For financial professionals helping clients navigate retirement planning, portfolio risk and market volatility, understanding newer annuity structures is increasingly important.
What is a RILA? A registered index-linked annuity (RILA) is a type of deferred annuity that offers market-linked growth potential while providing a defined level of downside protection. Unlike a fixed indexed annuity, a RILA can experience losses. Unlike a traditional variable annuity, a RILA uses features such as buffers or floors to establish defined boundaries around market risk.
That structure creates a trade-off between growth potential and downside protection. Understanding how that trade-off works is essential when determining whether a RILA may have a place within a client’s broader financial strategy.
Quick Overview: Index-Linked Annuity RILA Explained
A RILA is a contract between an investor and an insurance company. The investor pays a premium, and the contract credits returns based in part on the performance of a specified market index or benchmark over a defined strategy term.
At the end of that term, the insurer calculates the applicable return according to the contract’s crediting method. Depending on the selected strategy, that calculation may incorporate a cap, participation rate, buffer or floor.
RILAs are often viewed as sitting between fixed indexed annuities and variable annuities, although features differ by product and insurer. A fixed indexed annuity generally provides greater protection from negative index performance, while a RILA allows for losses in exchange for potentially greater market-linked growth. A variable annuity generally provides more direct exposure to investment performance and greater market risk.
The key consideration is whether the product’s risk and return characteristics align with the investor’s objectives, time horizon and tolerance for loss. Subject to the contract's crediting methodology and terms.
How a Registered Index-Linked Annuity Works
A RILA begins with a premium payment to the insurance company. The investor then selects from available strategies, which may differ by index, strategy term and level of downside protection.
One common crediting approach is point-to-point. Under this structure, the contract measures the performance of a specified index from the beginning of the strategy term to the end.
For example, assume a hypothetical RILA strategy tracks an index over a one-year term and provides a 10% buffer. If the index declines 7% during the term, the buffer may absorb that loss. If the index declines 15%, however, the investor may absorb the loss beyond the 10% buffer, subject to the specific terms of the contract.
Positive performance is also subject to the contract’s terms. A cap may limit the amount of an index gain that can be credited, while a participation rate may determine how much of the index’s performance is recognized.
Key Terms: Buffers, Floors, Cap Rates and Participation
Buffer: A buffer protects against a specified percentage of market losses. A 10% buffer, for example, is generally designed to absorb the first 10% of a qualifying index decline. Losses beyond the buffer remain the investor’s responsibility, subject to the contract’s terms.
Floor: A floor establishes a defined maximum loss for a particular strategy term according to the contract's terms. A 10% floor, for example, may limit the investor’s loss to 10%, with losses beyond that level absorbed by the insurer according to the contract.
Cap rate: A cap sets the maximum positive return that can be credited during the applicable strategy term. If an index gains 10% but the strategy has a 5% cap, the credited gain may be limited to 5%.
Participation rate: A participation rate determines how much of the index’s performance is recognized by the contract before other applicable limitations are considered.
These features can vary significantly from product to product, making the relationship between protection and upside an important part of the comparison.
How Does a RILA Compare with a Fixed Indexed Annuity?
One of the clearest differences between a RILA and a fixed indexed annuity is exposure to loss.
A fixed indexed annuity generally limits the impact of negative index performance as a loss during the applicable crediting period. A RILA can experience negative returns when market performance falls beyond the level of protection provided by the selected strategy.
That additional downside risk can come with greater growth potential. Compared with a variable annuity, a RILA may provide more defined boundaries around losses. However, the investor still assumes market risk and can lose principal.
The appropriate choice depends on the client’s objectives, risk tolerance, liquidity needs and time horizon.
Downside Protection, Growth Potential and Market Risk
RILA downside protection is not the same as full principal protection.
RILAs generally do not eliminate market risk. Instead, buffers and floors establish defined levels of protection against losses.
Consider a strategy with a 10% buffer. A 6% decline in the applicable index may be absorbed within the buffer. A 20% decline, however, could leave the investor exposed to losses beyond the protected amount.
