Registered index-linked annuities will capture much of market gains while offering downside protection. They are maddeningly complex. By Karen Hube

Retirement investors are pouncing on a type of annuity that promises the best of both stocks and bonds: gains and protection, wrapped neatly into one.

Traditionally, only wealthy investors working with private bankers had access to investments that tie your upside performance to the stock market and provide a customizable cushion under losses.

But lately these once-exclusive investment arrangements, known as structured products, have gone mainstream in the form of an annuity, and retirement investors are plowing money into them at a record-busting pace.

Called registered index-linked annuities, or RILAs, these investments drew $65.2 billion in sales last year -- up 59% over 2022 -- and are the brightest stars in the universe of annuities. Some fee-only advisors who have historically been annuities' most vocal critics are using RILAs for their clients.

"These give people the peace of mind they need to participate in the stock market when facing the end zone of retirement," says Adam Wojtkowski, a fee-only financial advisor at Copper Beech Wealth Management. "It's easier to withstand ups and downs in your 40s, but you don't want deep losses in a major selloff just as you're retiring. RILAs can protect against that."

Like all annuities, RILAs are complicated insurance products. They aren't for everyone, and even if you determine that one of these products makes sense in your portfolio, the next baffling question is, which one?

Since Equitable launched the first RILA (pronounced " rye-lah") in 2010, 21 other insurers -- including Global Atlantic, Symetra, Lincoln National, and Corebridge Financial -- have jumped into the market. And the number of RILA variations has exploded, with a daunting lineup of caps, participation rates, buffers, floors, crediting methods, and index options. Equitable alone has 252 variations of RILAs, including share classes.

"We're seeing more exotic designs around strategies to reduce volatility or risk," says Gary Baker, chief operating officer of Cannex, an annuity research firm.

Behind the scenes, insurers invest in bonds and buy options tied to indexes to create various combinations of downside protection with upside potential. Some of the newest configurations turn negative returns into positive returns. For example, MassMutual offers one that gives you a 9% annual return as long as the S&P 500's performance is better than negative 10%. The investor eats any loss in excess of negative 10%.

Unless you are an options expert with an awfully sharp pencil, you have no way of knowing how much profit insurers are making by selling these annuities. With most RILAs, there are no defined fees. Their cost to investors is baked into caps on returns or illiquidity, but many investors are willing to bear such costs given that the market has been blowing through record highs, says Michael Tricaso, a senior financial advisor at Valmark Financial Group. "It's not a bad time to be locking in protection."

Make no mistake: You can lose money in RILAs, and you often can't dump the product for years without being penalized.

RILA Nuts and Bolts

To understand RILAs, it helps to first consider the most basic design, which is a product with a buffer of your choice ranging from 10% to 50%, and a cap on an index's performance, not including dividends.

Caps are usually reset after either one or six years. Index options range from the S&P 500, Russell 2000, and MSCI EAFE to indexes customized by insurers.

Consider, for example, a RILA with a 20% buffer that is tied to the S&P 500 and a cap that is reset each year. Among the most competitive of these is Jackson National Life's Market Link Pro Advisory II RILA, which has a cap of 12.75%.

With this RILA, if the S&P 500 is up 10% after you've owned the product for one year, you get the full 10% gain. If it is up 20%, your gain is 12.75%. On the downside, if the S&P 500 loses 15%, the insurance company eats the loss and you get a 0% return. If the index loses 25%, the insurer absorbs 20% of the loss and you get dinged with a 5% loss.

The smaller the buffer you choose, the higher your cap will be on an index's performance. The same Jackson RILA with a 10% buffer has a 18.5% cap on the S&P 500.

A less popular, yet basic, RILA design is with protection as a floor rather than a buffer. With a 10% floor, if the market is down 12%, the investor gets hit with the first 10% of losses while the insurer picks up the excess 2%.

Be Wary of RILA Risks

Unlike fixed annuities, which guarantee your principal and typically come with a minimum fixed interest, RILA returns are variable. It's important for investors to understand how their gains are credited to grasp a RILA's downside risk, says Steve Parrish, professor of practice at the American College of Financial Services.

A one-year, point-to-point crediting method is common, in which an index's gain is locked in on your first anniversary after buying a RILA, and each annual anniversary after that.

"If at the point you're measuring it one year later, it happened to be a bad day, you could end up losing money, even if the next day the index is back up again," Parrish says.

How well a one-year RILA will perform relative to its index varies depending on market volatility.

Consider a RILA with a 20% buffer and an 18% cap on the S&P 500. If you had invested $10,000 in the RILA at the beginning of 1991 and held it for six years, it would have underperformed the index fund because the 18% cap lopped off significant gains during a steady stock market rise, according to a simulation run by the Securities and Exchange Commission. Your investment would end up at just over $18,000 versus just over $22,000 in the index fund.

In contrast, if you invested in the RILA at the beginning of 1999, just ahead of a 50% market decline in 2001-02, the value in your RILA would be up 27% by 2005, while the index would be down 1.5%, the SEC study found.

To mitigate volatility risk, advisors often steer clients toward RILAs that lock in gains after six years.

These are often structured with a 10% or 20% buffer and no caps, and capture 100% or even more of an index's performance. For example, TruStage's ZoneChoice annuity with a 10% buffer gives you 105% of the S&P 500's gains after six years of holding the investment. The rub: If you take out the money before six years, you get the value of the RILA's underlying hedging strategy, which could be less than the 105% guarantee you receive at the end of the six-year term.

Michael Kemp, an advisor at RBC Wealth Management, likes six-year RILAs with a 20% buffer that give you 100% of the S&P 500's rise. Investors' trade-off in these is a lack of liquidity for six years, but the chance of an index being negative and exceeding a 20% buffer after six years is low.

"The worst six-year period for the S&P 500 was when it was down 18.6% ending on Dec. 31, 1978," Kemp says.

There's another issue with annuities. All grow tax-deferred, but as with 401(k)s, they can't be tapped before age 59 1/2 without a 10% penalty.

In addition, most annuities are sold on commission by brokers or insurance agents, and the commissioned products come with surrender charges, typically of up to seven years. If you pull your money out early, you pay a charge that gradually declines over the surrender years.

Sizing Up What's Best

While the risk/reward trade-off in RILAs is fairly simple to grasp, the menu of RILAs can be head-spinning.

But it's worth paying attention to some of the newer RILAs with so-called trigger rates, because they can have even more favorable risk/return outcomes than the basic RILA or a portfolio with a 60%/40% allocation between stocks and bonds, says Wade Pfau, advisor and founder of Retirement Researcher.

For example, dual step-up RILAs provide a set return as long as an index's performance exceeds its buffer.

Allianz's Index Advantage+ NF, tied to the S&P 500 with a one-year term and a 20% buffer, will give you a 6.1% return as long as the index's return is better than negative 20%. If the index either sinks by 15% or rises by 15%, you get a 6.1% gain.

Using probability analysis with 100,000 simulations of market performance, Pfau found that the dual step-up RILAs outperform all other RILAs and a 60/40 portfolio, despite their lower caps. They also are less than half as volatile as a 60/40 portfolio.

Advisors say RILAs are best used as an alternative to some fixed-income exposure.

"We don't want to have to put 40% in bonds. If you've owned bonds for the past 15 to 20 years, you haven't made any money. It's like carrying dead weight," Kemp of RBC Wealth Management says.

While a lot of people need growth to achieve their retirement-planning goals, "they don't need to swing for the fences," Kemp says. "For these people, a RILA can be a great way to protect the downside."

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