Buffer annuities: What to know

See how the upside potential is coupled with downside protection but not in all markets.

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Key takeaways

  • Buffer annuities can be complex, which can make them a challenge to understand.
  • To evaluate if buffer annuities are appropriate for your situation, take time to assess the return an annuity would earn under a wide variety of market environments.
  • Depending on your financial situation, alternatives to buffer annuities to consider could include defensive mutual funds or managed accounts, variable annuities with a guaranteed floor, or an "anchor strategy."

Today, when you look to enhance your investment returns within a well-constructed portfolio, it often means you need to take on more risk. A relatively new way to enhance returns is by using something called a buffer annuity. With these products, typically your returns are determined by the change in the S&P 500 index (without dividends). You receive some protection from modest declines in the index in exchange for giving up some upside.

If this is something of interest, consider the following:

  1. No 2 buffer annuities are the same and they can be very complex. Take the time to understand all the features, know which ones can change after you buy, what happens if you need to access the money, and identify the timing of the returns. One way for people to confirm that they understand something is to be able to explain it to someone else, like a "a 2-minute description."
  2. Consider how an investment that provides limited protection in the worst of markets fits in your plan. Think about 2008–2009 when the markets were down 50%. What would that have meant if this investment were in your portfolio, and would it affect your plans going forward?

If you understand the product and how the limited downside protection fits in your plan, these may be right for you. If you're not sure, though, here's more information on buffer annuities to consider.

What is a buffer annuity?

A buffer annuity is a type of variable annuity that in some ways resembles an indexed annuity.

Indexed annuities link their growth to the movement of a market index, allowing investors to participate in some market gains. These products typically offer some protection against losses and cap the return you can earn over a specific period of time.

Like indexed annuities, buffer annuities also link investment returns to a market index, but typically offer higher caps on market participation than indexed annuities do, in exchange for less protection against losses.

Here's how a typical buffer annuity works in practice (see graphic below):

  • Caps limit your upside potential each rolling 12-month period. For example, say your annuity had a cap of 11%. If the index returned 5%, you would earn 5%. If it returned 20%, 30% or more, you would only earn 11%.
  • Buffers limit your losses up to a certain point during the 12-month period, and you'll be on the hook for any losses beyond that point. Say your annuity has a buffer of −10% and the index loses 10%. In that case, the insurer absorbs the loss, and your return will be flat. If the index falls 25%, the insurer absorbs the first 10% and you take the hit on the loss of next 15%.

Bear market losses, by definition, exceed the protection offered by the typical buffer annuity, providing protection for the first 10% of loss. (Bear markets are usually defined by a fall in prices of 20% or more from a recent high). The S&P 500 lost about 50% of its value in the Great Recession, the US bear market of 2007–2009. The upshot: A 10% buffer might take some of the sting out of the market losses, but won't protect you from it entirely.

Challenges of evaluating buffer annuities

Some investors might be attracted to the buffer annuity concept. "On the surface, the idea of protecting the downside in exchange for limiting the upside makes sense," says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company. "One of the challenges with buffer annuities is that they're very complex and the downside protection they offer is limited, leaving individuals potentially exposed to large losses."

For one thing, notes Fidelity vice president Steve Lunt, the underlying investments can be tricky to understand. To start with, you really don't own an investment. Instead, the performance of an insurance contract that is owned is based on the movement of a particular index and can exclude the impact of dividends.

In addition, all buffer annuities are not created the same. Their performance can be driven by a combination of these elements:

  • Caps on upside potential
  • Participation rates on upside potential
  • Floors on downside exposure
  • Buffers on downside exposure
  • The time that each of these elements is in force varies across different products

To add to the complexity, each element (cap/participation rate/floor/buffer) can renew on a schedule set by the insurance company, not yours. Some products reset buffers and caps annually and other products hold steady with the same rates for several years at a time. As a result, the performance of individual buffer products can be very challenging to calculate and even more difficult to compare to other "similar" products.

Likewise, some investors may not fully understand how a given annuity's combination of caps and buffers will affect their returns, especially in turbulent markets. "If markets decline significantly, an investor could be alarmed at the losses they experience," Lunt says. "On the other hand, if markets do well, they could be surprised at how much a cap limits their potential upside."

Further complicating matters, the combination of caps and buffers available can change frequently. "The upside participation and downside protection you can get vary with the market," says Lunt. "One month you might have one set of options, and the next month they might change. Those changes can make it hard to know if you're getting a good deal."

Potential alternatives to consider

If you are concerned about market losses, you can also consider financial products that help manage the downside while still providing the opportunity for growth. There are mutual funds, ETFs, or professionally managed portfolios such as a defensive portfolio advisory service that can also help reduce the effect of sharp movements in the markets. The upside is there are no limits on growth potential; however you absorb all the downside risk. Work with a financial professional to evaluate options that align with your risk tolerance and overall financial goals.

"If having a floor to protect against any losses is important, products with similar attributes include variable annuities with a guaranteed minimum accumulation benefit (GMAB) rider. "Because the GMAB acts as a floor, these products are more straightforward than a buffer annuity," says Lunt. The cost of the rider itself and limited equity participation are the only drags to capturing potentially positive returns, making such an alternative easier to evaluate.

Another option to consider is what is known as an "anchor strategy," which uses a fixed, predictable asset such as a certificate of deposit (CD) or single-premium deferred annuity (SPDA) in conjunction with an equity component. "In these strategies, the SPDA or CD can provide a known return on investment for a certain period of time," says Ewanich. "The market performance of the remaining assets is easy to understand."

To evaluate a buffer annuity thoroughly, Ewanich suggests investors consider how it might have performed in a variety of past markets. "Balancing risk and reward requires a thorough understanding of your available investment choices and their potential outcomes in a variety of market conditions," he says. "To make sure they're investing appropriately, buyers have to understand what these products are, how they work, and evaluate their tradeoffs."

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