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Burdened by bonds? A fixed indexannuity can be a better answer

by Joseph Arroyo | Contributor
May 5, 2021

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Bonds used to be a traditional cornerstone of conservative investing. Their stable pricing and consistent interest payments were used for generations to keep investment portfolios safe and provide for income during retirement. The famous 60/40 investment portfolio makes heavy use of bonds. These days seem long gone, however.

In today’s market, unheard-of low interest rates and federal intervention in the bond market make bonds less attractive than ever before. In fact, bonds may not be serving the purpose investors have counted on them for, and may in fact be a liability. Fortunately, fixed index annuities can not only take up the slack for bonds, they can even provide more income.

Why were bonds recommended in the first place?

Bonds have traditionally been part of conservative asset allocation for several reasons. Bonds used to provide:

  • Safety of principal
  • Conservative growth, reducing volatility
  • “Safe” income in retirement

By investing in bonds, both government and corporate, investors could park money in assets that would hold their value, or slowly grow in value over time while making a reasonable amount of interest. U.S. government bonds have long been considered the safest investment available, so much so that the rate paid by certain government bonds is often considered to be the “risk-free” rate when used to determine the value of potential investments.

Since blue-chip bonds are usually not susceptible to big losses, they have been the perfect vehicle to moderate exposure to stock market losses. One of the most often-used asset allocation formulas is based around increasing exposure to bonds as you age. The “100 minus your age” reduces your stock market exposure and increases your allocation to bonds every year.

This was all well and good for decades, or even generations. Inflation might occasionally be a problem, eating at the purchasing power of the interest paid, but even this didn’t really diminish the attractiveness of bonds for the last three decades. The interest earned by bonds was much greater than could be earned from savings accounts, money market funds or CDs.

Why are bonds a problem right now?

The bond market, as with so much of our society, is a completely different world today thanks to the COVID-19 pandemic. The result of unprecedented governmental response, especially by the Federal Reserve, to the economic consequences of various degrees of lockdown and social distancing policies has transformed the bond market. No longer can it be counted on for steady returns and interest payments.

The Federal Reserve (and central banks around the world, this isn’t restricted to the U.S.) aggressively lowered interest rates in an attempt to stimulate the economy. In addition to lowering the rates under their control or influence, they also expanded or created programs to directly purchase various bonds in an attempt to support the prices and drive interest rates down.

Lower interest rates have a number of effects, mostly having to do with the cost of borrowing. With very low interest rates, corporations and individual consumers can borrow money with lower interest payments. This can take the form of:

  • Lower mortgage rates and more home buying.
  • Lower corporate bond rates, greater investment in infrastructure or other corporate growth programs.
  • Lower interest expense paid by taxpayers on government debt – this allows more spending by congress and the president for economic stimulus projects, and an ability to run higher deficits without collapsing under the strain of higher interest payments.

Side effects of ultra-low interest rates and Federal Reserve intervention in the bond market are higher asset prices. With rates artificially depressed, investors pour money into riskier assets like stocks and commodities (oil, corn, gold, etc.) hoping to earn higher income than they can in cash or fixed income investments. The hope is that the result of the interest rate and bond market policies of the Fed will be market stabilization (no panic selling) and economic stabilization (no severe recession or depression).

While the usefulness and effectiveness of these policies can be (and is) endlessly debated, what is beyond question is that the Federal Reserve has succeeded in lowering interest rates. At the height of the pandemic-induced recession, the 10-year Treasury bond yield hit an intra-day low of 0.138% in March of 2020. Even though rates have climbed from the depths of that near-depression, their current rate of 1.64% is significantly lower than the average yield of 2.14% in 2019. As U.S. government bonds go, the difference in yields is huge.

Ignoring the potential benefits to the overall economy, the effects on investors, especially those in or near retirement, has been overwhelmingly negative. These negative consequences include:

  • Very poor income from interest payments.
  • Vulnerability to price declines and losses on investment as bond prices have “only one way to go” – down.
  • An increase in portfolio risk as investors have fled the traditionally “safe” investment in bonds for higher-yielding assets.

