Indexed Annuities as a Bond Replacement

In the context of an asset allocation strategy, bonds serve two primary purposes: 1) to provide steady income and 2) to counter the volatility of the equity portion of the portfolio and provide stability. How has that been working for you?

In recent years, income from investment grade bonds has shrunk to a trickle due to a lingering low interest rate environment. High-yield or junk bonds can provide the income, but generally at the expense of increased volatility.

Regarding portfolio stability, bond prices are already reacting to the expected increase in interest rates, which should continue to create downward pressure on the value of bonds. If you have an aversion to the idea of buying high and selling low, the timing is not so great for bonds right now.

What is an Investor to Do?

Consider the possibility of being able to buy a new 10-year investment grade bond with a 4% coupon and a guaranteed return of principal in today’s market. If you were looking for steady income and portfolio stability, you would probably buy it in a heartbeat, and happily hold it for the next 10 years. Of course, such a bond does not exist. But, what if there was an alternative investment that offered a similar opportunity? Would you consider it?

The Best Fixed-Income Alternative Your Clients Never Heard Of?

In view of the fact that bonds are likely to underperform in their portfolio duties in the coming years, an increasing number of advisors are expanding their fixed-income repertoire to include fixed indexed annuities (FIA). In fact, the record sales of FIAs over the last several years seem to reflect investor concerns over low yields and increasing stock market volatility. Advisors, who can see past the “annuity” aspect of FIAs and truly understand how they work in a portfolio setting, are hard pressed to find a suitable alternative.

Although fixed indexed annuities generate their earnings from participation in the equities market, they are considered a fixed income investment. The percentage gains of a stock index are merely used to establish a fixed rate to be credited to the accumulation account. However, the rate, whether it is the minimum guaranteed rate or the index-based rate, is fixed. Although the interest rate credited by FIAs will vary from year to year, once credited, the gains in the accumulation account are locked in and are not affected by stock market losses.

In terms of liquidity, some might argue that, in a rising interest rate environment, FIAs offer more liquidity than bonds. Investors can usually access up to 10% of their FIA account value without penalty during the surrender period. After the surrender period (typically around 10 years), withdrawals of any amount may be taken; however, if taken before age 59 ½, they are subject to a 10% penalty. The primary difference is that FIA investors don’t risk a loss of capital.

Not All Fixed Income Annuities are Created Equal

In the current interest rate environment, not all FIAs will average a 4% rate of return. A lot depends on the particular product and how it is structured. Some FIAs will have a higher participation rate that can capture a higher percentage of the index gain, but they might have a lower minimum rate guarantee. Or, they might have a higher cap rate, but a lower participation rate. With all of their moving parts, FIAs are not easily compared.

For several years now, conservative investors have been desperate for yield, but many have been unwilling to step outside their comfort zone for fear of higher risk and volatility. FIAs may be the most effective fixed-income alternative they have never heard of. For financial advisors searching for a bond alternative to offer their clients, FIAs should become a part of their fixed income repertoire.