These are difficult times to be financial advisors. Risk and volatility seem to be everywhere. And for clients, especially those who are in or near retirement and relying on interest-rate-sensitive products, seldom has interest-rate risk been higher. That’s why, in the current environment, it is important to educate your clients, help them recalibrate their risk tolerance, and offer them suitable vehicles for portions of their assets that they don’t want subject to volatility.
Today’s clients may have endured several gut-wrenching market corrections during their investing lifetimes, and many are only now getting back to even following the recession of 2008. In response to this volatility, investors have steadily liquidated their equity exposure by moving their assets into bond funds. In the four years ending 2011, individual investors pulled more than $395 billion out of stock mutual funds, according to the Investment Company Institute.1 By contrast, more than $775 billion has been funneled into bond funds.
However, DALBAR reports that the average fixed-income investor underperformed the Barclay’s Aggregate Bond Index by 5.56 percentover the last 20 years, which represents missed opportunities for significantly more income over time (see chart).2
To help clients avoid this experience, make sure they understand how interest rate changes will affect their bond portfolio. The fixed-income arena has significant interest rate risk. Many clients do not fully understand that if rates go up, bond prices will go down. As an example, show your clients how the 10-year Treasury was averaging a 3.58 percent yield to maturity in February 2011, versus 1.7 percent today. If rates moved immediately back to 3.58 percent, the client would have a paper loss greater than 15 percent.3
Taking action before a loss
It is likely that many of the under-performing investors highlighted in the DALBAR report sold their investments at or near their lowest value, then moved into cash or other low-risk products. Given today’s low interest rates, it takes a long time to recoup any kind of loss with these investments. Clients also need to understand the mathematics of loss. They often are surprised to learn that it takes a 33 percent gain to break even from a 25 percent loss. Sadly, many clients may be at a stage of their life when they will not have enough assets to buy into a correction. For these people, the margin for error has narrowed.
That’s why the time to get defensive is not when clients are behind by a big margin — it is when they are up in value. Fixed deferred annuities are especially well-suited for this strategy. Fixed annuities help many clients avoid potentially damaging buy-and-sell behavior by encouraging them to take a slow and steady approach — effectively removing the highs and lows that often lead to “emotional investing.”
When I was advising clients, I often utilized fixed annuities because they offered peace of mind for my clients and me. The portions of clients’ portfolios that were invested in fixed annuities were stable and were not subject to losses due to market fluctuations. If the client didn’t take withdrawals, the statement value only went up. Whether in environments like 2008 or today, keeping an amount of money in fixed annuities has merit because they dampen the overall volatility of the portfolio, which helps investors stick to their original plans and investments. The bottom line is that fixed annuities may help prevent clients from becoming DALBAR statistics. For that reason alone, they belong in many client portfolios.
The power of fixed indexed annuities
Particularly in today’s environment, fixed indexed annuities, or FIAs, can be a stabilizing solution for moderate-to-conservative investors with long-term horizons. FIAs help smooth out the volatility of their other investments, help prevent losses and earn potentially more than other fixed investments. FIAs vary by provider, but most combine a fixed interest rate providing guaranteed growth with additional accounts that are credited based on the performance of an investment index.
If held to maturity, FIAs generally are guaranteed not to lose value, regardless of economic environment. And aside from gains when interest is credited, they don’t fluctuate on client statements. All principal and gains, whether from a fixed interest account or indexed accounts, are protected by an interest rate “floor,” no matter what happens in the marketplace. In other words, clients cannot lose a positive return they earned in a previous year.
Inflation risk may be reduced because FIAs have the potential to grow beyond just a fixed rate. When the markets are performing well, FIAs receive additional interest credit (usually to a pre-determined interest rate “cap”). When markets are down, the contract’s previously earned gains are protected. Plus, like other fixed annuities, tax deferral helps FIAs create a “triple compounding effect.” Clients earn interest on their principal, interest on their interest, and interest on the money that they’d otherwise pay in taxes, helping them maintain — if not grow — their purchasing power.
FIAs also provide access to funds that other products do not. Clients can typically withdraw up to 10 percent of the accumulated value of their contract each year. With other fixed products, clients may receive only their interest income or bond coupon payments, which — given today’s low interest rates — are probably smaller than they used to be.
Winning with defense
Most clients understand that “safety” also signifies less opportunity for growth. In today’s rate environment, there are few opportunities to “swing for the fences” and still maintain low volatility. However, fixed indexed annuities may present growth potential that other fixed products do not.
FIAs can be positioned where uncertainty and opportunity intersect. Other products provide steady returns, but gains can be lost at the whim of the market and may not keep up with inflation. That’s why FIAs provide stability and growth potential that is not common in the market today.
In baseball, it’s said that pitching wins ballgames. When it comes to retirement planning, consider the FIA a Cy Young-winning pitcher who can also knock in game-winning runs.
Guarantees and benefits of annuity products are subject to the claims-paying ability of the issuing life insurance company.
Withdrawals in excess of 10% may be subject to surrender charges. Federal income tax and a 10% IRS early withdrawal tax penalty may also apply to amounts withdrawn prior to age 59½. Consult an attorney or tax advisor for more information.
1 Estimated Long-Term Mutual Fund Flows as of July 31, 2012. The Investment Company Institute. www.ici.org
2 Annualized over the last 20 years.“Quantitative Analysis of Investor Behavior,” 2012, DALBAR, Inc.. Bond benchmark performance examples are represented by the Barclays Aggregate Bond Fund, Indexes do not take into account the fees and expenses associated with investing, and individuals cannot invest directly in any index. Past performance cannot guarantee future results.
3 Federal Reserve Bank of St. Louis.