In other words, bonds are no longer the “set it and forget it” investment they have traditionally been. Reduced interest income and higher volatility have led to an increase in anxiety. Investors and retirees are vulnerable to loss of income in retirement if they stick with traditional asset allocation methods. They’re also facing potential market losses if they leave bonds and invest in riskier, higher-yielding assets.

Worst of all, the money they have in bonds is now also more exposed to market losses as rates potentially stabilize. For instance, bond prices have declined as rates moved from depression lows to the more “normal” rate of 1.64%. In other words, the 10-year is still only yielding 1.64% on an annual basis, but if you bought the bond when rates were less than 1%, you’ve lost money. Such a result is terrifying to conservative investors. For many, an alternative must be found or retirement savings and lifestyle projections will be unattainable. One alternative is to increase exposure to riskier assets in an attempt to earn better returns.

What to do now?

It would be well for investors to remember the volatility of financial markets. In other words, don’t “reach for yield.” Reaching for yield is the practice of either remaining in risky assets, or increasing exposure to risky assets, for the purpose of making up for low interest income provided by safer, less volatile assets. Reaching for yield is sometimes an unconscious action. As rates decline and the need for some kind of interest income is felt, risk tolerances are gradually increased.

On the other hand, some people purposefully chase yield, disgusted with the options for earning reasonable interest and income. Chasing yield is a dangerous practice that can have devastating results on investment portfolios. We’ve all heard about stock market bubbles before. Investors often wondering if we’re currently experience one. Unfortunately, bubbles seem to occur with regularity. They also burst regularly. Since 1980, there have been five major stock market crashes – 1987, 1990, 2000, 2007 and 2020. Three of them have occurred since the year 2000.

People often think that they’ll be able to sell at the top or sell quickly once the downturn starts. However, as we saw with the 2020 crash, markets can drop staggeringly fast, and they often open “limit down” which means that the market opens perhaps 1,000 points lower than it closed the day before.

If you can’t reach for yield, what can you do? You still need to earn income in your retirement. So what will take the place of bonds? Fixed index annuities may be the solution to your needs.

What are fixed index annuities?

You’re probably familiar with traditional annuities, which are assets issued by insurance companies that pay a guaranteed stream of income for a specified period of time. Typically, annuities are used in one of two ways:

  • You make one large payment, and begin receiving income payments right away (known as an immediate annuity).
  • You make a series of ongoing deposits (premium payments) that accumulate interest over time. You elect to start receiving payments sometime in the future (this is called annuitizing your annuity).

The payments you receive from the insurance company are guaranteed over a set period of time. The most common term is to receive payments over your lifetime. The insurance company takes the balance in your annuity and determines a payment amount. It promises to pay this amount every month for the rest of your life.

These guaranteed payments sound like a great idea, right, so do you expect that there’s a catch? The “catch” is that the interest payed by the insurance company is usually low. Lower even than what’s paid by bonds. So, while the guarantee is a nice feature, it can be hard to build up a large enough balance to provide a large income in retirement. This is where the power of indexed annuities come in to play.

Indexed annuities have the potential to pay much higher interest than traditional annuities. Instead of the insurance company declaring a fixed interest rate (which is pretty close to what you can get from the safest bonds), your interest rate is determined by the performance of one or more financial market indexes.

Every insurance company offers a variety of indexes for you to choose from. Often the indexes mimic famous stock market benchmarks like the S&P 500, or international stock markets. You can choose one or several indexes to set your interest crediting to. However, none of your money is actually invested in these indexes. This makes fixed index annuities totally different from variable annuities, which actually DO expose your money to the fluctuations in the stock market.

