Buffer annuities: Balancing protection and growth

After two-plus years of market volatility — and facing the possibility of further volatility in an environment of rising interest rates — some investors are looking for financial vehicles that can provide downside protection without relinquishing all of the upside benefits. One investment that has dramatically increased in popularity is the registered index-linked annuity, also known as a buffer annuity.

The buffer annuity is a relatively new solution in the marketplace that allows investors to transfer some risk without sacrificing the possibility for growth potential. These annuities combine benefits and features found in traditional fixed index annuities and variable annuities. For more information about each type of annuity, read our earlier article outlining the key features of each.

The buffer annuity is a relatively new solution in the marketplace that allows investors to transfer some risk without sacrificing the possibility for growth potential.

How does a buffer annuity work?

Buffer annuities have three key factors that need to be considered:

• Level of protection: The first item is the desired level of protection, referred to as a “buffer.” The buffer is the mechanism that provides your downside protection, typically covering losses up to a threshold of between 10 – 30%. This is the percentage of loss that the insurance carrier will absorb. For example, if you have a buffer of 10% and your investment is down 8%, you’ll lose nothing. However, if the investment is down 25%, the insurance company protects against the first 10% of the loss, and you’ll lose 15%. Conversely, the annuity is credited a positive return when markets are up.
• Investment allocation: Next, you’ll determine how you want your investment allocated. Instead of investing directly in underlying subaccount options like traditional variable annuities, buffer annuity assets track the performance of a market index. The available indices typically include the S&P 500, Russell 2000, MSCI EAFE, and others. It’s important to note that since the assets aren’t directly invested in a particular index, dividends aren’t included in any interest credited to the contract, and it’s merely the “price return” that will factor into the crediting rate.
• Investment duration: Buffer annuities are typically purchased in one, three, or six-year lengths called “segments.” The investment assets allocated to each segment will track the performance of the selected index over the specified period. At the end of the term length, interest may be credited, and the segment will mature. Afterwards, a new segment will begin. Generally, the longer the duration, the more safety it will provide.

The specific combination of the prior items will determine how much, if any, interest may be credited. Like a fixed index annuity, the insurance carrier will impose a cap rate for the segment selected — essentially a ceiling for how much return can be credited over the segment duration. For example, as shown in the image below, a segment allocated on the selected index with a 10% buffer could have a cap of 12%, while a segment with a 20% buffer could have a cap of 5%. This rate is set by the insurance carrier and is locked in for the specified segment duration. Generally, the longer the duration, and the smaller the buffer, the higher the cap will be.

Generally, the longer the duration, and the smaller the buffer, the higher the cap will be.

Additional features

• Tax: As with other types of annuities, the growth that takes place inside a buffer annuity is tax-deferred. This allows the contract value to compound over time. No tax is owed until withdrawals are taken, and any taxable withdrawals are treated as ordinary income.
• Annuity surrender: Most buffer annuities come with a six-year surrender schedule. This means that a penalty is assessed on any withdrawals during the first six years. The penalty is usually higher at the beginning and decreases each year. Most contracts, however, allow for penalty-free withdrawals up to 10% each year.
• Fees: As long as invested assets are allocated to the index segments there are no insurance costs associated with a buffer annuity. (This is similar to a traditional fixed index annuity.) As a registered product, it may provide the option for allocation toward variable subaccounts. In this case, any assets allocated to the variable subaccounts would have fees assessed. Buffer annuities also allow for add-on benefits such as guaranteed death benefit protection and guaranteed income, which may come with additional costs.

Summary

While a buffer annuity isn’t a one-size fits all solution, there are benefits that may be suitable in circumstances where an investor is seeking market-linked growth along with some protection of principal. It’s important to understand that the benefits come with some drawbacks such as limited growth due to caps and the potential for some loss. As with any investment, investors should consider personal financial objectives and risk tolerance prior to purchasing a buffer annuity.

For more information or to discuss your annuity investment options further, feel free to contact us.