Most investors have three goals when it comes to their money: they want growth, safety and liquidity. Finding an investment that provides all three is near impossible and therefore one of the biggest challenges in financial planning. For those nearing retirement, finding the right portfolio balance becomes even more important. It requires discipline in both diversification and asset allocation, a concern that often falls by the wayside when the stock market is consistently strong, like in 2017.
When investors see the market increasing regularly, they often forget about balance in lieu of their desire to get their piece of the pie. They want to see the same gains as their friends and feel like they might be missing out if they don’t. But when that market inevitably waivers, such as it has recently, those same investors become anxious about having too much risk. Greed and fear both lead to emotional decision-making, which often results in losses.
What’s an investor to do? Here’s a look at one strategy, specifically comparing bonds and fixed indexed annuities, from a recently published Kiplinger article.
How Market Losses Affect Portfolios
Jack Marrion, financial researcher and author, conducted an interesting study a few years back to find out how market losses affect a portfolio. He compared how a $1,000 investment in the S&P 500 would have performed from January 1, 1960 to January 1, 2010 under three different scenarios: with no dividends, with dividends, and with no dividends and no losses. While the first two scenarios followed the ebbs and flows of the market, the third followed the pattern of an indexed annuity, which is not invested in the markets, doesn’t include dividends, and credits interest based on how a market index performs.
Here’s what he found:
- With no dividends, in the first scenario, the $1,000 investment resulted in an ending balance of $18,615.
- In the second scenario, when dividends were included, the ending balance was $84,260.
- The final scenario, with no dividends but no losses, resulted in a $179,624 balance.
To answer Marrion’s question, losses have a HUGE affect. This is often why fixed index annuities are suggested as a bond substitute for retirees. They protect principal while providing reliable income, especially in times of market volatility.
New Research on Annuities vs. Bonds
Last spring, economist Roger Ibbotson published new research analyzing the emerging potential of fixed index annuities as a bond alternative in retirement portfolios. His research team worked with Annexus, a leading designer of indexed annuities and indexed universal life insurance, to simulate fixed index annuity performance over the past 90 years, using the S&P 500 dynamic participation rates. The team found that during this time, uncapped fixed index annuities would have outperformed bonds on an annualized basis. To better understand, let’s take a look at a few annuity basics.
How annuities work:
An indexed annuity is a contract that is issued and guaranteed by an insurance company. The funds used to set up the account are not invested and therefore protected against market downturns. Interest is credited based in part on the movement of an index (e.g., the S&P 500 Index), and in some cases, a guaranteed level of lifetime income through optional riders.
Caps vs. participation rates:
On each contract anniversary, the owner can choose from several allocation option strategies, including some with a “cap” (limiting the upside amount to be credited) and some with a “participation rate” (the percentage of the annual growth of an index). The participation rate does not have a cap.
An uncapped fixed index annuity:
A fixed index annuity that uses the participation rate strategy is known as an uncapped fixed index annuity.
Ibbotson’s team found that not only did uncapped fixed index annuities outperform bonds in the past, they have the potential to beat bonds in the future as well. They also found that uncapped fixed index annuities can help control equity-market risk while mitigating longevity risk.
What It All Means
Ibbotson said in his research results that shifting market conditions, longer life expectancies and uncertainties surround the future of Social Security all have an “immense impact” on the U.S. economy. “Conventional wisdom has most investors de-risking their portfolios by allocating more heavily to bonds as they approach retirement,” he said. “However, investors should consider other alternatives, such as FIAs. In this low-interest-rate environment, complacency can be a danger to [investors’] futures.”
While neither Ibbotson or Marrion is suggesting that anyone put all, or even most, of their portfolio into fixed index annuities, they are saying that investors should consider the advantages of this type of annuity as a bond substitute.
Written by Rachel Summit