RILAs also offer market-linked growth potential, but the upside is structured. Cap rates can limit gains during periods of strong market performance, while participation rates can affect how much of the index’s gain is recognized.
Investors may be able to choose strategies offering different combinations of protection and growth potential. In some cases, accepting less downside protection may provide access to a higher cap or another growth-oriented feature.
Costs, Liquidity and Tax Considerations
RILAs can include surrender charges and other restrictions that affect how easily an investor can access funds.
Financial professionals should review the contract’s surrender schedule, withdrawal provisions and any applicable market value adjustment before recommending a product.
RILAs also provide tax-deferred growth. In general, taxes are not owed on earnings while they remain inside the annuity. When funds are withdrawn, gains may be subject to ordinary income taxation, depending on the ownership structure and applicable tax rules.
Early withdrawals may also have additional tax consequences. Clients should consult an appropriately qualified tax professional regarding their individual circumstances.
Who Should Consider a RILA?
A RILA may be appropriate for investors seeking market-linked growth potential while also wanting a defined level of downside protection.
It may be relevant for clients who understand that protection comes with trade-offs and who have a sufficiently long investment horizon to accommodate the contract’s strategy terms and liquidity provisions.
A RILA may be less appropriate for an investor who requires full principal protection, needs frequent access to assets or cannot tolerate the possibility of investment losses.
Practical Steps to Vet a RILA Solution
A disciplined process can help financial professionals compare RILA solutions effectively.
1. Define the acceptable loss limit. Determine how much loss the client can reasonably tolerate before evaluating specific strategies.
2. Compare multiple products or strategies. Review caps, participation rates, buffers and floors rather than focusing on a single headline feature.
3. Request complete documentation. Review the prospectus, contract, crediting method, disclosures and applicable strategy details.
4. Run multiple scenarios. Model optimistic, moderate and pessimistic market environments to illustrate how the strategy may behave across different conditions.
5. Review liquidity. Identify surrender charges, withdrawal provisions and market value adjustments that could affect access to funds.
Because RILAs are complex financial instruments, professionals should evaluate how the product’s features work together.
Choosing an Insurance Company and Evaluating Credit Risk
The financial strength of the insurance company is an important consideration because the insurer is responsible for its contractual obligations.
Financial professionals should review insurer ratings from organizations such as AM Best and S&P Global Ratings and evaluate documented evidence of the insurer’s financial strength and claims paying ability.
State guaranty association protections and their applicable limits should also be reviewed.
RILA Frequently Asked Questions
Can I lose principal in a RILA?
Yes. A RILA does not provide 100% principal protection. If the applicable index declines beyond the protection offered by the selected buffer or floor, the investor may experience a loss.
How are gains taxed?
RILA growth is generally tax-deferred. Taxes are typically owed when gains are withdrawn and may be taxed as ordinary income, depending on the circumstances. Additional tax penalties may apply to certain early withdrawals.
Can I roll over IRA funds into a RILA?
Eligible retirement assets may be used to purchase an annuity, including a RILA, when the transaction follows applicable retirement-account and tax rules. Investors should consult a qualified financial and tax professional before initiating a rollover or transfer.
Building a More Informed RILA Selection Process
So, what is a RILA when viewed in the context of a broader retirement strategy?
It is a structured annuity designed to provide market-linked growth potential while establishing a defined level of downside protection. The trade-off is that investors may still experience losses and may accept limitations on their upside.
Evaluating a RILA means looking at the complete picture: the client’s acceptable loss limit, the strategy’s buffer or floor, its cap and participation rate, the strategy term, liquidity provisions, tax considerations and the insurance company’s financial strength and claims paying ability.
A thoughtful evaluation can help turn a complex annuity structure into a clearer portfolio decision.
For additional information, financial professionals should review the applicable prospectus, contract and product documentation and consult a licensed financial professional regarding individual investor circumstances. DFIN can support financial organizations with regulatory documentation and compliance requirements associated with complex financial products.
