The increase in bond yields in 2022 has resulted in notable shifts in the attributes of different products and strategies. One product that has been significantly affected is fixed indexed annuities (FIAs).
Before the recent surge in interest rates (i.e., pre-2022), when caps on one-year FIA strategies were around (or below) 5%, I wasn’t really impressed with the value proposition of FIAs. But with one-year caps on FIAs now approaching (or even exceeding) 10%, the products are worth a fresh look among financial advisors, especially for clients who want a strategy that has some market upside potential with strong downside protection, as well as tax deferral.
FIAs, first introduced in the 1990s, provide the annuitant with principal protection and some upside potential. The process of creating an FIA is relatively straightforward, where an at-the-money call option is purchased and an out-of-the-money call option is sold so that the total cost of the options was equal to the available options budget.
Bond yields play a significant role in determining the options budget. When bond yields are low, the caps on FIAs are going to be relatively low (and vice versa). This is a function of market prices, where insurance companies have to build products given existing market dynamics.
The relative appeal of FIAs is going to evolve over time as the market changes, both in absolute terms (i.e., the cap) as well as to other strategies (e.g., investing in bonds).
The exhibit below includes an analysis where I estimate the cap on a hypothetical FIA from January 2000 to October 2022 using the Black-Scholes pricing model (which is a partial differential equation that can be used to describe the price of a European option over time), based on the S&P 500 as the underlier with a one-year term and annual point-to-point crediting strategy.
For the analysis, implied volatility is based on historical values for the Cboe S&P 500 One-Year Volatility index when available (or a model fit to the more traditional VIX), dividend yields are based on data obtained from Robert Shiller’s website, and bond yields are based on the yields on one-year constant maturity Treasury bonds index.
In November 2021 (roughly one year ago), estimated caps were around 5%, consistent with actual products available at the time. Caps have roughly doubled since then (i.e., are around 10% now), but are still below where they were before the global financial crisis (e.g., in 2006), when they exceeded 15%.
Caps were estimated to be as low as 3% in July 2020 and hovered around 4% for most of 2020. This relatively limited side made the products relatively unattractive at the time, in my opinion, versus other more vanilla strategies (e.g., just shifting more of a portfolio into equities) or other strategies that could offer higher fixed returns that are less complex (e.g., multi-year guaranteed annuities, or MYGAs).
The recent improvement in caps has changed the equation, though. The higher FIA caps available today present a decent amount of upside for someone who likes the idea of market participation but wants to do so without the risk of losing money (i.e., is risk averse).
FIAs also benefit from tax deferral when purchased in a taxable account. Taxes are an increasingly important consideration in a higher bond yield environment, especially among more conservative investments, like bonds, that typically have unfavorable taxation (i.e., all gains are realized annually and taxed at ordinary income levels).
While FIAs do have an equity component, it’s important to realize they are far more bond-like than stock-like when including in a portfolio.