Buffer annuities: What to know

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 or registered index linked annuity (RILA). 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. They are very similar to, yet different from, indexed annuities. Read more: Indexed annuities: Look before you leap

If you are considering a buffer annuity, consider the following:

1. No two buffer annuities are the same. Take the time to understand all the features (including whether they can change after you buy), how investment returns are calculated, what happens if you need to access the money, and what the timing of the returns is.
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 fully understand the product and how it 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.

How does a buffer annuity work?

Buffer annuities link their growth to the movement of a market index, allowing investors to participate in some market gains. Similar to index annuities, these products typically offer some protection against losses and cap the return you can earn over a specific period of time. However, buffer annuities typically offer higher caps on market participation than indexed annuities 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 over a given 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 would see a loss of 15%.

For illustrative purposes only.

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 of 2007–2009. While a 10% buffer might take some of the sting out of the market losses, it won't protect you entirely.

Challenges of evaluating buffer annuities

Some investors might be attracted to the buffer annuity concept. "The idea of protecting the downside in exchange for limiting the upside makes sense, but it's important you really understand the specific product you're purchasing," says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company. "Buffer annuities can be complex, and the downside protection they offer is limited, leaving individuals potentially exposed if the market performs poorly."

For one thing, the underlying investments can be tricky to understand. To start with, you really don't own an investment. Instead, you own an insurance contract whose performance depends 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
• Buffers on downside exposure
• The varying time that each of these elements is in force 

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," says Tim Gannon, vice president at Fidelity Investments Life Insurance Company. "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. "Because each product may change the upside potential and loss protection while you own the product," says Gannon, "it is challenging to compare products and know if you're getting the right one for your situation."

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 that 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 an absolute floor to protect against any losses is important, you might consider variable annuities with a guaranteed minimum accumulation benefit (GMAB) rider. "Because the GMAB acts as a floor, these products may be easier to understand than a buffer annuity," says Gannon. The cost of the rider itself and limited equity participation are the only obstacles 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."