Living benefit riders to life insurance policies: Pricing considerations and strategy
Adding benefit riders to policies provides meaningful coverage for those who need it, and carriers usually can do so at a relatively low cost.
Milliman Portfolio Manager Simon Ho fielded questions from financial advisers about SmartShield at a recent seminar. He explained how SmartShield works and why it provides a compelling reason to stay invested through all market conditions.
SmartShield stands unique among more than 3,700 funds management products1 in the Australian market. It recognises that investing is not a one-way bet by directly managing risk while still generating competitive returns.
While research shows that risk is not as strong an influence on investment decisions as investment returns2, financial advisers know better.
The sharp COVID-19 downturn, which resulted in equity markets losing about one-third of their value, caused emotions to run high, leaving investors prone to making poor decisions. Meanwhile, retirees overinvested in equities were left exposed to sequencing risk.
But taking an alternative approach requires some investigation. We invited a group of advisers to a forum where we explored the evidence and answered the following questions about how SmartShield works.
SmartShield dynamically hedges the portfolio against volatility and extended market downturns by reserving a small portion of the portfolio to trade futures. This is the same strategy used by large insurers and institutional investors over many years to hedge their long-term liabilities.
It provides a cushion—not a guarantee—against severe downturns and ongoing volatility, making it different from products of the past. This predictable, rule-based system also preserves liquidity for investors.
"This is done systematically," says Ho. "The level of hedging is adjusted daily based on the market environment and implemented by our trading team in Sydney, Chicago, London and Amsterdam in real-time throughout the day."
The actual hedging level varies based on expected versus actual market volatility, and the level of market drawdowns. This approach provides downside protection, but also smooths returns over time.
The graph in Figure 1 shows this downside protection in action (and the limits of portfolio diversification as a risk management strategy during a market crash).
Note: Prior to 3 March 2020 SmartShield performance is derived from hypothetical back-testing and actual results thereafter.
SmartShield offers four managed account portfolios: Moderate, Balanced, Growth and High Growth. The strategic asset allocation of each fund is based on the Morningstar Multi-Sector Market Indices3—with one important difference.
"We allocate roughly 10% more growth assets compared to the benchmark," Ho says.
"This is to recognise the fact that we can dial up and down the equity exposure as part of our risk management process through trading futures. This gives the portfolio extra power during benign periods, knowing that in volatile times we can hedge the equity exposure rather quickly as we have demonstrated during COVID-19."
This extra allocation to growth assets has been fine-tuned to offset hedging costs over the long term and maintain performance when markets are slowly trending up over an extended period.
Historically, many funds management products that offer some form of protection came with high fees. SmartShield is a different type of product, offering downside protection through futures, which are highly liquid and are expected to cost less than similar option strategies.
"If you were to buy a put option on the market, it is expected to cost more over the long run, partly because you're buying it through an investment bank which may need to cover their capital charges and profit margins," says Ho.
Milliman also has significant global trading infrastructure in place because it implements these strategies across more than USD 50 billion in assets for global asset owners.
"Due to our sheer economies of scale, we're able to offer low-cost risk management solutions to retail clients," Ho says.
The underlying investments in each portfolio are inherently low-cost because they are invested in exchange-traded funds offered by Vanguard, iShares and BetaShares. This keeps the products very competitively priced with the total investment costs sitting below 50 basis points.
The SmartShield portfolios aim to deliver investment returns that are similar to their benchmark, the Morningstar Multi-Sector Indices. However, the downside protection makes the SmartShield risk profiles of managed account portfolios different.
"Volatility will be a lot more subdued," Ho says.
In fact, the volatility of the SmartShield portfolios was approximately one-third of the volatility of their respective Morningstar multi-sector indices during the COVID-19 downturn. This clearly demonstrates the effectiveness of the downside protection.
The hedging strategy can produce a drag on performance during positive markets, but this is partly offset by the extra 10% allocation to growth assets.
While SmartShield is primarily targeted toward pre-retirees and retirees, it offers a solution for many different types of investors:
Ho says SmartShield's downside protection and lower volatility means advisers don't have to try to time their market calls, which is notoriously difficult to do.
"A lot of advisers' clients have their assets in cash-like assets," he says. "It's quite tiring to keep having conversations with investors about when we are going to move that 'dry powder' into growth assets again. SmartShield takes a lot of the guesswork out of the adviser's hands."
Trying to time the market often means missing out on a market recovery. The upswing after COVID-19 was one of the fastest in history, meaning many investors who had moved to cash actually missed out.
SmartShield offers a genuine solution for investors who need the potentially higher returns of growth assets yet can't accept the higher risk that comes with it.
You can check the potential benefits of downside protection on your client portfolios at https://advice.milliman.com/en/insight/The-SmartShield-digital-portfolio-simulator.
For more information about Milliman go to https://au.milliman.com/en/
Milliman Pty Ltd ABN 51 093 828 418 AFSL 340679 (Milliman AU) for provision to Australian financial services (AFS) licensees and their representatives (and for other persons who are wholesale clients under section 761G of the Corporations Act). Not for public use or distribution. Past performance is not indicative of future results. Recipients must make their own independent decisions regarding any strategies or securities or financial instruments mentioned herein. Milliman does not make any representations that products or services described or referenced herein are suitable or appropriate for the recipient. Many of the products and services described or referenced herein involve significant risks, and the recipient should not make any decision or enter into any transaction unless the recipient has fully understood all such risks and has independently determined that such decisions or transactions are appropriate for the recipient. Any discussion of risks contained herein with respect to any product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. The recipient should not construe any of the material contained herein as investment, hedging, trading, legal, regulatory, tax, accounting or other advice. The recipient should not act on any information in this document without consulting its investment, hedging, trading, legal, regulatory, tax, accounting and other advisers. Milliman does not ensure a profit or guarantee against loss. Materials may not be reproduced without the express consent of Milliman.
1Australian Securities and Investments Commission. Review of competition in the Australian funds management industry. Retrieved 8 July 2021 from https://asic.gov.au/regulatory-resources/funds-management/review-of-competition-in-the-australian-funds-management-industry.
2High historical returns are a strong determinant of investment allocation decisions, while risk factors are not strong influences on investment decisions, according to a study that looked at net cash flows data from 1991 to 2013. See Gupta, Rakesh & Jithendranathan, Thadavillil (March 2012). Fund flows and past performance in Australian managed funds. Accounting Research Journal 131. Retrieved 8 July 2021 from https://www.researchgate.net/publication/236165375_Fund_flows_and_past_performance_in_Australian_managed_funds.