Replicating Maximum-Yield Annuities with US Treasury Funds

Abstract

Many individuals rely on annuity purchases to provide a steady stream of income during their post-retirement years. Life insurance companies provide a variety of annuity contracts, but they often come with sizable fees that are extremely detrimental to the purchaser in a low-interest-rate environment. This article develops a methodology that enables retail investors to structure annuities using commonly available US Treasury exchange-traded funds (ETFs) or mutual funds. Only historical price or NAV data and Treasury yield data are required to implement the strategy. The funds compose a dynamically managed portfolio requiring only an initial investment. Each period, the portfolio is rebalanced to match the modified duration of a reference annuity. This minimizes interest rate risk from parallel shifts in future yield curves. The weights are optimized to provide the highest yield possible. The objective is for the portfolio to provide the required periodic annuity payments and have a zero balance at annuity maturity under a variety of interest rate scenarios, while providing the maximum possible yield. Scenario tests show that the strategy is effective under parallel yield curve shifts, but may have shortfalls for curve steepening and gains for curve flattening. Investors may choose to add to their initial investment to reduce the risk of shortfalls if the curve steepens. The article concludes with an implementation of the strategy using actual Treasury ETFs. <b>TOPICS:</b>Retirement, exchange-traded funds and applications, fixed income and structured finance, performance measurement <b>Key Findings</b> ▪ US Treasury ETFs can be used to replicate an annuity, thus enabling retail investors to avoid the sizable fees charged by life insurance companies. ▪ The replication performs well for parallel yield curve shifts. ▪ Future work using key-rate durations may enhance the performance of the replication for non-parallel yield curve shifts.