Instead, the interest rate you earn on your money is calculated based on the performance of the indexes you choose. Your actually interest rate is determined by two other factors:

  • The participation rate – the percentage of the index return that is eligible to be applied to your account. For instance, with an index return of 10% and a 60% participation rate, your potential interest credit would be 6% (10% return multiplied by 60% participation rate).
  • Cap rate – the maximum interest rate payable under the terms of your contract. To continue the example, if your cap rate is 4%, then you wouldn’t ever receive an interest credit higher than this amount, even if your index performed much better.

Participation and cap rates vary. There are 100% participation indexed annuities with no cap rates. The cap and participation rates are key components of the research you’ll want to do with your financial professional when you look to find the right indexed annuity for your needs.

Perhaps the best news with these annuities is that you’re protected form market losses. The worst that would happen in a given year is that you would earn 0%. You can see the benefit here: potential exposure to high, stock-market based returns in good years and a guarantee to not lose money in bad years.

The combination of higher interest crediting with downside protection is truly a “best of both worlds” scenario. You’re probably wondering if there’s another catch somewhere. There really isn’t a catch as long as you understand how surrender charges work for annuities. Most annuities impose a charge for cashing in or withdrawing your money within the first 10 years. For this reason, you should only fund an annuity if you intend to keep it for the long haul, at least 10 years.

This shouldn’t be a problem if you use a fixed index annuity as part of a sound financial plan. You’ll want to accumulate the highest possible balance, so you’ll want to keep your annuity in force for 10 or more years in any case.

Higher income streams with fixed index annuities

The truly great thing about the potential for higher interest crediting is that fixed index annuities also pay a guaranteed income stream, just like traditional annuities. With the potentially higher account balances, you’ll be able to receive larger income streams in retirement than you would have received from either traditional annuities or interest from bonds. These higher accumulated values and income payments can more than make up for the decline in interest rates paid by bonds.

A successful fixed index annuity strategy can enhance your retirement savings and planning with:

  • A higher standard of living from larger income payments.
  • Eliminate re-investment risk (the situation where one bond matures, and you have to reinvest the proceeds into lower-interest bonds).
  • Simpler to implement and keep track of than a laddered bond portfolio.

Since annuities often have 10-year surrender periods, it can be useful to compare the interest you’d earn from 10-year U.S. Treasury bonds. In this example we’ll assume the following:

  • You annuitize (begin receiving payments) / receive interest at age 65.
  • The 10-year Treasury interest rate is 1.64%.
  • You have a portfolio of $500,000.

With a life annuity payment, you’d receive monthly payments of between $2,000 and $2,300 per month for the rest of your life. The same $500,000 invested in 10-year treasuries would pay a monthly income of $683 per month.

Now, this is obviously a huge difference, so you need to remember that at the end of the 10-year term of the Treasury bond, you get your principal back ($500,000 in this case). However, when that happens you stop receiving interest payments, so you need to purchase more bonds to generate monthly income. If interest rates are lower, then your income declines. Of course, they could be higher, too, but you can see that they would have to be tremendously higher in order to provide income anywhere close to what’s possible as a life annuity payment.

The true benefit to the fixed index annuity strategy is that you can have greater peace of mind about your retirement. You’ll know you’re protected from market losses. You’ll know you’re earning higher interest rates than are currently available with bonds or traditional annuities. Plus, you’ll know you have a guaranteed stream of income to look forward to in the future; this should allow you avoid “scrimping” in the early years of your retirement. In short, moving from bonds to fixed index annuities can bring you a better retirement with less stress.

Incorporating fixed index annuities into your retirement plan

It’s very important to work with your financial professional to develop a strategy for using these annuities. They are definitely longer-term assets and should not be used if you can’t commit to keeping them in-force at least until the surrender period runs out. Plus, you’ll want to make sure that you find an annuity with favorable participation and cap rates. Your financial professional can also help you review your indexing options and choose an optimal strategy based on your needs.

Alliance America can help

Alliance America is an insurance and financial services company. Our financial planners and retirement income certified professionals can assist you in maximizing your retirement resources and help you to achieve your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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