Annuities as a Bond Alternative

Bond investors, or investors considering adding bonds to their investment portfolio, are in a pickle. After near three decades of declining bond yields, they’ve hit rock bottom. That’s great if you have been holding bonds during that period because the decrease in bond yields pushed bond prices to record highs. However, with bond yields still hovering near historic lows, there’s only one way they can go – up. When that happens, bond prices will decline. There goes your portfolio stability, which is one of the main reasons for owning bonds.

The other reason for owning bonds is to generate a steady income. With historically low yields, the income from bonds has been meager, forcing many investors to seek out alternatives, such as high-yield bonds, REITs, and dividend-paying stocks, which can introduce more risk into their portfolios. Although signs point to higher bond yields in the future, they can’t come fast enough for yield-starved income investors.

Building a Better Bond Investment

Consider for the moment that you could find a 10-year, investment-grade bond with a 4 percent coupon rate and a principal guarantee. Sound attractive? Most bond investors wouldn’t hesitate to add them to their portfolio and hold them for the entire 10-year period. Unfortunately, such a bond doesn’t exist.  However, a vehicle with very similar characteristics does exist and it’s called a fixed indexed annuity (FIA).

FIAs have experienced strong growth over the last several years, logging record sales in 2015 and 2016 before leveling out in 2017. Their popularity surge has been attributed to the increase in market volatility during that period. Although they offer limited upside, investors have become more concerned about limiting their downside by increasing portfolio stability.

FIAs offer the fixed income component of bonds but without the exposure to interest rate risk. They offer participation in the gains of the stock market without exposure to market declines. Bond-like returns can be earned without risking principal and earnings grow tax deferred.

How a Fixed Indexed Annuity Works

There are two ways to invest in FIAs. A single-premium FIA is a one-time investment, while a flexible-premium FIA allows for smaller, incremental investments over time, which makes it a good alternative for bond fund investors. Investments in both types can be allocated between a fixed account and one or more indexing strategies. The fixed account pays a fixed rate of interest for one or more years that is competitive with CDs of similar duration.

The indexing strategies offer the opportunity to generate returns based on the performance of an underlying stock index, typically the S&P 500 index. Instead of a direct investment in the index, where you experience both gains and the losses, an interest rate is credited to the account based on returns of the index.

If the index’s return is positive, interest is credited to your account subject to a cap. If the index’s return is negative, no interest is credited but the account is credited with a minimum rate guarantee. Each contract year, any gains in the account are locked in.

Advantages and Disadvantage of FIAs as a Bond Alternative

When looking at a fixed indexed annuity as a bond alternative, there are several distinct advantages to consider:

  • Participation in stock market gains
  • Protection from market losses
  • Simplified investment management
  • No credit risk or interest rate risk
  • Tax deferred growth
  • Lifetime income sufficiency with an income rider or minimum guarantee withdrawal benefit

The disadvantages of FIAs should also be considered:

The most notable disadvantage is that FIAs require a long-term commitment. Most FIAs have a surrender period during which any withdrawals that exceed 10 percent of the annuity balance is subject to a surrender charge. The surrender period varies, ranging between five and 10+ years. The surrender charge can start as high as 15 percent but declines each year until it reaches zero, after which there are no more surrender charges.

For long-term investors who don’t need short-term access to their funds or who typically maintain a long-term fixed income allocation in their portfolios, duration should not be a concern.

When investing in any type of annuity, especially when you expect to convert it into a guaranteed lifetime income, the financial quality of the issuing insurance company should be a primary concern. With fixed annuities, the insurance company bears the underlying investment risk, protecting investors from market and default risk. While life insurers have rarely run into financial difficulty, for the greatest peace-of-mind, investors should consider insurers with the highest financial ratings from A.M. Best, Moody’s, and Standard & Poor’s.

Transferring Pension Risk through Buyout and Buy-in Arrangements

Companies seeking to reduce costs continue to offload pension liabilities at a record pace. Pension buyouts swelled to $23 billion in 2017, a 68 percent increase over the prior year. With rising interest rates and lower corporate taxes, an increasing number of companies are seeing their pension funding levels rise enough to make transferring their pension liabilities to an insurance company through terminal funding and other pension risk transfer strategies.

With the liability transferred, the insurance company assumes the risk of future payment obligations. However, the premium cost is prohibitive for companies with low funding levels because they still have to make contributions to close the funding gap while paying annual premiums to the Pension Benefit Guarantee Corp (PBGC). Rising interest rates and lower taxes, companies have been able to close that gap through improved investment performance and higher contributions to the pension plan.

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The Impact of the New Tax Bill on Annuities

The highly anticipated Tax Cuts and Job Act signed into law in December 2018 is the most significant tax legislation enacted since the 1980s. Most taxpayers across the spectrum – both individual and business – come out ahead with the reduction in tax rates, the increase in the standard deduction, and the business income deduction for many small businesses. The tax treatment of investment income from capital gains and dividends is left untouched. The tax advantages of annuities, long considered a target of policymakers as a source of new tax revenue, also escaped unscathed. For now, annuities maintain their tax-favored status and remain a viable investment option and planning tool for many different purposes.

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Sweep the Gains from Equity Positions Into an FIA

For Investors on the glide path to retirement, they have a nine-year bull market to thank for rescuing their retirement plans. In 2017, the surging stock market produced double-digit gains in all sectors except energy, which means, if you were invested in stocks, you did well. For pre-retirees preparing to transition into retirement over the next five to ten years, it may be the perfect opportunity to lock in some gains and protect them to maximize future income.

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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?

