Is there an alternative to investing in bonds for retirement?
Introduction
There are many challenges involved in planning for your retirement, but one challenge takes precedence over all others. And what is that challenge? It is making sure that your money does not end up dying before you do. If we asked 1,000 retirees what their goals were in retirement, we would probably get 1,000 different responses. Everyone's vision of what they want their future to look like is unique to them. There is, however, one retirement goal that I think would be common to nearly everyone: the goal that their retirement dollars last as long as their retirement years. Traditionally, for most folks that brings to mind the idea of 'de-risking' their portfolio as they approach and enter retirement. Bonds are often considered a 'conventional wisdom' investment for achieving this goal and this re-balancing. But if our goal is retirement income security, we must be open to the best means of achieving it, not just the conventional means. In some cases, there may be an alternative to the way bonds have been used in retirement portfolios. Specifically, a fixed indexed annuity (FIA) may, depending on your unique situation, needs, and goals, be a compelling alternative for the space in your portfolio that would historically be filled with bonds. Let's talk about why.
What is a bond?
A bond is essentially an IOU, whereby you effectively 'loan' your money to a bond issuer and they in return promise to pay you back your principal with interest over a stipulated period of time. The bond issuer may be a corporation, a municipality or even the federal government. A bond could be purchased from a U.S.-based entity or internationally. Historically, bonds have been used to be both a stable counterweight to the volatility of stocks, as well as a way to generate interest income that could either be reinvested or taken to supplement retirement income. The two key questions that we will consider momentarily are:
- Can a fixed indexed annuity better serve both the role of lowering volatility and the role of providing income?
- Can this be accomplished with as little risk or even less risk than with bonds?
First of all, let's look at the issue of risk.
Are there risks with bonds?
There are two primary risks associated with bonds: the risk of default and interest rate risk. Let's take a look at both.
Default Risk
When clients tell their broker that they want to be more conservative, it is very common that the broker simply increases the bond allocation in the client's portfolio, without the client always fully understanding that they can indeed lose money if the bond issuer were to default. A bond does carry with it the promise of principal repayment with interest, but that promise is only as good as the ability of the bond issuer to keep it. On numerous occasions over the years, I've met with people who show me their current portfolio and express to me that with such a large bond allocation, they were comfortable that their risk level was very low. Sometimes their perception does not square with the reality of the risks they are carrying in their bond allocations.
The bottom line is that all bonds are not alike. A bond that is paying an unusually high interest rate could be doing so because the issuer's financial strength is shaky enough that it needs to offer a high rate to attract investors. Using analytical tools such as Morningstar, a bond portfolio can be examined to provide an honest appraisal of the quality of your bond holdings and the risks you may unknowingly have. The chart that you see here shows the various rating agencies' grade charts for bonds. As you can see, there are plenty of opportunities for people to own poorly rated bonds. This is one area where using a fixed indexed annuity from a highly rated insurance company may offer a genuine alternative to the default risk that can exist if you own poorly rated bonds.
Interest rate risk
There is also an inverse relationship between interest rates and bond values. Think of it like a teeter-totter. Generally speaking, when interest rates go down, bond values rise, but when interest rates go up, bond values tend to fall. Because most bonds are not bought on the primary market directly from the bond issuer, but rather are bought in the secondary market from people who have previously bought them, there is the risk that if you bought a bond and wanted to sell it, a rising interest rate environment (like the one we are in now!) since the time of purchase might mean that you will have to sell it at a loss. It's really not that complicated. If, hypothetically, you bought a 10-year bond paying 4% interest three years ago and you now wanted to sell it, you would need, through your brokerage firm, to look for a buyer. Well, if in the past three years interest rates have risen so that a new bond comparable to the one you have is now paying 6%, you are going to have trouble selling the bond you own for the same amount you paid for it. This is interest rate risk, and it is commonly not understood by bond owners. When interest rates rise, it is common for bond holders to see the value of their bond holdings decline. With a fixed indexed annuity, there is a known early surrender penalty for a stipulated number of years, but unless there is an MVA on the annuity, the client is protected from interest rate risk.
How could a fixed indexed annuity serve as an alternative for a bond allocation?
It could be said that an annuity is nothing more than life insurance in reverse. We buy life insurance when we are young in case we die too soon. We buy annuities when we are older in case we live too long. The wonderful thing about fixed indexed annuities is that they can so effectively help bring more stability to your retirement, while at the same time generating income that cannot be outlived - income that can help you to fully embrace all of the wonder and the adventures of retirement, to live your life aggressively and joyfully, and to avoid looking back in regret at an unfulfilled bucket list. Every situation is different, but an annuity may help you achieve those goals much more effectively than bonds. There are three primary reasons why: Safety, Growth and Income. Let's look at each.
