For many investors, bonds are supposed to represent safety. Investors understand that stocks are volatile, but bonds and other fixed income assets are supposed to be a portfolio’s anchor. But as we saw last year, that isn’t always the case. The worst return for bonds in nearly 250 years made that apparent. Financial advisors are now facing a quandary on just how to provide the steady returns that many investors crave without the volatility.
The answer could be fixed annuities.
With their steady guarantees and ability to provide income to a portfolio, fixed annuities could be one of the best bond substitutes around these days. And with yields high, they can actually accomplish what many investors are looking for. For advisors, getting familiar with the product could be a real win.
A Lack of Use
According to a recent Mass Mutual survey, the vast majority of advisors have at least some familiarity with fixed index annuities. However, they only discuss the product with about 30% of their clients and recommend them to less than 19%. That’s a real shame as fixed annuities could be the solution to many issues investors are currently facing.
As we said in the opening paragraph, bonds have long been seen as the buoy in a portfolio. As equities gyrate, bonds sit in the shadows, producing steady coupon and interest payments to their owners. But last year’s 13% drop in the major bond benchmark, the Bloomberg U.S. Aggregate Bond Index, threw cold water on that idea. Most investors don’t own individual bonds till maturity and hold bond funds. This exposes them to the volatility.
Fixed annuities are different.
Like any annuity, a fixed annuity is a contract between an investor and an insurance company. With this form of annuity, investors are promised a guaranteed interest rate on their contributions to the account for a period of time. So, they invest $10,000 and, for the next five years, the insurance company will pay X% on the investment every year, for example. Better still, the value of a fixed annuity can’t go down.
A Fixed Income Replacement
Part of the problem and lack of recommendations could be that advisors are confused on how to use them for portfolios. Most advisors and investors sell equities to purchase fixed annuities. However, that thinking is wrong. Here, investors are simply selling one asset class with volatility for another with volatility and doubling up on fixed income assets.
Instead, investors should treat a fixed annuity under their fixed income sleeve. Replace bonds with the fixed income annuity. This allows the fixed annuity to fully function as a buffer for portfolios and that helps to mitigate sequence-of-return risk. Research by DPL Financial Partners shows that by allocating 20% of a fixed-income allocation in a 70/30 portfolio to a fixed annuity, the success rate of not outliving your money would jump to 72%, up from about 60%.
Additionally, advisors may be missing out on important tax benefits with fixed annuities.
Aside from municipal bonds, bond interest in a taxable account is generally taxed as ordinary income rates. If the annuity is bought with non-qualified money (i.e., in a taxable account), taxes can be deferred until the contract matures or investors start taking distributions from the contract. This can provide better tax planning and allow portfolios to shield more assets from Uncle Sam. Moreover, once distributions start, fixed annuities’ taxes can be beneficial as well. Only the annuity’s return on investment is taxable, what investors have paid in is considered tax-free. This can provide a steady stream of income at lower-than-expected tax rates.
This is just what investors want. According to a survey by WealthManagement.com, the most important features that investors are looking for in a fixed income annuity are principal protection (87%), downside market protection (86%), and predictable income (57%).
Check out this article to see why fixed annuities can be perfect bond alternative for retirees.
Add Fixed Annuities to Clients’ Portfolios
Given that fixed annuities offer a host of benefits to a portfolio, advisors may want to start advocating for the product with their clients. Mass Mutual suggests that more than 61% of clients who discuss fixed annuities with their advisor extensively are very satisfied.
Advisors should consider them part of a fixed income sleeve and fit them into that allocation. Things to keep in mind are:
- Fees
- Crediting rates
- Ability of clients to withdraw their money early if need be
The guarantees of annuities aren’t free. But they also don’t have to cost an arm and a leg. Most top-notch and reputable fixed income annuity issuers have low costs. Additionally, advisors need to be cognizant of any clients’ emergency needs. Fixed annuities can be ended early, but with hefty surrender charges. Making sure clients have an emergency fund first before investing is key.
As for the interest itself, these days, fixed annuities are offering crediting rates in the 3.5% to 5.5% range, depending on time, length of contract, and issuer strength. That’s well above the 1% to 2% just a year ago. Better still, the tax deferral makes that yield even better.
The Bottom Line
Despite the benefits, many advisors aren’t using fixed income annuities for their clients. That’s a shame as they could provide the steady returns they crave and the potential for lifetime income. Adding them to a fixed income sleeve of a portfolio could be a great win for both advisor and client.
