Fixed Indexed Annuities (FIA) are emerging as a potential alternative to bonds in retirement portfolios at a time when overreliance on bonds may result in critical retirement shortfalls for US investors, according to a research paper by economist Roger Ibbotson (pictured) and his team at Zebra Capital Management.
The whitepaper "Fixed Indexed Annuities: Consider the Alternative" suggests bond returns in today's historically low interest rate environment may be insufficient in meeting the anticipated retirement needs of US investors, potentially placing many at risk of outliving their retirement savings.
Ibbotson's latest research demonstrates that uncapped FIAs help control equity market risk, mitigate longevity risk, and have the potential to outperform bonds in the near future.
'What financial advisors should acknowledge is the immense impact that shifting market conditions, longer life expectancies, and uncertainties surrounding the future of Social Security have made on our US economy," said Ibbotson. "In recent years, we recognized the potential of these conditions to result in a perfect storm where investors may be left with insufficient funds to carry them through retirement.'
According to Ibbotson, conventional wisdom has most investors de-risking their portfolios by allocating more heavily to bonds as they approach retirement. 'However, investors should consider other alternatives such as FIAs,' he said. 'In this low interest rate environment, complacency can be a danger to our clients' futures.'
In collaboration with annuities provider Annexus, the researchers utilized S&P 500 Index dynamic participation rates to simulate FIA performance over the past 90 years. The subsequent data, which considered historical volatility, interest rates, and dividend rates, indicated that uncapped FIAs would have outperformed bonds on an annualized basis for the past 90 years; that it is highly unlikely bond investors will realize as high a return from capital gains in the coming 10 years as they have realized in the past 10 years (in fact, if rates rise, capital gains in the future will be negative); and that uncapped FIAs offer a more tailored risk profile than bonds, capturing a portion of the growth offered by large-cap stocks, while lowering overall market risk.
Tailored returns
According to the research, a major advantage of an FIA is the ability of the insurance provider to "transform" equity returns into a more "tailored" return/risk profile (eliminating downside risk and providing an opportunity for interest earnings based upon a portion of equity returns).
The research also found that during the "accumulation" phase, growth of a generic uncapped FIA is based upon an index subject to a floor and a participation rate. For example, over a three-year period, the FIA might use the S&P 500 Price Index subject to a 0% floor and a participation rate of 60% of any positive index performance. In a 3-year period where the S&P 500 Price Index gained 10%, the FIA would credit interest at 6.0%. In a 3-year period where the S&P 500 Price Index declined -10%, the FIA would not lose money subject to the 0% floor.
Don Dady, co-founder of Annexus said this is the 'single most important body of work' in this industry for over 25 years, and the 'first to validate Fixed Indexed Annuities as an asset class.'
'The evolution of the industry has made these vehicles more flexible and attractive than ever with the emergence of uncapped product designs and smart beta indices,' said Dady. 'In today's fiduciary environment, it is imperative that advisors know what products are available and best suited to address the needs of their clients.'
Sales of indexed annuity in Q4 2017 amounted to US$14.7bn, a seven percent rebound from the prior quarter and a five percent increase compared with the fourth quarter of 2016, according to Limra Institue. SRP data shows that the S&P 500 index (81 products) is the most popular index in the US annuities market followed by the Nasdaq-100 index, DJ Industrial Average Index, Russell 2000 index, S&P Midcap 400 ETF TRST, Bloomberg Barclays Aggregate Bond Index and the ML All Convertibles Investment Grade, according to SRP data.
Recent FIA launches include two Legacy Marketing Group offerings including the ClassicMark FIA linked to the Morgan Stanley Target Equity Balanced Index, and the FlexMark Select Series linked to the BNP Paribas Momentum Multi Asset 5 Index.
Click in the link to access the full Zebra Capital Management whitepaper, Fixed Indexed Annuities: Consider the Alternative.
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