 2018 for purposes of this analysis and is therefore entirely backtested and not an investment strategy that is currently managed and offered by Newfound.
Data Source: Bloomberg, CSI. Calculations by Newfound Research. Past performance does not guarantee future results. Drawdown is a statistical measure of the losses experienced by a security or strategy relative to its historical maximum. The maximum drawdown is the largest drawdown over the security or strategy’s history. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. The Tactical Equity strategy was constructed by Newfound in August 2018 for purposes of this analysis and is therefore entirely backtested and not an investment strategy that is currently managed and offered by Newfound.
Not Always a Smooth Ride
While it would be nice if this outperformance accrued steadily over time, reality is quite a bit messier. All eight strategies exhibit significant variation in their rolling one-year returns vs. the S&P 500. Interestingly, the two strategies with the widest ranges of historical one-year performance vs. the S&P 500 are also the two strategies that have delivered the most downside protection (as measured by maximum drawdown). Yet another reminder that there is no free lunch in investing. The more aggressively you wish to reduce downside capture, the more short-term tracking error you must endure.
Relative 1-Year Performance vs. S&P 500 (December 1997 to July 2018)
Data Source: Bloomberg, CSI. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. The Tactical Equity strategy was constructed by Newfound in August 2018 for purposes of this analysis and is therefore entirely backtested and not an investment strategy that is currently managed and offered by Newfound.
Thinking of Risk Management as (Uncertain) Portfolio Insurance
When we examine this performance dispersion across different market environments, we find a totally intuitive result: risk management strategies generally underperform the S&P 500 when stocks advance and outperform the S&P 500 when stocks decline. The hit rate for the risk management strategies relative to the S&P 500 is 81.2% in the four years that the S&P 500 was down (2000, 2001, 2002, and 2008) and 19.8% in the seventeen years that the S&P was up.
In this way, risk management strategies are akin to insurance. A premium, in the form of upside capture ratios less than 100%, is paid in exchange for a (hopeful) reduction in downside capture.
With this perspective, it’s totally unsurprising that these strategies have underperformed since the market bottomed during the global market crisis. Seven of the eight strategies (with the long-only defensive equity strategy being the lone exception) underperformed the S&P 500 on an absolute return basis and six of the eight strategies (with defensive equity and the 60/40 stock/bond blend) underperformed on a risk-adjusted basis.
Annual Out/Underperformance Relative to S&P 500 (December 1997 to July 2018)
Data Source: Bloomberg, CSI. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. The Tactical Equity strategy was constructed by Newfound in August 2018 for purposes of this analysis and is therefore entirely backtested and not an investment strategy that is currently managed and offered by Newfound.
Diversifying Your Diversifiers
The good news is that there is significant year-to-year variation in the performance across strategies, as evidenced by the periodic table of returns above, suggesting there are diversification benefits to be harvested by allocating to multiple risk management strategies. The average annual performance differential between the best performing strategy and the worst performing strategy is 20.0%. This spread was less than 10% in only 3 of the 21 years studied.
We see the power of diversifying your diversifiers when we test simple equal-weight blends of the risk management strategies. Both blends have higher Sharpe Ratios than 7 of the 8 individual strategies and higher excess return to drawdown ratios than 6 of the eight individual strategies.
This is a very powerful result, indicating that naïve diversification is nearly as good as being able to pick the best individual strategies with perfect foresight.
Data Source: Bloomberg, CSI. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. The Tactical Equity strategy was constructed by Newfound in August 2018 for purposes of this analysis and is therefore entirely backtested and not an investment strategy that is currently managed and offered by Newfound.
Why Bother with Risk Management in the First Place?
As we’ve written about previously, we believe that for most investors investing “failure” means not meeting one’s financial objectives. In the portfolio management context, failure comes in two flavors. “Slow” failure results from taking too little risk, while “fast” failure results from taking too much risk.
In this book, Red Blooded Risk, Aaron Brown summed up this idea nicely: “Taking less risk than is optimal is not safer; it just locks in a worse outcome. Taking more risk than is optimal also results in a worst outcome, and often leads to complete disaster.”
Risk management is not synonymous with risk reduction. It is about taking the right amount of risk, not too much or too little.
Having a pre-defined risk management plan in place before a crisis can help investors avoid panicked decisions that can turn a bad, but survivable event into catastrophe (e.g. the retiree that sells all of his equity exposure in early 2009 and then stays out of the market for the next five years).
It’s also important to remember that individuals are not institutions. They have a finite investment horizon. Those that are at or near retirement are exposed to sequence risk, the risk of experiencing a bad investment outcome at the wrong time.
We can explore sequence risk using Monte Carlo simulation. We start by assessing the S&P 500 with no risk management overlay and assume a 30-year retirement horizon. The simulation process works as follows:
We plot the distribution of PWRs for the S&P 500 below. While the average PWR is a respectable 5.7%, the range of outcomes is very wide (0.6% to 14.7%). The 95 percent confidence interval around the mean is 2.0% to 10.3%. This is sequence risk. Unfortunately, investors do not have the luxury of experiencing the average, they only see one draw. Get lucky and you may get to fund a better lifestyle than you could have imagined with little to no financial stress. Get unlucky and you may have trouble paying the bills and will be sweating every market move.
Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends.
Next, we repeat the simulation, replacing the pure S&P 500 exposure with the equal-weight blend of risk management strategies excluding the equity collar and the protective put. We see quite a different result. The average PWR is similar (6.2% to 5.7%), but the range of outcomes is much smaller (95% confidence interval from 4.4% to 8.1%). At its very core, this is what implementing a risk management plan is all about. Reducing the role of investment luck in financial planning. We give up some of the best outcomes (in the right tail of the S&P 500 distribution) in exchange for reducing the probability of the very worst outcomes (in the left tail).
Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends.
Conclusion
There is no holy grail when it comes to risk management. While a number of approaches have historically delivered strong results, each comes with its own pros and cons.
In an uncertain world where we cannot predict exactly what the next crisis will look like, diversifying your diversifiers by combining a number of complementary risk-managed strategies may be a prudent course of action. We believe that this type of balanced approach has the potential to deliver compelling results over a full market cycle while managing the idiosyncratic risk of any one manager or strategy.
Diversification can also help to increase the odds of an investor sticking with their risk management plan as the short-term performance lows won’t be quite as low as they would be with a single strategy (conversely, the highs won’t be as high either).
That being said, having the discipline to stick with a risk management plan also requires being realistic. While it would be great to build a strategy with 100% upside and 0% downside, such an outcome is unrealistic. Risk-managed strategies tend to behave a lot like uncertain insurance for the portfolio. A premium, in the form of upside capture ratios less than 100%, is paid in exchange for a (hopeful) reduction in downside capture. This upside underperformance is a feature, not a bug. Trying too hard to correct it may lead to overfit strategies fail to deliver adequate protection on the downside.