A Key Rate Approach to Replicating Annuities with U.S. Treasury Funds

Abstract

Prendergast (2021) develops a methodology that enables retail investors to structure annuities using commonly available U.S. Treasury Exchange Traded Funds (ETFs). This article extends that methodology through the use of key rate durations. Back tests and stress tests show that the use of key rate durations substantially enhances the ability of the portfolio of ETFs to replicate an annuity in an environment where yield curves undergo a variety of slope and curvature changes over time.

TOPICS: Fixed income and structured finance, exchange-traded funds and applications, quantitative methods, statistical methods

Key Findings

• ▪ Relative to using single durations, the use of key rate durations dramatically improves the ability of an annuity replicating portfolio to provide the desired annuity payments while achieving a zero-ending balance.

• ▪ This article provides a means for retail investors, or their advisors, to design an annuity that is robust to interest rate changes without paying sizeable fees to life insurance companies and other annuity providers.