Joe Halpern Published in California Broker: A New Approach to Annuities

I recently authored an article on structured note annuities which appears in the October 2014 issue of California Broker. They have graciously allowed me to it reprint here:

The structured note annuity (SNA) is a compel­ling and important offering that will profoundly affect the insurance complex. The flexibility of SNAs to match risk/return objectives opens the door to meeting a wide array of client needs that are not well met within existing annuity programs.

The launch of fixed indexed annui­ties (FIAs) in the 1990s was an innova­tion on a longstanding fixed annuity model. Owners could take a little risk on the yield in return for a higher potential payout. Using current pric­ing, a fixed annuity might offer a set 2% annual yield whereas an FIA would pay up to 3.5%, depending on market performance. Driven by the promise of greater upside, FIAs have grown to roughly $40 billion in annual issuance from their inception 20 years ago.

Fifteen years after the introduction of the FIA, a new annuity category was born: the structured note annuity (SNA). For brokers and clients alike, SNAs intro­duce increased flexibility to match risk/return objectives with an additional tool in the annuity product line. The insur­ance industry is increasing the level of risk in return for higher potential returns. Thus, while FIAs are limited to fully principal protected products and rela­tively modest caps, SNAs offer products with a defined level of principal at risk in exchange for higher profit potential.

Risk/Reward Comparisons

SNA’s fill a gap in the cur­rent annuity offering:

• Fixed annuities offer fixed returns

• Fixed indexed annuities offer higher potential but capped re­turns with complete protection

• Variable annuities do not have defined protection but provide conceptually unlimited upside

• SNA’s provide increased upside at the cost of increased risk

As of the end of 2013, there was approximately $4 billion of notional invested in these products. While asset growth has been impressive, this is still an asset class in relative infancy, and we expect to see a plethora of new and hopefully innovative structured strate­gies to meet client retirement objectives.

Understanding Structured Notes

SNAs were born out of the existing struc­tured note market. Dominating this $2 trillion global asset class are large bank issuers that sell them primarily to high net worth retail clients. In the United States, annual issuance is approximately $100 billion. Similar to an FIA, the defining characteristic of a structured note is a defined outcome to the investor. A defined outcome is a commitment by the bank or insurance company issuer to deliver a return based on a refer­ence index. For instance, an FIA on the S&P 500 may guarantee 100% princi­pal protection if the S&P 500 finishes down and has the same return as the S&P 500 if it finishes up. It is capped at an annualized performance of 3.5%.

Existing Annuities Comparisons

The major distinction between SNAs and FIAs is that an FIA must guarantee 100% principal protection while an SNA can guarantee less than 100% protec­tion. So, an SNA can offer more upside potential. For example, while an FIA may offer 100% principal protection and a 3.5% maximum yield an illustra­tive SNA may offer only 90% princi­pal protection and have the ability to provide a higher maximum cap of 15%.

In summary, an SNA customer can take on a measured level of risk for increased return potential. The SNA innovation could widen the use of de­fined outcomes in the annuity space. Currently, the only defined outcome products available to annuity investors are FIAs — products that appeal to an audience that values principal protection much more than they value apprecia­tion potential. In contrast, SNAs appeal more to appreciation-seeking investors who want a level of downside protection.

Due to the exposure of potential princi­pal losses, SNAs are considered securities (unlike FIAs) and therefore must be regis­tered with the SEC and advisors offering the product must be licensed with FINRA.

Fit With Issuers

The SNA product platform is compelling to issuers of FIAs and variable annuities (VAs). The product allows FIA issuers to offer similar defined outcome products with additional flexibility in risk/reward characteristics. You can offer your clients 100% principal protection with up to 3.5% annual upside and then graduated levels of risk with higher annual upside. The product allows VA issuers to offer a unique array of protection features sought by the market. Products like man­aged volatility have been popular over the past few years due to their reduced volatility for the client and insurer and their perceived mitigation of downside risk. While managed volatility should help dampen downside loss, there is no defined buffer or protection level as­sociated with the strategy. SNAs would allow a VA issuer to provide a defined level of protection, which is a compelling characteristic of FIAs. Therefore, the SNA is a bridge between FIAs and VAs.

Understanding SNA Characteristics

SNA purchasers must select from the following variables, which dictate invest­ment characteristics. These characteris­tics improve with the following variables:

• Duration of the product – The longer the client commits to the structure.

• Underlying index – The more vola­tile the underlying index is.

• Degree of principal protection – Themore risk the investor is willing to accept.

A buffered cap option is the most popular product type. A buffer pro­vides a level of protection for first losses of an index. For example, if an SNA offers a 10% buffer on the S&P 500, the customer would be protected on the first 10% drop in the index and have exposure to negative moves thereafter. For instance, if the S&P 500 was at 1,800 when the SNA was issued, the SNA would protect the client from principal losses until the S&P 500 declined below 1,620, representing a 10% drop (10% of 1,800 = 180; 1,800 – 180 = 1,620).

A cap is the maximum gain that a client can generate. Let’s imagine that the cap is 5%: If the S&P 500 finishes up 3%, the client would receive a 3% gain. If the S&P 500 finishes up 10%, the client would receive a 5% gain since the 5% cap limits the upside.

As mentioned earlier, issuers can pro­vide different upside scenarios by adjusting buffer protection and total duration. For example, while a one-year 10% buffer can provide a 5% cap for the year, a six-year product with the same buffer can offer a total 66% cap for the six-year period. Simi­larly, the cap amount declines as higher buffer levels provide additional protection. For example, for a six-year duration, the carrier can offer a 66% cap with a 10% buffer and a 30% cap with a 25% buffer.

Sorting through the dizzying array of SNA permutations can be challeng­ing for even a seasoned investor. As the SNA offering matures, new instruments will arise to help guide the consumer to the product that best matches their risk/reward profile. Also, potentially simplified products may offer similar investor freedoms with fewer options.

Many of the largest variable annuity issuers are in the process of developing an SNA program or closely watching the early SNA movers — as a testament to its potential, SNAs have garnered $4 billion in notional value from the few current issuers available. It is a space worth watching closely as it continues to grow and evolve.

What’s in a name?

A few names have been used to describe this annuity category:

• Indexed variable annuities — These are in­dexed funds in the VA space, which may cause product confusion.

• Structured note annuities /Structured Prod­uct annuities — The product is very similar to the current bank product defined as “struc­tured notes” or “structured products.”

• Author’s recommendation — If I had my druthers, FIAs would be renamed “struc­tured fixed annuities” and SNAs would be renamed “structured variable annuities.”

The Skinny On Structured Note Annuities

Structured note annuities are performance driv­en by a reference index, such as the S&P 500. Investors can choose from a selection of defined protection options against market downturns (e.g., protection against the first 20% decline), in return for capped upside performance. This middle ground product provides more upside than fixed index annuities and more defined protection than variable annuities. There is a diz­zying array of product choices to make without intuitive guidelines on how to make them.

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