Bond data in a newspaper

Roger Ibbotson, best known as the founder of Ibbotson Associates, an asset allocation research firm, has published new research championing fixed indexed annuities as an alternative to bonds for investors approaching retirement.

Those investors usually increase their bond holdings to reduce risk in their portfolios, but doing so in the current low-yield environment means risking not having enough income in retirement along with reduced prospects for capital appreciation.

Fixed indexed annuities can offset those shortcomings: In addition to earnings that grow on a tax-deferred basis, they guarantee a set interest rate and provide exposure to stock market returns, which tend to be higher than bond market returns, according to Ibbotson’s white paper.

Their performance is linked to the performance of a stock market index, which is often but not always the S&P 500 — Nationwide’s New Heights Fixed Indexed Annuities offers the option of linking to a index from Zebra Capital Management, founded by Ibbotson, its chairman and chief investment officer — but the gains are limited because the insurance company bears the risk,  and losses are not a factor.

For example, an FIA linked to the S&P 500 would collect just 6% of a 10% gain over three years but would not lose money if the S&P 500 lost 10% during that time period.

“The downside protection is very powerful and attractive to many individuals planning for retirement,” writes Ibbotson in his report.

He simulated the performance of $1 invested in an uncapped large-cap equity index FIA compared to the performance of long-term government bonds over the period from 1927 through 2016, net of expenses. He assumed annual expenses of 10 basis points for a passive stock portfolio and 10 basis points for a passive bond portfolio.

The hypothetical maximum annualized return for the FIA was 5.81% compared with 9.92% for large-cap stocks and 5.32% for long-term government bonds.

The maximum annualized return for a three-year holding period of the FIA was 27.56% versus 30.76% for large cap stocks and 23.3% for long-term government bonds. The minimum annualized three-year return of the FIA was zero compared with a 27% loss for large-cap stocks and 2.32% loss for long-term government bonds.

Ibbotson also compared the performance of a 60/40 stock/bond portfolio to that of portfolios with 60% stocks, 20% bonds and 20% FIAs and 60% stocks 40% FIAs over the same 1927-2016 period.

The average return of the 60/40 stocks/FIA portfolio was 8.77% versus 8.66% for the 60/20/20 stocks/bonds/FIA portfolio and 8.55% for the 60/40 stock/bond portfolio.

Ibbotson also simulated the performance of those three portfolios when annualized three-year return for large-caps were flat, down 10%, up 10% and up 20%. The two portfolios incorporating FIAs outperformed the 60/40 stock/bond mix only when stocks had positive three-year annualized returns of 10% and 20%, not when stocks were flat or lower.

Ibbotson then overlaid interest rate increases on those four comparisons. He found that when rates rose 1%, 2% or 3% the expected three-year annualized returns of the two portfolios that included FIAs outperformed the 60/40 stock/bond portfolio. They either lost less — when equities fell — or gained more when equities rose by 10% or 20% on a three-year annualized basis.

Ibbotson concludes that “FIAs have many attractive features for principal protection, accumulation and as a potential source of income in retirement.”

Micah Hauptman, financial services counsel at the Consumer Federation of America, agrees that the FIA “concept is a sound one,” but he cautions that many FIA products on the market are “highly complex, opaque and subject to conflicts of interest” if the seller earns a commission.

Hauptman notes there liquidity risks in these products because investors are locked in for a certain period of time — often 10 or 12 years — if they don’t want to pay penalties.

In addition, according to Hauptman, many fixed indexed annuities not only limit their gains to a percentage of the gains in the linked stock index, known as the participation rate, but also include an additional cap on those gains. They may use proprietary indexes, which are easy to create but not easy to understand.

“Most of these products are impossible to understand,” says Hauptman. “I’m a lawyer and I can’t make sense of them.”

The risk of fixed indexed annuities ultimately rests with the insurance company that sells them and guarantees the payments. For that reason, “it’s important to go with a highly rated insurance company and one you trust,” says Ibbotson.

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