Annuities: What is a RILA? And Why Retirees Should Know About Them

With over $182 billion of new annuity sales in the first half of this year alone, annuities are more popular than ever.  Baby boomers may be drawing unprecedented attention to retirement planning, but annuities were first introduced to America in 1759 when Presbyterian ministers in Pennsylvania contributed to a fund in exchange for lifetime payments.  In 1812, the Pennsylvania Company for Insurance on Lives and Granting Annuities was founded and began offering such products to the general public.  Over the past two centuries, the annuity marketplace’s growth in terms of assets has coincided with a growth in complexity, most noticeable since the Great Recession of 2008.  

Changing consumer wants and needs gave rise to fixed annuities, variable annuities, and indexed annuities.  According to the latest data from LIMRA, there are roughly $3.2 trillion invested in annuities.  Of this massive sum, $520 billion are in fixed annuities, $585 billion in indexed annuities, and $2.1 trillion in variable annuities.  Within these products exist an endless array of benefit riders allowing the owner to customize their contract, akin to adding toppings at the world’s largest ice cream sundae counter.  Then, to enhance retirement planning a step further, the 2010’s launched the RILA.

What is a RILA?  The acronym stands for registered index-linked annuity.  RILAs are the fastest growing segment of the annuity marketplace and are set to have another record-breaking year in 2023.  Its purpose is to offer growth potential while limiting exposure to downside risk.  Returns are based in part on the performance of an underlying index or indexes, but it is not a stock market investment and does not directly participate in any stock or equity investments.  Similar to other annuities, RILAs can grow tax-deferred and provide the ability to convert the annuity into a stream of income payments in retirement through annuitization to address longevity risk.  

Where RILAs attract the most interest, and begin to differ from previous variable and index annuities, is through a feature they often contain referred to as a “buffer”.  The buffer typically offsets potential losses the annuity owner might otherwise realize had they invested directly in the underlying index.  A simple example might be:

• Sample RILA contract offers a 10% annual buffer against the S&P500 Index performance.
• Assume the annuity owner allocates their entire annuity into the S&P500 Index.
  • Scenario 1- During the annuity’s contract year (the date the contract was issued to exactly 12 months later) the S&P500 Index returns -7%.  Due to the 10% buffer, the annuity does not recognize a market loss in that contract year.
  • Scenario 2- During the annuity’s contract year the S&P500 Index returns -22%.  After the 10% buffer is utilized, the annuity recognizes a -12% market loss for the contract year.

RILA owners may watch their contract gain or lose value before the end of their strategy term, but buffer protection and growth potential are not fully realized until the end of the strategy term.  Strategy terms can vary from annuity to annuity, with the most common being annual buffers, but many offer 2-year strategies, 3-year, and so on.  As Scenario 2 above suggests, RILA buffers can lessen losses, but there is potential for unlimited losses beyond the buffer amount.

So, what is the tradeoff for receiving this added level of protection from the annuity carrier.  There are 3 primary concerns for potential annuity investors.  First, there is a ceiling or upper limit to the potential market gain.  Assume that the annuity has a 20% cap on their S&P500 1-year strategy, meaning if the index gains less than that during their contact year, all of the return may be realized, but if the index returns higher, say 25% in the contract year, the owner will be capped at a 20% market gain.  Second, the RILA may carry an annuity product fee.  Hypothetically, a RILA with a 1.25% product fee would realize a lower net gain in a positive year versus having invested directly in the underlying index over the same timeframe.  Lastly, most annuities have a surrender period.  It is important for prospective annuity owners to remember that withdrawals made during this period may be subject to contingent deferred surrender charges (CDSC) and withdrawals taken prior to age 59.5 may be subject to a 10% federal tax penalty in addition to ordinary income taxes.

With these pros and cons in mind, prospective RILA investors should recognize the annuity as a long-term investment for retirement.  Furthermore, the RILA may not be suitable if their risk tolerance is high enough to warrant investing directly in the stock market indexes at a lower fee with unlimited upside potential, assuming there is not a concern for downside protection or lifetime annuity income to supplement social security or pension benefits.

Individuals should review their plans on a case-by-case basis with professional assistance.  Please consult your attorney or tax advisor for specific tax or legal advice.

Written by Bryan Kuderna.

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