Indexed annuities can function as an asset class within an accumulation portfolio

Fixed-indexed annuities can play a pivotal role in managing risk in pre-retirement years and provide alternatives to the risks of traditional fixed income investments, according to Dr. Wade Pfau (pictured), professor of retirement income at the University of Iowa.

In a recently published white paper, Managing Risk with Fixed-Indexed Annuities, Dr. Pfau noted that the low interest rate environment has led to lower returns for fixed income assets and created 'unique challenges for those approaching retirement, as the practical impact of low interest rates is an increase to the cost of funding retirement goals'.

Longer maturity bonds may offer higher yields, but they will experience capital losses with a rate increase whereas shorter-term bonds may not experience losses with rising rates, but their lower yields may lead to unsatisfactory returns.

'Though bonds are generally perceived to be less risky assets, they are exposed to interest rate risk,' said Dr. Pfau, adding that a second option is to shift toward a higher equity allocation to avoid the low yields and potential risks from bonds, but this creates additional risks.

'A particularly important matter for near retirees is sequence of returns risk. Two individuals who behave the same way over their careers-saving the same percentage of the same salary for the same number of years-can experience disparate wealth accumulation outcomes based solely on the specific sequence of investment returns that accompanies their career and retirement.'

Sequence risk also exists prior to retirement if individuals add new savings to their investment portfolio over time. Investment losses (either through stock market downturns or capital losses on bonds) experienced as the retirement date approaches have the biggest impact on final wealth accumulations, because these returns affect a longer history of contributions and savings into the account.

However, pre-retirees should consider fixed-indexed annuities (FIA) that provides structured returns to manage downside risks, according to Dr. Pfau.

'Fixed-indexed annuities can also function as an asset class within an accumulation portfolio to better manage downside risks, while still allowing for participation in the market upside,' said Dr. Pfau. 'The ability to better manage downside risks can lay a foundation to either reduce the asset level necessary to successfully retire, or to enhance the returns produced by a given asset base.'

Dr. Pfau points that risk averse households will seek a high probability of success that their financial plan will work, which implicitly leads them to assume a lower rate of return from their investments.

'By managing downside risks through a more structured approach that prevents negative market returns, a fixed-indexed annuity may allow for greater wealth accumulation at lower percentiles of the distribution of outcomes when markets perform poorly,' he said. 'This protection may make it easier to retire successfully in down market environments.'

By limiting participation on the upside, the positive impact on wealth accumulation in good market environments may also be reduced, resulting in a set of tradeoffs for clients, according to Dr. Pfau.

'These tradeoffs can be analyzed through calculators comparing financial performance for investment strategies with and without a fixed-indexed annuity,' said Dr. Pfau.

The research also found that FIAs can also provide some protection against interest rate risk and other sources of investment volatility, according to Dr. Pfau.

'Unlike a bond fund or individual bonds not held to maturity, fixed-indexed annuities do not experience investment losses if interest rates rise,' said Dr. Pfau, noting that FIAs also offer tax deferral, 'unlike investment assets held in taxable accounts that face ongoing taxes on their growth'.

Advisors should explore the role of fixed-indexed annuities in helping clients consider the range of potential outcomes for different investment strategies, according to Dr. Pfau.

'Even if the overall portfolio standard deviation increases with the inclusion of a fixed-indexed annuity, the ability to protect from downside losses, as returns for the annuity do not follow a traditional bell-shaped distribution, may serve to reduce risk for the distribution of wealth outcomes,' said Dr. Pfau.

Click in the link to read Dr. Wade D. Pfau's white paper.

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