IAs As An Alternative To Bonds
December 11, 2013 by Chris McDonald
The old standby for retirement income – the traditional bond-equity mix – could have a new contender: the indexed annuity (IA) with guaranteed minimum income benefits rider. With inflation rising, interest rates ticking up and equities perched at all-time highs (and a possible correction looming), a portfolio that swaps bonds for IAs could be a safer alternative, according to a new analysis.
Research by Dr. Wade Pfau, a professor of retirement income at the new Ph.D. program for financial and retirement planning at The American College in Bryn Mawr, Pa., found that an IA with a 30-year inflation-adjusted income rider outperformed other product allocations — including bonds, variable annuities (VAs) and single premium immediate annuities (SPIAs) — at a 4 percent assumed inflation rate. Offering greater flexibility and inflation-adjusted income, these new and improved IAs could be the perfect solution for baby boomers, who consistently have bristled at the very thought of giving up control of a considerable portion of their retirement in a traditional annuity.
Pfau’s research is captured in “Mitigating the Four Major Risks of Sustainable Inflation-Adjusted Retirement Income,” a white paper he co-authored with Rex Voegtlin, a Certified Financial Planner with more than 25 years of experience. The four risks, as Pfau and Voegtlin explain them, are equity sequence of returns, bond-yield sequence of returns, longevity risk and sequence of inflation. They modeled the efficiency of equity/bond portfolios in the current interest rate environment and the efficiency of portfolios that substitute VAs, SPIAs and IAs for bonds.
The co-authors concluded that a retiree potentially may align his retirement income to mitigate the four major risks of sustainable inflation-adjusted retirement income through investing 100 percent of his retirement assets into a state-of-the-art IA. The models showed that replacing bonds with a SPIA solved three of the four risks – the risks of equity sequence of returns, bond-yield sequence of returns and longevity risk. Meanwhile, the state-of-the-art IA solved those three risks, plus the fourth, which is the sequence of inflation risk.
And inflation likely will be a major factor in the portfolios of the soon-to-retire. The authors assert that more than a few economists view inflation to be a significant future risk to retirees who currently own bonds. After hovering at historical lows for years, interest rates finally are trending upward. And, as we know, rising interest rates are the enemy of bonds. If your client owns a bond and interest rates go up, the value of that bond on the open market, with few exceptions, will go down. Your clients with money under management have probably noticed their bonds losing value already. Recently, we saw U.S.-based bonds post outflows of $6.94 billion in one week amid fears of rising interest rates. It’s reasonable to expect that interest rates will continue to move upward, as they are still well below historical average and way below historical peaks.
So where do you move that bond money? More equities? Here’s where taking a glance at history helps.
Think of the years 1901, 1929, 2001 and 2008. What do they have in common? When reflecting on bear markets, we tend to focus on the events that triggered the market downturn: a bad housing market, political unrest, droughts, bank failures – each market downturn can be traced to a different trigger. But one consistent condition has preceded market downturns across the decades: high price/earnings (P/E) ratio.
Now, take a look at the current Shiller Cyclically Adjusted Price Earnings (CAPE P/E) ratio, an excellent tool to help determine if stocks are too expensive. As of press time, stocks on the Shiller CAPE were trading at 23.6 times earnings, compared with the long-term average of 16. That’s still far below the all-time high of 44.2 in 1999, but it still means stocks are expensive right now. And if you look at a historical chart of the Shiller CAPE P/E, over time you see all the major market downturns were preceded by a high P/E ratio.
If you’re looking for a link between high P/E and lower bond yields, it’s this: much of the money flowing out of bonds will likely make its way into the equity markets, pushing prices even higher.
What event will trigger the next recession? How quickly will interest rates rise? No one really knows. But a catastrophic event can make your clients fall a long way if they’re already perched on a ledge.
According to Pfau’s research, investing part of a client’s portfolio in IAs may be the solution to the colliding forces of rising interest rates and an overpriced market. Even if equities and bonds are your go-to favorites, remember that IAs can be a third-door option – so you aren’t leaving clients in the cold.
Current competitive state-of-the-art IAs:
· Allow emergency access to remaining principal
· Link the retiree’s income to inflation (consumer price index) for up to 30 years
· Turn income streams off and on
· Don’t cap earnings
· Continue to be risk-pooled
The retiree electing an IA often gives up a little initial guaranteed income potential but gains the possibility of higher market-linked retirement income, especially for those who experience longevity in retirement.
Chris McDonald is a senior marketing coordinator at Senior Market Sales, a national insurance marketing organization. Chris may be reached at Chris.McDonald@innfeedback.com.
