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Annuities as an Asset Class for Fee-Based Advisors l 26 © Envestnet 2022 The parameters offered by an FIA will depend in large part on the level of interest rates and the cost of financial derivatives for the associated index. Higher interest rates mean that principal can be protected with less assets, which then leaves more for the options budget used to purchase upside exposure. Less expensive call options will also allow for more upside participation to be purchased. Factors that reduce the options prices include less implied volatility for the underlying index, an increase in the strike price for the option relative to the current index price, a lower risk-free interest rate, and a shorter term to maturity. Participation rates can conceivably be higher than 100 percent if interest rates are high enough and the call options are cheap enough. On a related point, it should also be clear that if the owner is willing to accept a lower floor, it would be possible to gain more upside potential since less is needed for bonds and more is available to purchase call options. It is also vitally important to understand that the amount of upside potential that can be offered by an FIA will vary over time as interest rates and call option prices change. With an annual reset design, the insurance company must repeat the process each year and will face different interest rates and call option pricing as these variables change values over time. More upside potential is possible with higher interest rates and cheaper call options, and vice versa. This is the reason why insurance companies maintain the freedom to change the contract parameters (such as the fixed rate, participation rate, cap rate, or spread) at the beginning of each new term, subject to a minimum or maximum value allowed for each parameter within the contract. With indexed annuities, the floor could be negative or there may be other mechanisms that allow for capital losses on the contract value. If the floor is less than zero, then the annuity is technically a variable annuity that maintains most characteristics of the FIA except that it is also regulated as a security because it can experience losses. These types of structured annuities are growing in popularity and go by various names including registered index-linked annuities. Aside from a negative floor, these annuities may also have buffers. For instance, a product that provides a 10 percent buffer would mean that the interest credited is zero percent for index losses of up to 10 percent. If the index loses more than 10 percent, then this approach would credit the amount of the loss exceeding 10 percent. An 18 percent loss on the index would lead to an annuity loss of 8 percent, but an 8 percent loss for the index would lead to no loss. Accepting this greater downside risk can support more upside potential, which contributes to their growing use in the marketplace. Annuities as an Asset Class for Fee-Based Advisors l 26 © Envestnet 2022

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