At least two insurance companies are adding “buffered” investment portfolios to the lineup of underlying funds that are available to support their variable annuity and variable life insurance policies.

These buffered funds are in many ways similar to the popular “buffered” index-linked annuity and universal life options that insurers have offered under Form S-1 or S-3 registrations with the SEC. The new buffered funds, however, will instead be registered on the same Form N-1A as more conventional underlying fund options, and the variable annuity/life benefits that they support will be registered on the same Form N-4 or N-6 that is used for other interests under such variable products.

Investment Objective

The buffered funds, like index-linked products, offer investors the prospect of earning returns over specified periods of time (outcome periods), based on the performance of a specified securities index. For example, the underlying funds that insurers are currently planning would offer one-year outcome periods (or in some cases five-year periods) that seek to provide a return that closely approximates the return of the S&P 500 (without reinvestment of dividends), subject to (a) a specified maximum rate of return (i.e., a “cap”) and (b) a “buffer” that seeks to provide a specified amount of protection against negative returns over that period.

This type of investment objective was first adapted to registered investment companies via buffered ETFs that we discussed at the time in “Buffer ETFs vs. Index-Linked Annuities,” Expect Focus – Life, Annuity, and Retirement Solutions (December 2018). We pointed out there that the same concept, in non-ETF form, might be adapted to underlying variable product funds. And that is now happening.

Investment Program

Like other mutual funds, the buffered funds’ investment return over any period is determined by the actual change in its NAV and any distributions paid on its shares during that period. The buffered funds’ portfolio investments could include, among other things, index funds and various types of derivatives, including customizable put and call options on the S&P 500 that are traded on the Chicago Board Options Exchange (Flexible Options).

Specifically, the buffered funds’ portfolio managers will seek to structure and manage each fund’s portfolio positions so that its total return over the outcome period will closely approximate the return of the index, subject to the specified cap and the buffer for that outcome period. Investors will have no guarantee, however, that any buffered underlying fund will achieve the return that the fund seeks for any outcome period. Therefore, even if investors maintain their investment in such an underlying fund for an entire outcome period, their investment return and buffer protection may be less than that outcome period sought to provide.

In contrast, under an index-linked VA or VLI option, the issuing insurance company promises that investors who maintain their investment for an entire outcome period will be credited with the index’s performance over that period, subject to the cap, buffer, and other terms that apply to that outcome period. If the insurer’s return on the assets it invests to support this promise is less than it has promised to investors, the insurance company must bear the loss. Similarly, the insurer can keep any amounts that it earns above the return promised to investors.

Other Differences

The following possibilities that could affect an investor’s return or liquidity under a buffered underlying fund generally would not be relevant to investors in an index-linked product.

• Any suboptimal decisions by the subadviser in managing the buffered fund’s Flexible Options or other portfolio investments.
• Any illiquidity, unavailability, or difficulty in valuing any of such investments that the buffered fund holds or that its subadviser would like to use.
• The risk of large flows of funds into or out of the buffered fund during an outcome period, which could complicate portfolio management in a way that adversely affects even investors who persist throughout the entire outcome period.

On the other hand, an insurer’s costs may be lower in connection with a buffered underlying fund, as compared with an index-linked product option, which could enable the insurer to charge lower fees to investors. For example, the insurer’s costs may be reduced because the insurer would not guarantee that the buffered fund would achieve its investment goal over the outcome period, and the cost of registering a buffered fund on the SEC’s forms for investment companies may be less than the cost of registering an index-linked option on Form S-1 or S-3.