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Using a SPIA to Purchase Life Insurance

If you work with older, high net worth clients, you have most likely uncovered the need for life insurance, either to provide estate liquidity or for the purpose of increasing a family legacy. Whatever the reason, a life insurance policy is a major purchase for older clients, often requiring the payment of large premiums for the remainder of their lives. While you wouldn’t recommend such a purchase for any clients who don’t have the income or the assets to comfortably cover the premium payments, you could greatly enhance the financial position of those who do with the use of a Single Premium Immediate Annuity (SPIA) as a funding source.

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Annuities and Retirement Planning

Retirees’ demand for more predictability and security in their retirement income has led an increasing number of financial advisors to look to annuities as way to provide more stability in their clients’ investment portfolios. They are also looking to annuities as a way to replace the third leg of the retirement income stool as a guaranteed lifetime income. Retirement planning occurs in different phases and at different stages of peoples’ lives. Depending on what stage of life a person is in, there is different kind of annuity that is best suited for their situation.

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Creating a Pension Using a Fixed Indexed Annuity

You’ve probably never heard anyone complain about their pension. That’s because it provides the certainty of knowing how much income they will receive and that it will last as long as they do. That kind of certainty is very difficult to replicate, which is what makes annuities so attractive.

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Educate Your Clients on Annuities as a Wealth Transfer Tool

As a financial producer, you’re aware that one of the main concerns of your clients is how to efficiently and responsibly pass on their wealth, whether it’s to younger siblings, children or even grandchildren.

While there are numerous ways your clients can leave inheritances, certain methods create more burdens than your clients would prefer. For instance, a lump sum often creates harsh tax implications that your clients’ heirs then have to deal with. Additionally, a lump sum without any spending restrictions can be used quickly and not help family members throughout their lives, as your clients likely intended for it to.

Instead of leaving a large sum as an inheritance, you can advise your clients of a more beneficial and structured method: a deferred annuity.

Looking at annuities in a new light

In most cases, your clients will have heard of annuities as a means to manage finances and retirement income, not as a wealth transfer tool. But, as long as the primary and contingent beneficiaries of an annuity are who the client wishes, it can act as a well-structured inheritance, paying out only after your client’s death.

Benefits of a fixed annuity

Two major benefits of using annuities as a wealth transfer method are that your clients can design exactly who receives funds and how the proceeds will be disbursed. An annuity can be set up with one beneficiary or more, as well as with contingent beneficiaries in case an heir is no longer living when the annuity becomes active.

If your client has three children, all of whom have children of their own, he or she can design the annuity to provide income to all three children. In the situation where a child has passed before the annuity begins to pay proceeds, that child’s children could be named the contingent beneficiaries and receive that person’s share of the inheritance.

This is just one example you can provide to your clients to illustrate the flexibility in assigning inheritances.

Annuities not only allow your clients to determine who receives an inheritance, but how. Proceeds can be paid throughout beneficiaries’ lifetimes or in larger sums for a shorter period of time. The ability to customize how the annuity will pay out is important as your clients can manage the tax burden on their heirs and reduce the likelihood of the inheritance being used irresponsibly.

You can even advise your clients regarding the possibility of using a restrictive endorsement with an annuity, ensuring their control over the sum isn’t lost. Under a restrictive endorsement, the beneficiary is unable to sell or assign his or her rights to the annuity, ensuring he or she can’t receive a lump sum in place of timely disbursements.

Using an annuity as a wealth transfer tool offers your clients control and flexibility. In addition to these qualities, which are lacking in lump sum inheritances, an annuity helps your clients protect their families years into the future, ensuring they have the income they need with fewer tax consequences.

Fixed Annuities Give Consumers Confidence

There’s a good chance many of your clients are experiencing worry over retirement. Such a significant life transition is bound to come with feelings of apprehension, and it’s typically the financial side of things that gives clients the most pause.

Fortunately, fixed annuities could be the ideal solution to provide clients with a valuable product while also reducing retirement trepidation.

The benefits of a fixed annuity

Like with life insurance and other types of investment, annuities lead to greater feelings of financial security thanks to the guarantee involved. In most cases, a fixed annuity can act as a guarantee that individuals will not outlive their income – a growing fear as people continue to live longer lives.

Financial advisors who do not include annuities among the products they offer are missing out, as worry over retirement only appears to be expanding. More individuals are turning to professionals for financial advice, and retirement planning is often the driving force.

Fixed annuities, along with products like life and long term care insurance, provide clients with the tools they need to face retirement confidently.

Future costs leave Americans concerned

It’s not just maintaining a comfortable lifestyle that has Americans worried about their retirement prospects. Many individuals are even more concerned with the future costs of aging as they’re related to health care.

In fact, research from Fidelity shows that health care costs for couples in retirement are on the rise. They estimate that a couple, aged 65 and retiring in 2016 will need $260,000 to cover health related expenses.

“In recent years, the health care industry has experienced a period of historically low spending levels, due to a range of factors including a period of slow economic growth,” said Adam Stavisky, senior vice president, Fidelity Benefits Consulting. “Looking forward, we expect health care spending to pick up from where it’s been in recent years, though less than what we’ve seen over the last few decades.”

In addition to standard health care, which can at least be partially financed by Medicare, retirees must also come to terms with the need for long term care.

Since Medicare can only be used to fund long term care in very limited and temporary instances, it’s vital for Americans to invest in ways to fund their future care needs.

In addition to LTC insurance, a fixed annuity can be counted on to provide steady income as long as an annuity holder lives. Together with Social Security, life insurance and other investment opportunities, fixed annuities can offer your clients the reassurance they crave and help them obtain the services they need as they age.