The Risk and Return Profile of Index-Linked Annuities: How to Build the Optimal Portfolio

Registered index-linked annuities (RILAs) offer a balance of growth potential and downside protection. But while they have gained popularity as retirement and investment products, they also present capital, liquidity and asset-liability management challenges to insurance companies.

These complex products appeal to consumers because they provide exposure to market gains while limiting losses – a benefit that is particularly attractive during periods of extreme market turbulence. However, RILAs are also complex, making it difficult for consumers, their financial planners and the insurance companies issuing these annuities to estimate their overall portfolio impact.

Alla Gil

Chief risk officers of insurance companies certainly have their share of concerns about RILAs. These products not only impact insurers’ capital and liquidity ratios but can also potentially cause ALM mismatches. Indeed, sudden changes in the market environment may prove hedges to be either inadequate – because of increased correlations – or excessive – because, say, early withdrawals overwhelm embedded penalties.

Some features in product design, moreover, might trigger reputational risk for insurers, if a lack of demand causes income disruption or if specific RILAs are determined not to be in the best interest of consumers. Construction of optimal hedges for these products therefore requires a full understanding of potential cash flows and mark-to-market (MTM) outcomes in a dynamic correlation setting. 

The Role of Caps and Buffers: Breaking Down RILAs

The potential to diversify investment or retirement portfolios is perhaps the greatest appeal of RILAs to consumers. While there is nothing new about the diversifying effect of the underlying indices, these products are supposed to provide additional advantages through their structured features: caps and buffers.

Caps and buffers have far-reaching implications and vary widely between various underlying indices, RILA issuers and lock-in terms. They are critical in determining the risk-return profile of the investment.

Insurance companies that issue these annuities also have a responsibility to ensure that their products are designed to meet the needs of specific market segments and that they are transparent about the risks and benefits. They must help financial planners understand which products serve the best interests of their clients, while providing clear information on the functionality of the RILA caps, buffers and index-linking.

A lack of understanding of the full range of RILA product outcomes could lead to mismatches between the investor's goals and the product the investor chooses. One way of achieving the required transparency is to factor the full range of market scenarios – including potential shock events and their ripple effects – into RILA forecasts.

Caps limit the maximum gain an investor can earn in a given period. While this can protect the insurance company from excessive payouts, it also limits the upside for the consumer. Buffers, meanwhile, protect against losses up to a certain percentage.

For instance, if a product offers a 10% buffer, the insurance company absorbs the first 10% of losses, with the investor bearing any losses beyond that point. Understanding which caps and buffers are appropriate for different market segments is therefore crucial.

A retiree with a conservative risk tolerance, for example, might prefer a product with a lower cap and a higher buffer, accepting limited gains in exchange for more protection. In contrast, a younger investor with a longer time horizon might seek a higher cap and a lower buffer to maximize growth potential.

One hypothetical example of such a product is depicted in Figure 1.

Figure 1: A Sample RILA Product

Source: Schwab.com

The "cap rate" in the left-hand chart in Figure 1 is 10%, meaning you capture any growth up to 10%, under the following scenarios:

Scenario 1: Index return = 6% → RILA return = 6%.

Scenario 2: Index return = 12% → RILA return = 10% (10% cap rate)

The "buffer" in the right-hand chart of Figure 1 is –10%, meaning the insurance company will absorb losses up to –10%. Your account value is reduced when the negative index return exceeds the "buffer" percentage. (See Scenarios 1 and 2 in the right-hand chart.)

Scenario 1: Index return = –6% → RILA return = 0%

Scenario 2: Index return = –12% → RILA return = –2% (–10% buffer)

Let’s now consider an example with some of the most common underlying indices offered in these products – lock-in terms and sample cap and buffer features (Figure 2).

Figure 2: RILA Products (with Typical Features) and Their Projection Results

Source: Straterix

The products highlighted in Figure 2 were projected on the full-range scenarios over a six-year horizon. All their features were applied along each scenario, with capped positive returns and respectively reduced negative outcomes. Products with lock-in terms of shorter than six years were rolled over to match the horizon for consistent comparison.

The two most attractive products with the highest expected returns and worst-case outcomes are highlighted in green. However, it is possible to further improve these results by considering various combinations of these products and by constructing investment portfolios with the different weights applied to them.

By projecting these portfolios on the full-range scenarios and comparing their average and the worst-case outcomes, we can select the optimal combination of RILAs. Our analysis revealed that the following optimal combination generates an expected return of 40.95%, with the 99th worst-case percentile outcome of only -5.84%:

• 47% of gold-based RILA
• 23% of MSCI EM, with 9.75% cap and a 30% buffer
• 16% of U.S. RE ETF-based RILA
• 6% of Nasdaq-based RILA
• 8% of S&P 500, with 95% cap and a 50% buffer

On the downside, the above portfolio is heavily concentrated in gold-based RILA, which may be prone to idiosyncratic shocks. To quell worries of these possibilities, we constrain allocation to a single index at 20%. This produces a balanced portfolio with 34% expected return over the six-year horizon and the 99th worst-case percentile of -14%.

These results quantify the power of diversification. To fully understand where the diversification is coming from, we calculate in Figure 3 (below) the correlations between the underlying indices in the central part of the balanced portfolio return distributions (see the fields in green, 50th percentile, reflecting stable markets) and the tail of the returns’ distribution (see the red fields, 99th worst-case percentile, corresponding to the stressful conditions).

Figure 3: Correlations Between the Indices in Stable and Stressful Markets

Source: Straterix

These dynamic correlations calculated around the respective percentiles show that most indices exhibit slightly higher correlations in the tail, while the product based on gold provides greater diversification in the tail.

Through reverse scenario analysis, we can also look at the paths leading to both average and stressed outcomes. While analyzing these scenarios, we can see which typical trends lead to the average and the worst-case outcomes.

Figure 4: Rates and Credit Spread Trends

Source: Straterix

Stressful markets are not influenced much by interest rates, as they do not exhibit substantially different behavior between the 50th and 99th percentiles (Figure 4, left-hand chart). But they are characterized by increased credit spreads (Figure 4, right-hand chart). Consequently, credit spreads might serve as effective tail hedges for adverse performance of the balanced portfolio of RILA products.

Parting Thoughts

The full-range scenario methodology we have outlined allows insurance companies to analyze additional features of RILA products, like leverage, floors and early withdrawal anticipation. Using this approach, insurers can balance their objectives of servicing consumers and maintaining stable earnings.

While RILAs can be valuable tools for investment and retirement planning, it's crucial that all parties involved — consumers, financial planners and insurance companies — fully understand how these products work. This is key to ensuring that RILAs provide the intended diversification and risk management benefits, appropriately matching the investor's needs and current market conditions.

Alla Gil is co-founder and CEO of Straterix, which provides unique scenario tools for strategic planning and risk management. Prior to forming Straterix, Gil was the global head of Strategic Advisory at Goldman Sachs, Citigroup, and Nomura, where she advised financial institutions and corporations on stress testing, economic capital, ALM, long-term risk projections and optimal capital allocation.

Alla would like to express her gratitude to Henry Pu, a summer intern at Straterix, for his help with research and analysis for this article.