Here’s One Way to Protect Near-Retirees From Market Shocks: Wade Pfau

What You Need to Know

Investors who are closing in on retirement tend to shift their allocations away from stocks to reduce portfolio risk.
However, risk-averse near-retirees with significant fixed income allocations can still be steered off course by a rapid rise in interest rates.
For these investors, adding allocations to certain structured annuity products can help them access the market’s upside while preventing big losses.

Near-retirees who are depending on bond funds to maintain the value of their assets without taking excess equity market risk are still vulnerable to having their financial plans steered off course by rapidly rising interest rates.

As noted in a new report published by the well-known retirement researcher Wade Pfau in collaboration with Equitable, this concept shifted from abstraction to reality in 2022. The year brought stock and bond markets losses in the double digits, and the pain on the bond side was mainly driven by rising interest rates.

As Pfau explains, rapidly rising rates reduce the value of existing bonds, but investors who fear equity market volatility often feel they have little choice but to stick with their bond-heavy portfolio allocations. This is because the traditional approach of investing only in stocks and bonds creates a big limitation.

“The only mechanism [such] an investor can use to adjust the distribution of potential returns is the allocation of their savings between the asset classes,” Pfau notes. In this binary framework, moving away from bonds means taking more risk in the equity market, which itself may be a bigger worry for some investors.

Fortunately, according to Pfau’s latest work, there is an emerging alternative approach for advisors and investors to consider, and it involves using structured investment products as a complement to the standard 60/40 portfolio.

Recent innovations in the structured annuity market, in particular, offer an alternative distribution of returns through guarantees that offer both the opportunity for growth and protection against loss, Pfau says.

As Pfau explains, structured annuities use financial derivatives to create a structured return that changes the shape of the portfolio’s projected return distribution and the relationship between downside risk and upside potential.

Though the mechanics are somewhat complicated, when added to a diversified portfolio, these solutions may provide an opportunity for household investors to improve their financial outcomes by offering a beneficial trade-off between upside and downside risk, he says.

Ultimately, Pfau argues, the growing category of structured annuity products provides an alternative for households to manage market risks as they approach retirement. He says these annuities allow an investor to design their own distribution of investment outcomes to better manage downside risks, while still providing participation in the market upside.

Structured Annuities Gaining Attention

“The ability to better manage downside risks can lay a foundation for either needing less savings to successfully retire, or to enjoy a higher standard of living from a given asset base,” Pfau posits.

Speaking with ThinkAdvisor about his latest project, he emphasized that this research is focused on asset accumulation during the run-up to retirement. Often, when people hear the word “annuity,” he explained, they tend to think more or less exclusively about retirement income.

“It’s exciting because this research project with Equitable is actually broken into two phases, and this first phase is not specifically talking about retirement income,” Pfau notes. “That will be the second part of the project. This initial phase is about exploring the question of what having a structured return on a portion of your investments can allow you to do with the overall asset allocation and your risk and performance goals.”

According to Pfau, advisors and their clients are used to talking about bell curve distributions of stocks and bonds, and about setting limits on both the upside and the downside. Generally, advisors seek to limit the downside while the client is approaching retirement, at the expense of potential upside performance.

“Well, we are asking, what if you change that approach in a more fundamental way, for example by bringing a registered index-linked annuity into the picture, one that features a buffer on the downside performance,” Pfau explains.

The Dual Step Up Approach

According to Pfau, another emerging investing approach that was “really intriguing” and that contributed significantly to the positive performance seen in the analysis is called the “dual step up,” which is a feature of some structured products already available in the marketplace.

“The basic idea here is that you are going to get credited with a fixed return whenever the index achieves a certain degree of performance,” Pfau explains. “So, for example, consider a 15% segment buffer. As long as the market was not down more than negative 15% — even if it was down 14% or up 50% — that investor will be credited with an 8.5% return for that year, and you’re only exposed to the loss beyond that negative 15%.”

In Pfau’s extensive Monte Carlo performance simulations, a theoretical near-retiree could expect to get that 8.5% return in something like 92% of the years projected, and the other 8% of the time they see only a small loss. Naturally, this is an attractive performance distribution for a near-retiree worried about market shocks.

“The big conclusion we can draw here is that you can basically treat this structured, buffered approach as an asset class in an asset allocation model,” Pfau emphasizes. “That’s the punchline of the research, seeing what these types of solutions can do to move the efficient frontier for the whole portfolio.”

Put another way, when one adds these types of structured annuity segments that change the distribution of returns, an investor can dramatically improve portfolio performance while also achieving higher risk-adjusted returns.

“We found strong evidence that you can build portfolios with a higher return expectation and less volatility relative to what you can achieve with stocks and bonds alone,” Pfau says.

A Bond (or Stock) Replacement?

According to Pfau, if explained clearly to clients, this approach to investing can be very appealing, especially to those pre-retirees who feel they have saved successfully and want to protect what they have set aside, but who are also worried about their longevity risk. Using these solutions provides meaningful downside protection without sacrificing too much upside.

“In addition, there is another really interesting dynamic in our findings,” Pfau says. “I often talk about annuities as a bond replacement, and certainly you see that, compared to bonds, these types of structured financial products can perform significantly better, especially when you layer in the tax-deferral factor.”

But, Pfau says, it was also interesting to see that, if one looks to more conservative investors, this approach can also be really appealing.

“I don’t want to say these annuities are good stock replacements for the typical investor, but they can play an interesting role if someone was only going to have a really low stock allocation anyway,” Pfau said. “By allocating to bonds in the structured product, they can still dramatically improve the frontier of potential returns compared with, in this case, a small stock allocation.”