The American retirement market remains one of the biggest investment sectors in the world. This is not surprising given the size of the US economy and the large numbers of savers and retirees, many of them classed has high net worth.
In the last few decades, advancing regulation with changing solvency and capital treatment for insurance companies and the advent of newer financial solutions have changed the picture significantly. Traditional retirement solutions no longer seem efficient and these structural changes have also coincided with lower interest rates over the 12 years since the financial crisis. This has directly impacted annuity rates, with further downward pressure by longer life expectancy meaning that the income stream must be budgeted to last longer, either actuarially or self-directed.
The long road of accumulation
Retirement saving has now fully transitioned away from defined benefit solutions into a regime of flexibly increasing an investment pot (the accumulation phase) and then drawing that down either via a conventional annuity or other income producing means (the decumulation phase). Given all these factors and the appeal of a precise risk controlled strategy it is no surprise that the structured products market has been supplying solutions to this area for over twenty years.
Many investors will build a balanced portfolio of equities, bonds and other assets either themselves or through a managed savings plan. While this is a perfectly valid and popular approach it does have fundamental contradictions. In order to produce acceptable long term growth rates it is necessary to have a sizeable proportion in equities. However this runs the risk of sudden market falls, particularly at crucial times such as at the end of the accumulation phase or beginning of the decumulation phase. This effect is known as sequencing risk, one of the biggest concerns of this sector. Reducing the equity component will drastically inhibit growth potential particularly in a low interest rate environment. Although the risk of short term falls is lowered there is near certain underperformance over the longer term.
Structured products providing solutions
In the variable annuities market structured product solutions have taken on many different forms. Some of these run for longer maturities such as ten years which in principle are a natural choice because retirement has a long investment horizon. However for a variety of reasons these have proven less popular. Firstly, the investor base seeks flexibility to allow them to decide to work longer or shorter than originally intended and to adapt to how their retirement pot Is performing. On the supply side, for both the banks and insurance companies, providing long dated structured products has problems of liquidity and the capacity for banks to be willing to take on such risk. It is also necessary to get insurance companies comfortable with taking issuer risk and having such assets on their balance sheets.
Therefore the most common structured products solutions in the variable annuity market now generally use rolling one or two year option strategies. The investment is still intended as a long term wrapper because the insurance company wants to earn fees over the long term by looking after the investment assets for the full horizon. However from a structured product perspective it is simply a series of shorter dated contracts rolled from one to the next. This avoids any party having to commit to providing longer term exposure and pricing is only done on this shorter horizon. This approach also reduces liquidity risk for all parties.
The typical solutions now divide between products linked to mainstream indices and other choices, such as lower volatility underlyings. The basic construction is the same in that the investor will start at a certain base and each structured product will be principal protected which means that over each one or two year horizon the investment pot cannot fall, unlike direct equities and other investments.
As is well known in the regular retail structured product market, it is very difficult to structure principal protected products of such short maturities, especially in a low interest rate environment. The two most popular variants are to achieve feasible pricing by either capping or reducing participation.
Current market offerings
Two of the biggest providers in the market are Athene and Security Benefit. Athene market as Agility and Security Benefit through Clearline. Both have investments with a cap on S&P-500 currently at around 3.25% for a one year deal or 7% for two years. If the S&P-500 is up over the term then the amount earned is 100% of the upside subject to the stated caps. While this protects principal there is a danger of missing out significantly on the good years which are the ones that carry an investment strategy over the longer term.
The alternative is to use a lower volatility underlying that has good prospects of matching mainstream indices in many scenarios. Because of the lower volatility level it is possible to offer more attractive participation rates, though generally less than 100%.
Athene also have products linked to the BNP Paribas Multi Asset Diversified 5 Index and the Nasdaq FC Index, both of which are volatility controlled. Security Benefit Clearline also offers products linked to the S&P 500 Low Volatility Daily Risk Control Index.
Another provider in the market is Delaware Life who also have a low volatility offering which is through the Deutsche Bank CROCI Index, a volatility controlled index with global exposure. These solutions typically have participation rates between 50% and 85% depending on index and term. The source for all these product details is www.structuredretailproducts.com.
It remains a matter of debate as to how efficient these strategies are over the long term since they are known to be sub optimal in terms of fees and risk reward profile. However they do have considerable appeal in terms of capital protection and investment flexibility so we should expect these products to remain an important part of the US retirement saving landscape.
A version of this article has also appeared on www.structuredretailproducts.com
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