Safety
It is somewhat ironic that as we discuss the possibility that fixed indexed annuities can serve as an alternative to bonds, the reality is that the investment portfolios of the insurance companies that issue these annuities are made up mostly of…bonds. The difference is that with a fixed indexed annuity the bond risk is assumed not by the contract holder, but by the insurer. With an indexed annuity, the insurer will take a small percentage of the premium (typically around 5%) and purchase an option on an index, such as the S&P 500. If the index goes up in a given year, the insurer exercises the option and any interest earned for the contract holder (up to any caps or participation rates stipulated by the annuity contract) is credited to the annuity. If the index goes down, the client is protected against market loss. In a year where the index goes down, you do not earn credited interest but you do not lose any principal either. It is what many satisfied annuity purchasers call 'when zero becomes your hero.' All the interest rate risk and default risk associated with bonds is taken on by the insurer and kept from the annuity contract owner, who is contractually protected from loss of principal and any 'locked-in' credited interest. It is important to note that these contractual guarantees are backed solely by the financial strength and claims-paying ability of the issuing insurance company, so it is important to work with an insurance company who is highly rated and financially strong. In most instances, state guaranty associations also guarantee the premium amounts of indexed annuity contracts up to a certain amount, but annuity contracts are not guaranteed by the FDIC.
Growth
Not only do bonds have risks of which investors are not always fully aware, they can have a low upside potential, especially in a low interest environment. In an important white paper published in 2018, entitled "Fixed Indexed Annuities: Consider the Alternative," highly regarded economist Roger Ibbotson suggests bond returns in today's historically low interest rate environment may be insufficient in meeting the anticipated retirement needs of U.S. investors, potentially placing many at risk of outliving their retirement savings. Ibbotson says, "Conventional wisdom has most investors de-risking their portfolios by allocating more heavily to bonds as they approach retirement. However, investors should consider other alternatives such as Fixed Index Annuities. In this low interest rate environment, complacency can be a danger to clients' futures."
Backing up his assertion, Ibbotson conducted a study where he looked at the performance of bonds versus 'uncapped' fixed indexed annuities (those with participation rates but no caps). What he found is that uncapped FIAs would have outperformed bonds on an annualized basis for the past 90 years. Past performance is indeed no guarantee of future results, but that is some impressive past performance! Additionally, he maintains that it is highly unlikely bond investors will realize as high a return from capital gains in the coming 10 years as they have realized in the past 10 years. In fact, if interest rates rise (as they are now doing), Ibbotson says that movement in the values of bonds in the future will be negative (capital losses).
This is where fixed indexed annuities may be able to ride to the rescue, providing more upside potential than bonds, but without some of the risks associated with bond ownership.
Income
Ultimately, annuities are primarily valuable for their ability to generate reliable income. As our population ages, new societal challenges have created the need for retirees to find new ways to ensure that they do not outlive their income. These challenges include:
- The decline of pensions - for most Americans, the days of 30 years of service followed by a gold watch and guaranteed lifetime pension are long gone!
- Increasing life expectancy - there is about a 50% chance that at least one member of a 65-year-old couple will live past age 90! We are generally spending more years in retirement than our parents or grandparents ever dreamed.
- Questions about Social Security solvency - Social Security faces questions about funding its future obligations to retirees and was never intended to provide a primary source of income for most Americans.
Annuities are unique in the financial world in that they can guarantee an income for life. Traditional 'life-only' annuities have always had the uncomfortable tradeoff of the insurance company keeping your premium at the time of your death. In other words, if someone chose a life annuity it would be a great deal if they lived a really long time, but if they were hit by a bus as they left the bank after cashing their first monthly check…well, it was not such a great deal. But a lot has changed in annuity design!
With the income riders on fixed indexed annuities that concern is set aside. The client can still have an income for life that will continue even if the account value has been spent down to zero, but whatever is in the account value at the time of their death will go to their specified beneficiary. Can a bond do that? If the need arose to spend down a bond portfolio, would that income continue even if the account had been depleted? Of course not! The day the last dollar is spent in the portfolio is the day the monthly checks would stop. And when you factor in the additional income that can come from many annuities if the client is confined in a long-term care facility or, in some cases, if they are simply unable to perform 2 out of 6 activities of daily living…well, there is considerable value there. And what of the fees? With many income riders, the annual fee is around 1%. Some fixed indexed annuities offer no-cost lifetime income riders. While this is certainly a consideration in purchasing the rider, the fact that many actively managed mutual funds have expense ratios that can exceed 1% and yet have no underlying guarantees that protect against market loss or provide a lifetime income should put any potential annuity fee into perspective.
Summary
In today's volatile market, with Americans living longer than ever, there is a need for reliable, income-based products in a retirement portfolio. As with any financial product, including bonds, fixed indexed annuities are not appropriate in every situation, and are not a one-size-fits-all solution. However, when you consider the potential risks of bond ownership on the one hand, and the contractually guaranteed principal protection and income, coupled with growth potential, of annuities on the other hand, there is a compelling rationale for at least considering a fixed indexed annuity as an alternative to the space in a retirement portfolio that has historically been filled with bonds.
©2022 Tarkenton Financial LLC. Fixed indexed annuities are products of the insurance industry. Annuities are not FDIC insured. Guarantees in insurance products are based solely on the financial strength and claims-paying ability of the issuing company. This article is not intended to provide specific guidance or recommendations for your individual financial situation. Speak to a qualified financial professional for guidance on your individual situation.