Is there a viable alternative to bonds?
Is there a viable alternative to bonds?
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Annuities often get a bum rap, generally from market-based planners who view them as a threat, or other financial advisers that don’t really understand them very well. However, once you do understand how they work, it’s easy to see why nearly everyone would want them as a component of their portfolio.

Notice I wrote “component.” You should not put all your assets in any one asset type. On the other hand, the typical practice called “diversification” is something of a farce.

But, you may ask, what about if you have several different funds, including a value fund, a growth fund, an income fund and a couple of bond funds for safety. Am I not well-diversified?

I hear you, but how well-diversified (and safe) are you really? According to Statista, a leading provider of market and consumer data, as recently as 2018 there were only 5,424 actively traded companies in the U.S. At the same time, there were 8,094 mutual funds in the U.S., which meant 8,094 funds were all competing for the same 5,424 securities.

Do you think there was any overlap? And which of those 8,094 should you be in? That’s probably largely determined by which funds are in your 401(k) at work.

According to a study from Bright Scope and the Investment Company Institute, “In 2016, the average large 401(k) plan contained 27 investment options, including a mix of equity, bond, and target-date funds.” So, 5,424 actual companies spread among 8,094 mutual funds, of which your plan provides a choice of about 27. And that doesn’t even count international companies and funds.

How are you supposed to work with that?

Now, let’s consider an example of five different funds from the same wire house, which will remain unnamed. (See Chart #1.) These funds are a domestic growth fund, a capital income fund, a Europacific growth fund, an income fund and a domestic balanced fund between 2006 to 2010, the most active part of the Great Recession. Even though these are supposedly “well-diversified funds,” they moved in virtual lockstep during one of the most volatile times in our history, acting as if they were all the same.

But what about bonds? They are the safe bet, right? Well, it depends on the bonds. Typically, Treasurys are a good bet, and so are munis. However, they, like corporate bonds, are tied to the solvency of the jurisdiction in which they are sold. Generally, Treasurys will hold out if held to maturity, but munis can be another story.

During the Great Depression, 4,770 municipalities defaulted on their bond obligations. In 1983, the Washington Public Power Supply System’s $2.25 billion debt was defaulted, making it the largest municipal bond default in history, with its bondholders recovering by only 40%. In 1984, Orange County in California defaulted on $1.2 billion. So, while munis can be relatively safe, they are just like any other security in that you can lose money. And, Treasury, municipal and corporate bonds are subject to interest-rate risk when traded on secondary markets.

Think of a seesaw: When interest rates go up, bond prices go down. Since we are in a record low-interest environment, they look a bit sketchy now.

Given the record-low interest rates and the record-high equities markets, what are your alternatives? I suppose you could look to the flavor of the day — tech stocks (already at historic highs), cryptos (risky to say the least) or many of the other alternative investments that might serve as a buffer but can just as easily create further drag on your portfolio.

Enter fixed index annuities. These remarkable contracts may be just what you need. They are an amalgam, of sorts, between the stock market, bonds and life insurance. They work like this: You give your money to an insurance company that puts it into its general fund. Historically, these have been shown to be the most secure accounts in history. During the Great Depression, for example, according to the U.S. Department of Commerce, the insurance industry pumped more than $18 billion into the nation’s economy. If you adjust the dollars based on percentage of gross domestic product, using the average GDP of the 10 years of the Great Depression, that equates to around $3.2 trillion in today’s dollars!

At the same time, its assets and ability to pay actually increased from $18.01 billion in 1929 to $23.3 billions in 1934. That represents a gain of $ 5.3 billion, or $946 trillion in today’s dollars. During the worst economic downturn in our history!

So, the insurance company puts your money in this very safe general fund, which, because of its size and safety, can earn around 5% to 6% in its investment-grade bond portfolio, purchased at issue and retired at maturity. Since insurance companies purchase millions of dollars a day, they can drive prices and returns in a very safe manner.

The insurance company takes the 5.5% it makes from investing your money in bonds, and it takes 2% right off the top. This is its revenue and must cover all the overhead, company profits, etc. The remaining 3.5% is used to purchase typically 12-month call options in the market. If the market is up on the anniversary, the options are exercised, and a portion of the gain is credited to your account. This becomes part of the principal and can never be lost.

If the market is down at the end of the period, the options expire, and you lose the amount you put in. But remember, the only money invested was the interest you would have otherwise earned. None of your principal is lost because none was put at risk.

Now think of that. The thing that drives how much you make is partially the amount of interest available to purchase options. That means as interest rates rise, so, too, can your return. And since the company holds all its bonds to maturity, the rising interest rates strengthen, rather than depress, the value of your annuity.

An example of how this can work is something I call MaxGrowth Dollar Cost Averaging. Deposit $100,000 in a fixed index annuity. Every year, you can take a 10% free withdrawal, which you then invest in a selection of securities. You do this with the same set of securities every year at about the same time. This will super-charge the performance of the market and the annuity (as shown by the green line in Chart #2). Since the money grows in both places, it can go up quickly. And since the money in the annuity never goes down, the entire plan is quite stable, making FIAs one of the best safe-money instruments you can use to bolster the performance, and the stability, of your important retirement nest egg.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, N.H., he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die and I’ll Tell You How Well You Can Live,” which deals with the problem that unknown lifespans create for retirement planning. www.FreeToRetireRadio.com.