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.