Ohio National Pioneers a Low-Risk GLWB Strategy
It’s both surprising and not surprising that Cincinnati-based Ohio National Life is the first variable annuity issuer to offer funds that incorporate the TOPS/Milliman volatility-controlled, futures-driven, ETF-based investment technology.
Surprising, because conservative mutually owned life insurers like Ohio National usually leave radical innovation up to their more aggressive publicly held counterparts. Not surprising, because, in this case, the innovation seeks less risk, not more.
“Ohio National is a little unique in the VA space. We’re one of the few mutuals with a presence among the top 20 VA issuers. Usually it’s companies with access to fresh capital that have a more aggressive presence,” said Steve Murphy, FSA, senior vice president, Capital Management.
On January 3, Ohio National Life introduced a new guaranteed lifetime withdrawal benefit rider—GLWB Plus—for its ONcore suite of variable annuities. The new rider offers contract owners a distinctive 5.25% payout at age 65 (single or joint-life) along with the existing 8% annual simple-interest deferral bonus that can double the income base after 10 years without withdrawals.
To earn that extra quarter-percent payout, purchasers have to agree to put at least half their premium into TOPS Protected Balanced, Moderate Growth or Growth ETF funds (67 bps; 92 bps in a version that includes 12b-1 marketing fees) and no more than half into any of four funds—an Invesco Balanced Risk Fund, the AllianceBernstein Dynamic Allocation Fund, the Federated Managed Volatility Fund II or the Legg Mason Dynamic Multi-Strategy Portfolio.
The key to the product is the TOPS—it stands for The Optimized Portfolio System. It combines a short ETF futures strategy created by Milliman, Ohio National’s actuarial consultant, with a dynamic asset allocation. Together, the two risk-mitigation techniques make the returns of the underlying portfolio relatively predictable, which enables Ohio National to offer generous benefits. Ohio National also uses a hedge strategy to offset risk.
Cheaper and safer
The beauty of Milliman’s short ETF futures strategy is that it puts a low-cost risk management mechanism inside the subaccount investment.
As Milliman’s Kamilla Svajgl explained, this mechanism requires five to 10% of the fund assets to be set aside as collateral for purchases of futures contracts. When the equity market goes up, Milliman buys low-cost short equity ETF futures. If the market goes down by more than 10%, Milliman will close out the short futures at a profit and use the proceeds to enlarge the portfolio’s long position in ETFs.
It turns out that it’s both cheaper and safer for the insurer if the fund manager uses the fund’s own money to purchase short equity futures than if the insurer buys options and carries them as volatile assets on its own balance sheet.
Cynics have said that the strategy shifts the cost of hedging onto the contract owner. On the other hand, if the carrier returns the costs savings to the client in the form of richer benefits or lower expense ratios, the contract owner could benefit in the long run.
The cost savings of this strategy can be game changing. “Before the financial crisis, a company might charge 65 bps for a GLWB rider and spend about 40 bps of that on hedging costs,” Svajgl said. “Since the financial crisis, a policyholder could pay 105 bps for the rider and it might cost 90 to over 105 bps to hedge it.
“But all of our vega [volatility] and most of our delta [changes in equity prices] is being done in the subaccounts. That reduces the overall hedge costs to manage the living benefits. So, if you charge 105 bps for the rider, only 50 to 60 bps will be spend on raw vega hedging or residual delta hedging.”
“If the insurer bought put options, it would have to pay an option premium. But we’re using futures. The fund manager is entering a futures position instead of the insurer paying a premium,” said Michael McClary, TOPS’ chief investment officer.
This strategy demonstrated its value during the August 8 collapse in equity prices, when the S&P 500 Index dropped 6.65% and the equity exposure of the TOPS Protected portfolios had dropped to just 30% at one point. “Our goal is to get 75% up-capture and 25% down-capture over time,” said McClary. “If the market goes dead straight up, we won’t get 100% of it. But when it goes down we won’t go down as much.”
In theory, this model can provide as much downside protection as Constant Proportion Portfolio Insurance (CPPI) does while being more nimble than CPPI at capturing the upside opportunity that often appears after a sharp market dip.
Because Milliman hedges the effects of a potential fall in equity prices by holding short equity futures, TOPS managers are able reduce their funds' equity risk exposure without actually selling depressed equity ETFs.
“Our system can then reset the capital protection, reinvesting the cash profits from hedges into long ETFs, so that we don't stay at 30% long forever and miss the opportunity for market growth,” McClary said. “Some strategies that include a hedge can effectively become very expensive money market accounts [because they miss market rebounds]. It is our goal to avoid that.”
No free lunch
Of course, none of the TOPS financial engineering tames or beats the market, but merely shaves off the tail risk from an aggressive portfolio. According to Milliman’s analysis of “1,000 stochastically generated real world scenarios based on 30 years of daily returns for indices and interest rates,” a portfolio equipped with its protection method had half the average annualized volatility of an unprotected fund while lagging in average return by just 95 basis points, 7.66% to 8.51%.
Interestingly, the data shows that the protection works better during portfolio decumulation than during the accumulation stage. The average annual internal rate of return of an aggressive portfolio decumulating over 30 years was 6.86% for the protected portfolio and only 6.06% for the unprotected portfolio. Hedging appears to pay for itself and more by buffering the effects of sequence risk during retirement drawdown, when selling depressed assets can accelerate portfolio ruin.
“Overall, it’s better for the consumer,” Murphy told RIJ this week. “Lower volatility funds do perform better over the long run. The client won’t see the same run-ups, but in the financial crisis, some of these risk-managed funds would have experienced losses of 10% instead of 40%. People don’t need to be out there swinging for the fences.”
For Ohio National, which ranked 20th in VA sales in 2011, with $1.2 billion in premiums during the first three quarters of the year, the new offering represents a significant shift in product design. In the early part of the last decade, it focused on the guaranteed minimum income benefit product, whose insurance benefit requires the client to buy an income annuity after a deferral period.
“You wouldn’t necessarily have been able to observe this, but we did have a conservative approach to VA guarantees,” Murphy said. “We were reinsuring our living benefit riders from the point of inception in 2002 until reinsurance became unavailable in 2008. Our reinsurance served s well through the financial crisis.” The company switched its emphasis to the GLWB in 2010, retooling within a period of months.
The TOPS strategy gives Ohio National the protection it needs in order to offer a competitive 5.25% payout at age 65 in a world where 5% is the norm. “We went with TOPS to preserve the income bands, Murphy said. To compete, “you can lower the price or raise the benefit, and marketing felt that raising the income bands was the better move.”
The newly enriched product benefits should help Ohio National sell through third-party distributors. “About 20% of our VA sales come from our own broker dealer and our career agents,” said Jeff Mackey, FSA, Ohio National’s director of Annuity Product Development. “Of the other 80%, about 40-50% comes from independent advisors and about 30-40% from the national wirehouses. Bank sales account for no more than 5% to 10% of the 80%.”
Every product needs a story line, and Murphy has one. “I use the analogy of an airline,” he told RIJ. “ An airline can’t sell tickets for flights five years from now because it can’t hedge the volatility of fuel prices. We’re different. For us, the targeted volatility strategy keeps the cost of hedging predictable. Going forward, I think the only sustainable product designs will be in the context of risk-levered funds.”