It’s Good to Have Options, Part 1: Meet Registered Index-Linked Annuities (RILAs)
There’s a new annuity in town: registered index-linked annuities (RILAs).1 Technically, RILAs aren’t new since they’ve been available for a decade. But given the increase in interest of RILAs and consistent growth in sales, advisors should understand the basics of the product and how it works.
RILAs are a riskier version of fixed-index annuities (FIAs), where the upside potential is higher than a FIA, but the investor has the possibility of incurring a loss (i.e., negative return), depending on the structure. There are two primary features of RILAs: floors and buffers. Floors limit the maximum potential loss (e.g., if the floor is 10%, you can’t lose more than 10% even if the underlying return is significantly worse), while buffers “absorb” the first amount of losses but subject the investor to the remaining downside (e.g., if the buffer is 10%, the first 10% of losses are covered, but that’s it).
I’m going to cover the features of RILAs, which is an options-based strategy, in a series of four articles, with part 1 dedicated to the basics. In part 2, I’ll review some of the different approaches that can be used to implement options-based strategies (e.g., ETFS). In part 3, I’m going to compare floors and buffers and review the some of the dynamics of the options pricing. Lastly, in part 4 I will consider these options-based strategies as part of total portfolio to understand where and how they might be a good fit.
While there are a number of important things to consider before purchasing any type of financial product, RILAs have the potential to be useful. Plus, as noted in the title – it’s good to have options.
The assembly process
Investors often want the impossible: infinite upside with no downside. While this isn’t a realistic goal, it is possible to implement a strategy with some upside potential that limits downside risk by using options such as puts and calls.
The “assembly process” creates an investment strategy that has upside potential with no downside risk and is depicted in the exhibit below. As an aside, a product with upside and no downside risk is effectively a FIA.2
Creating upside with no downside
Zero-Coupon Bond + Long Call - Short Call = Product Return
In this example, most of the initial investment goes to purchasing a zero-coupon bond, which is assumed to be free from default risk. The cost of the zero-coupon bond sets the budget that can be used to purchase call options to generate the potential upside (i.e., the “options budget”). For example, if the initial investment is $1,000, and the zero-coupon bond costs $980, the options budget would be $20 (ignoring any fees associated with operating or implementing the strategy).