“Diversification is not only the first important thing investors should think about, but the second and the third, and probably the fourth and fifth, too.”
-John C. Bogle, founder of the Vanguard Group, as quoted in the Wall Street Journal, Sept. 10, 2011
In today’s fast-changing global economy, investors need to view diversification through a wider lens. As mentioned above, thinking about diversification for the fourth or fifth time could entail going beyond just spreading growth potential and risk across different markets and asset classes.
Investors now need to take into account how the new normal of continuing market volatility and prolonged low interest rates can erode assets over time. Along with stocks and bonds allocations, retirement income planning tools may also need to be diversified.
Let’s take a quick look in the retirement income planning toolbox. One likely missing item is a traditional defined benefit (DB) pension. The extinction of the DB plan has been well documented. According to the Employee Benefit Research Institute, only 3 percent of private sector employees are solely covered by a defined benefit pension plan, down from 28percent in 1979. Today, in many debt-burdened states, even public employee pensions are now under attack.
Another old tool, Social Security, may not be as dependable as many workers had hoped. Experts continue to debate the sustainability of the Social Security system to pay future retirees benefits. Funding the system may require significant changes in participant behavior, such as working longer or delaying Social Security benefits.
With these predictable pension tools either gone or now in question, the pressure is on individual Americans to take personal responsibility for their individual retirement planning. That puts pressure on their advisors to help them diversify their retirement income sources against new normal risks.
Luckily both old and new tools are available to help. Variable annuities with optional living benefit riders have long been and remain effective tools for helping to create and protect a guaranteed retirement income stream, regardless of market performance. Since the market crash of 2008 and the subsequent waves of volatility, these products have gained wider acceptance among advisors. Former skeptics now may value the predictable level of retirement income variable annuities can help provide their clients, even in down markets.
Guarantees are based on the claims-paying ability of the issuing insurance company. Guaranteed living benefit riders are optional and available for an additional cost. The guarantees do not apply to the investment portfolios, which will fluctuate and may lose value.
Along with these traditional variable annuities, insurance companies are applying risk management expertise to create new strategies for navigating today’s economic challenges. One challenge is the risk low rates pose to growth in fixed-rate investment instruments. While the Fed has indicated that it may keep Treasuries artificially low through mid-2013, many experts believe that rates will then begin to rise. When it comes to diversification, advisors need to position their clients to take advantage of such rising rate opportunities.
Among the new tools available to do that are variable annuities with guaranteed income streams tied to the performance of Treasury rates. Such floating rate products can help clients take advantage of the prospect of rising Treasuries. For investors looking to put money to work immediately, some companies are offering special temporary rate holds that present an attractive way to ride through today’s low rate climate and take advantage of the potential for rising rates in the future.
While current interest rates may be in the doldrums, the stock market over the last several years has been a volatile tempest. However, the alternative—stashing money in traditionally safe-bet savings accounts or low-interest bearing fixed investments—can pose the threat of being outpaced by inflation. Another alternative is an entirely new type of buffered variable annuity that offers a certain level of down market protection and an opportunity for market growth participation, up to a cap.
With this new tool, clients have access to the growth potential of participation in equity or commodity indexes, with a performance cap and downside buffer. A performance cap limits the investors return in certain up markets and through a buffer the insurance company absorbs up to a certain amount of loss with the investor covering the remaining portion of the loss.
The balance between a growth cap and a partial downside protection buffer may help stabilize returns and reduce the emotional toll of volatility. By reducing or in some cases, eliminating losses, it can offer weary clients the protection needed to remain invested, even during periods of volatility.
Fast changing economic and market conditions have created new challenges for retirement savers. The insurance industry has responded by adding to its existing portfolio of traditional variable annuities. In addition to traditional variable annuities with riders that can provide guaranteed income, new products can help address a wide range of client needs and changing economic conditions, from market volatility to low interest rates. Taking John C. Bogle’s advice, advisors today might ask themselves how their clients’ retirement income tools are diversified. Are they considering just one kind of variable annuity or are they diversifying across today’s broader range of VAs?
Michael McCarthy is senior vice president of AXA Distributors, LLC. He can be reached at email@example.com.