06/04/2018

Structured Note Innovations vs Traditional: Competitive or Complimentary

Buffer annuities will continue to grow in popularity: Blackrock research finds that 39 percent of retirement savers would move further away from their cash holdings if their capital was protected. As cash continues to be a non-performing asset, interest in products that offer upside potential and downside protection will increase” – Point #1 in “Critical Trends in 2018” from the Insured Retirement Institute (IRI) State of the Insured Retirement Industry 2017 Review & 2018 Outlook

The top trend according to the State of the Insured Retirement Industry is for the buffered annuity and like products to continue to grow in popularity. That is quite the statement given what the category has done from its creation in 2010 by AXA, a mere eight years ago. According to LIMRA, there were $9 billion in buffered annuity sales in 2017, a 250% growth spike in a three year period. Now they are on the verge of breaking out as a category killer.



To be clear, the strategies in question are primarily the graphic above on the left (Buffer) but also to some extent the one on the right (Shield). The annuity providers had borrowed the proven strategy from the banks who issue it in the form of a structured note. An example of how the buffer strategy works is as follows: 10% first-loss protection (i.e., buffer) on the downside and 150% leveraged participation up to a cap of 14% over an 18 month period on the S&P 500. The orange line on the graph illustrates the return expectations at the end of the period based on how the S&P 500 price return performs – it is important to note that the strategy will not capture the dividend of the underlying index regardless of the structure (e.g., whether a structured note, annuity or mutual fund). Clients and advisors alike find this compelling as it provides a level of definition to one’s exposure.

Given the popularity and relative newness of the annuity product it is worthwhile reviewing some of the differences between a bank issued structured product and an insurance issued one (i.e., annuity). All the differences ultimately stem from the fact that one is executing the insurance issued note within an annuity platform which adds an additional layer of complexity to the transaction. This extra layer of complexity results in lower liquidity due the realities of both surrender charges and limited alternative investment choices on these dedicated platforms. Due the longer term nature of the annuity product, there is also a mismatch between the underlying credit component of the strategy and the equity exposure. For example, if you buy a one year note from a bank you are taking on the credit risk of the bank for a single year which the bank is paying you for (whether you or your clients realize this or not – note Lehman bankruptcy – structured notes for more detail). If you purchase a one year buffered note in an annuity you are actually taking on the credit risk of the insurer for multiple years and should therefore be paid based on a longer term credit yield. As a result, an insurer may be able to provide better terms relative to a bank currently but, based on the path of future yields, may provide worse terms in the future at a point when the client is locked in. The fact that client exposure is much less defined over the term of the investment than might be believed is a very complex point. Furthermore, that initial level of definition materially erodes over time. As opposed to having pure definition as to a specific return outcome, the client in reality has a defined exposure to a particular type of strategy – the buffered or shield strategy. This is not necessarily a negative, just the reality of the position being taken on by the client.

Some benefits that the annuity products bring to the table is a much higher level of consistency regarding the product and transparency regarding initial product characteristics. The insurance providers have truly standardized their offerings which is always helpful for advisors and clients alike. The product also does a great job in bridging the fixed indexed annuity to the variable annuity space. Fixed indexed annuities are limited in their upside due the constraint of providing full principal protection on the downside. Meanwhile, variable annuities provide a low level of definition to performance though have better upside potential. Buffered annuities strike a nice middle ground where additional upside is provided by taking a defined level of downside risk, providing elements of both product offerings.

There have been a number of additional innovators over the last five years, my own firm included, that have introduced structured note type investments within funds and UITs. While these type of investments have not enjoyed the pop in assets buffered annuities have, they have also been introduced by groups with less firepower then the insurers. It is worthwhile taking a look at these product types as they contain many similar characteristics to both the annuity product and structured note as detailed in the table above.

In summary, it is an exciting time in the Defined Outcome space as the product type becomes more mainstream due the demand of the end client for a hedge product with a bit more definition. It will be interesting to see the additional innovation within the structured annuity space as well as the traditional investing space (e.g., mutual funds, ETFs, UITs).