#192 | The Curious Case of the Structured Annuity
If you’re even a passive observer of the annuity market, you’ve probably noticed that a new product category has burst onto the scene in the past 5 years and is quickly gobbling up share against traditional variable annuities (VAs) and fixed indexed annuities (FIAs). There are lots of different names for these new products – index-linked variable annuities (IVAs), registered index-linked annuities (RILAs), buffer annuities and structured annuities (SAs) – that no one can seem to agree on. But for this article, I’m sticking with calling them structured annuities because I think that’s the most comprehensively accurate description of the product. Regardless of what you call them, their growing influence on the annuity space is undeniable. This year alone they’re up nearly 60% over last year and now constitute a significant portion of overall industry variable annuity sales. More and more insurers are getting into the market with their own twist on the structure in hopes of capturing a slice of a rapidly growing category. It seems like annuity companies have found a new and better mousetrap, one that will inevitably make its way over to life insurance as well, but is that actually what’s going on? Not quite.
The basic structured annuity value proposition is simple – the client receives exposure to the movements of an external index while taking a defined amount of downside risk for a defined amount of upside return. The classic structured annuity design is to offer a “buffer” of protection against market downturns, after which the client is fully exposed, in exchange for capped upside participation. Think of it like an Indexed UL crediting strategy but where the client can get a negative credit to the extent that the index falls below the specified buffer level. In option terms, the trade is equivalent to selling a put option at the buffer level and using the proceeds (in addition to the earnings on the fixed income portion of the account) to buy a call spread for the cap. Think of it like a fixed indexed annuity with more downside risk and more upside potential, which is exactly why it’s classified as a securities product rather than a state-regulated fixed insurance product.
So what’s the problem? The problem is that although structured annuities are new to the annuity market, they are not a new idea at all. Structured notes are virtually identical to structured annuities but they use a single zero-coupon bond (the “note”) rather than the insurer portfolio to generate the yield to fund the option package. Structured notes attract nearly $50B in new flows annually in the United States, which is dwarfed by Switzerland (over $400B), South Korea ($140B), Germany and other European and Asian countries. Structured notes are the real deal. And before you get super excited about structured annuities, you should probably know more about what they are and how they work.
The first time I was exposed to structured notes, I thought I’d entered a fantasy world. I couldn’t believe it existed. Whereas structured annuities are rigidly constrained by state filing and FINRA requirements, structured notes can exist in a nearly infinite array of forms. The bank you use, the payoff you want, the compensation structure, the term length and a variety of other factors are all customizable or available off the rack from the structured notes issuer. Buying a structured note can be as simple as making an equity trade – click a few buttons and you’re done. Unlike an annuity, the note sits in your account at the custodian just like any other asset, so you see it alongside of your other investments. Oh and the tax treatment is generally accepted to be long-term capital gains for any note longer than 13 months, which is obviously superior to ordinary income taxation for an annuity.
Structurally, structured notes are an obviously superior choice to structured annuities. But the problems for structured annuities don’t end there. If you design a structured note that is identical to your favorite structured annuity, guess which one has better rates? Yup, the structured note. Structured annuities lose the features war, the flexibility war, the transparency war and the value war. So why in the world would anyone buy a structured annuity over a structured note?
That was exactly what was going through my head the first time I really understood what a structured note was and how it worked. I started asking around and got some answers that didn’t satisfy me. Some folks said “well, structured annuities get tax deferral” because that’s the stock line for why annuities make sense, but it doesn’t really apply here. Structured notes get deferred long-term capital gains treatment. Structured annuities get deferred ordinary income tax treatment. Then some folks said “well, structured annuities have a defined surrender value where structured notes don’t have a liquid secondary market.” This is also not really an issue. Structured annuities offer interim value calculations that are basically shadow secondary market valuations, with the notable exception of Shield, the Brighthouse product, which uses a generous pro-rata valuation. And these days, there actually is a pretty robust secondary market for structured notes and you don’t necessarily have to sell it back to the bank who issued it to you. Then other folks said “well, it’s because people would rather be exposed to the credit quality of an insurance company than a bank.” That’s fair, but now there are non-bank issuers in the market operating through third-party platforms so you can, for example, use something like a Toyota note to back your structured note packaged for you by Halo Investing.
And so my question went unanswered and that ate away at me, as the head of product development and pricing for an insurance company that was hanging its hat (and is still hanging its hat) on structured annuities. I kept digging into the world of structured notes. I even managed to get a seat on a panel discussion at the big annual structured note conference put on by SRP, where I was literally one of two insurance people there and the other guy was from AXA, then and now the largest issuer of structured annuities. By and large, what shocked me was that insurance people who were getting excited about structured annuities were ignorant about structured notes. They treated it as if it was a distant and unrelated market, as if Kennedy had ignored Russia building up a missile stockpile in Cuba because Russia itself was far away.
But here’s the crazy twist – structured notes are a superior form of a structured annuity, but fixed indexed annuities are a superior form of a principal-protected structured CD (also called a market-linked CD, or MLCD). FIAs obviously have deferred ordinary income tax treatment. Structured CDs, by contrast, require the accrual and taxation of an equivalent yield even though interest is contingent on the movement of the index. Furthermore, the yields underlying structured CD rates are subject to bank capital requirements and investment restrictions, which are arguably more onerous than the restrictions for fixed life insurance products, which means the option budget on an FIA can and should exceed a structured CD. The only real benefit of a structured CD over an FIA is FDIC insurance, but you can obviously buy an FIA from a A+ rated insurer to hedge that risk. There’s a reason why the structured CD market in the US is tiny by comparison to international principal-protected structured notes. It’s called an FIA, a $70B market that’s even bigger than structured notes. If people want principal protection with upside potential in the US, they’re better off in an FIA than a structured CD.
The irony of the rise of structured annuities is that structured notes are superior in every way except that, theoretically, structured annuities offer indefinite tax deferral. But what about if you could offer structured annuity payoffs in a chassis that offers tax free income? Enter life insurance. Insurers could easily put structured crediting options into a VUL chassis, which would lack many of the flexibility benefits of a structured note but would have clearly superior tax treatment. Now it’s a fair fight. So if you’re looking for the next growth market in VUL that doesn’t exist yet*, I think the answer is pretty obvious – Structured Variable UL. Get ready.
But in the meantime, before you pull the trigger on selling a structured annuity, I’d highly recommend you check out Halo Investing, SIMON and contact banks directly for their off-the-shelf (“calendar”) structured note offerings. You’ll be amazed at the universe of available offerings and how incredibly attractive the pricing can be.
*AXA actually has had a structured crediting option, which they call the Market Stabilizer Option, in their VUL products since 2010 (or so). It has suffered from a variety of afflictions but the primary one is AXA’s insistence on making the rates terrible relative to virtually identical structured annuity offerings in their own annuity products. From what I’ve heard, AXA prices the MSO based on 1 year earned rates rather than more traditional 7-10 year fixed income instruments used for annuities and other life insurance products. Hence, the terrible rates that won’t get any attractive relative to other options unless interest rates go to zero (conversation for another day) or AXA changes its asset-liability matching strategy for the account.