Replicating Maximum Yield Annuities with U.S. 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 often come with sizable fees that are extremely detrimental to the purchaser in a low interest rate environment. This paper develops a methodology that enables retail investors to structure annuities using commonly available U.S. 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 comprise a dynamically managed portfolio requiring only an initial investment. Each period, the portfolio is rebalanced to match the modified duration of a reference annuity which will minimize 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 paper concludes with an implementation of the strategy using actual Treasury ETFs.

Keywords: Annuity, Retirement, Fixed Income, Duration, Hedging

JEL Classification: G11