By Dan Schulte, Senior Vice President and Manager, Annuities and Insurance
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There are times when stock market volatility leaves some investors worried about meeting their retirement goals. This has left many of these individuals seeking products and strategies that can provide downside protection with upside potential. A product that can help give investors some degree of peace of mind in turbulent times is a Registered Indexed-Linked Annuity (RILA).
A RILA is a type of annuity that is designed to bring levels of protection and opportunities for growth together. Although all investments are subject to risk, a RILA seeks to provide protection and growth by tracking the performance of a market index, offering an opportunity to capture positive index returns (up to a limit), while providing a level of protection if the index return is negative. RILAs, however, are not directly invested in either an index or the market.
As a RILA owner, you can choose from a broad range of investment strategies that include downside risk protection (typically referred to as a buffer or floor) and upside performance tied to a specific market index, subject to a maximum defined in the contract (typically referred to as a cap rate). Some common examples of these indexes include the S&P 500, the NASDAQ 100 and the Russell 2000. There are various crediting methods to track a market index’s performance. For example, a RILA typically allows investors a choice of one or more investment segments (usually one to six years) that establish the time horizon for your strategy—a beginning point and an ending point. Each investment segment will credit/debit the account value based on the unique option selected.
What this means to an investor is that a portion of their account can be insulated from market loss, but it’s important to understand that for that portion to be protected, a limit on earnings will be placed on that money. When the selected index increases, typically there will be a limit (i.e., cap) on earnings. The crediting rates vary, but generally the longer the segment duration and the smaller the segment buffer or floor, the higher the rate for the particular index allocation selected.
It is also important to realize that this annuity can still be exposed to extensive market downturns—and along with that, investors can still suffer the loss of principal. With that in mind, risk tolerance should be carefully reviewed prior to purchasing a RILA.
Buffers, Floors, Caps and Participation Rates
Several key features define RILAs. A common option is the utilization of buffers, floors, caps and participation rates.
- Buffer: A buffer rate protects a percentage of loss on the downside. For example, a -10% buffer rate means the insurance company will absorb up to 10% of index losses at the end of the strategy term. If the index loss is 25% on the contract anniversary, the performance will be
-15%. - Floor: With a floor rate, the policyowner will absorb a certain percentage of risk on the downside. For example, assuming a 10% floor rate, if the index selected performance is -15%, the policyowner will receive a 10% loss.
- Cap: A cap rate limits the investment return on the upside. For example, if a policy owner elects a one-year S&P 500 strategy segment and a 10% buffer rate that offers a 15% cap on the upside, on the contract anniversary, if the performance of the S&P 500 is 15% or better, the contract will be credited at 15%.
- Participation Rate: The participation rate determines the percentage of index gains credited to the annuity. For example, if there is an 80% participation rate on a 10% index gain, that will result in an 8% return. A higher participation rate increases the upside potential but may involve higher fees.
More Features: Performance Trigger and Dual Direction
A “performance trigger rate” credits a predetermined cap rate at the end of the term example, the indexed performance is zero or positive. For example, if the 1-year S&P 500 trigger rate cap is 9%, and the annual S&P growth is 3%, 9% will be credited to the contract. These options will generally have a buffer rate for downside protection.
The “dual direction trigger rate” is credited to your account if the index change is up, flat or down within the protection level at the end of a term. If the index change is down more than the protection level, the dual performance trigger rate is used to offset loss, which may provide a positive return. For example, assume a policyowner selects the 1-year S&P 500 dual direction performance trigger rate of 7% with a 10% buffer. In this example if the performance of the S&P 500 is flat or positive, 7% will be credited to the account. Also, if the rate of return is negative up to -10%, 7% will also be credited. If the performance loss is greater than -10%, the contract will continue to buffer the first 10% of loss. For example, if the performance is -15%, the return will be -5%.
Performance Lock
Many contracts offer a “performance lock” feature that allows investors to periodically lock in index gains or limit losses during a segment term. Generally, a new crediting rate strategy will be established on the next monthly or annual contract anniversary or the end of the segment term.
Access to the Funds
Most RILAs have no ongoing annual fees, however, most do restrict access to the funds. Typically, if a withdrawal is made within a certain period after a purchase payment (typically within three to six years, but sometimes longer), the insurance company usually will assess a withdrawal charge, which may also be called a contingent deferred sales charge. Most contracts will allow you to withdraw 10% of your account value without paying a withdrawal charge. Also, any withdrawals prior to age 59 1/2 (an age set by law) may be subject to additional fees and penalties.
RILAs can be complex products, and you should understand the features, risks and costs prior to making a purchase. Your financial advisor can help you analyze your situation and discuss various annuity options to consider as a complement to your portfolio.
Variable annuities are subject to investment risk, including loss of principal, and contract/policy values fluctuate daily. Investment returns and principal value will fluctuate with market conditions so that units, upon distribution, may be worth more or less than the original cost. Any guarantees are backed by the financial strength and claims-paying ability of the issuing company.
IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.