Safer havens: bonds vs. indexed annuities

By Joe Anzalone

Asset Marketing Systems

"The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already, but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him."
--Leo Tolstoy

During the younger, prime earning years, an investor looking for maximum accumulation should have a portfolio weighted heavily towards stocks, which offer the best opportunity for growth over a long time horizon. As that same investor approaches the retirement years and income becomes their primary investment objective, they should shift their portfolio towards bonds. After all, bonds are generally safer than equities. In their many forms, bonds offer a variety of ways to take income. And bonds are certainly a more appropriate investment than an indexed annuity, since indexed annuities are complicated, high-commission, shady insurance products. Right?

Ever heard that before? I have. In fact, one of my own advisors -- a smart, thorough professional -- has laid that pitch on me. He, and almost any broker trained over the last 30 years, is the "most intelligent man" that Tolstoy refers to. It's not that his intentions are misguided; he is simply part of the "broker bias" culture that dismisses insurance products, and especially indexed annuities, as the redheaded stepchild of the investment world. Mention the word insurance, and an otherwise reasonable advisor loses their objectivity and immediately thinks "bad investment." Say the words indexed annuity, and they think "high commissions, hidden fees, hard to explain, ripping off seniors." Most brokers confuse the surrender charges and fees inherent in variable annuities with those in indexed annuities.

Bonds and bond funds, however, they feel more comfortable with, and recommend to their investors as their prime earning years begin to wane and their objectives shift towards stable growth and income. One could say that the bond is the broker's annuity -- their "safe money place." Given that fixed indexed annuities (FIAs) also espouse stability and income, let's compare the two.

1. Ease of explanation

What is a bond? A loan. Your investor is loaning money to an entity -- a corporation, state, municipality, or government -- with an expectation of repayment. That definition, however, is only part of the story. One of the most prevalent tenets of Broker Bias is that annuities, especially fixed indexed annuities, are either too complicated for the advisor to explain or for the typical client to understand. But bonds are not the most decipherable of investments. The run-of-the-mill Series 7 candidate spends an inordinate amount of time studying the inverse relationship between bond prices and interest rates -- and explaining the concept to a prospective customer is yet another matter. The disclosed yield on the bond sold (yield to maturity, yield to call) varies according to its sale price relative to par. Depending on whom the investor is "lending to," different bonds have different tax implications. And researching and understanding a bond's price on any given day is not a simple exercise, as it is for stocks.

What is a fixed indexed annuity? Fundamentally, it is a contract between the issuer (the carrier) and the customer that outlines (in more exhaustive detail than ever) the responsibilities of both parties. The money is given to the insurance company by your client. Like a bond, the company agrees to return their investment, in accordance to its terms. The various crediting methods, income options, and surrender periods can be confusing to investors, and a good advisor must explain them both simply and thoroughly. Similarly, the investor's objectives for the funds, and their anticipated time horizon, are factors that demand that the FIA is explained and positioned carefully.

By any measure, an FIA and its proper placement in a customer's portfolio is no more difficult to explain than bond investing; moreover, in many cases, it could be argued that the annuity -- a vehicle specifically designed to provide income for a lifetime -- is easier to understand for most.

2. Stability

Bond investing has experienced an enormous spike in popularity in recent years, as investors have been spooked towards safety. This trend is disturbingly ironic, as the ever-murkier world of bond derivatives has been an instrumental cause of the economy's unprecedented collapse in the first place. While the average investor did not directly pour money into a collateralized debt obligation made up of subprime mortgages, that investor has certainly suffered their consequences.

Moreover, traditionally safer bond strategies have been affected by the malaise. Nowhere has this trend been more evident than in municipal bond investing. While munis have remained a popular destination for the flight to safety, some have experienced a bumpy landing, as described in this Smart Money piece:
    Since last July, 201 municipal bond issuers have missed interest payments on some $6 billion worth of bonds, or an average of about one every other day. That's up from 162 in 2008, and a hefty increase from the 31 that did in all of 2007. Almost 13 percent of municipal bonds currently active are trading at less than their face value, according to Barclays -- up from 7 percent before the recession... even if the crisis doesn't spread, it remains bigger than it has been in decades.1
Predictably, the corporate bond investor must be just as careful. Indeed, some are wary of new "bubble" in the economy -- the bond bubble. Bond strategies are often depicted as relatively stable, a claim that seems hollow given our extraordinary market and economic conditions. To wit:
    Investors have gotten a push from the financial industry. Many brokerages started touting bonds right after the crash, but they've continued to pitch them as bond yields drop... (but) bond investors have to keep an eye on the companies and governments that issued bonds. Some firms get into so much trouble, they can't pay the interest or principal on the bonds they've issued...when that happens, the company defaults, and bondholders could lose half their investment or more, analysts such as Roland Manarin, an Omaha-based money manager who in the 1990s advised clients to stock up on bonds, now tells clients who insist on a guaranteed return to buy annuities instead.2
Simply put, when compared with fixed indexed annuities, the stability argument is a rout in favor of the insurance vehicle. Unlike its higher-risk cousin, the variable annuity, an FIA is a principal-protected contract with a minimum guarantee. In fact, "not a single indexed annuity purchaser has lost a penny as a result of the market declines, bank failures, or general weakening of the economy."3 As with other fixed annuities, the risk is borne by the insurance company, not the investor.4 And while some may criticize the perceived liquidity restrictions of FIAs, virtually all FIAs today offer 10 percent free withdrawals annually, and shorter contract lengths are common today. Many now offer income options without requiring annuitization.

3. Income

"The future ain't what it used to be."
--Yogi Berra

Yes, bonds offer an investor income with degrees of risk that are often manageable. An investor accustomed to equity investing might feel comfortable with the interest payments offered by bonds, especially those from traditionally reliable sources such as blue-chip companies or municipalities. Despite recent trends, default rates on municipal bonds are still extremely low. As an income play, your broker might point out that corporate bonds may offer a more effective inflation hedge over the long-term than indexed annuities; and certainly, if you want to eliminate risk, treasuries may be more appropriate for a portion of your portfolio.

The flaw, however, with positioning bonds and bond funds as income vehicles is their lack of guarantees, especially over a lifetime; something that annuities have been specifically designed to accomplish. Given the characteristics of America's fastest growing retirement demographic, the baby boomer generation, guarantees are absolutely essential in the distribution phase of retirement, because any period of substantial losses can be devastating. The objective scholarship on this point is stunning in its unanimity, as recent studies by Ernst & Young, Hewitt & Associates, and the Wharton School have demonstrated. The E&Y study describes the pending dilemma succinctly:
    A much less-recognized retirement vulnerability is the risk of outliving one's financial assets due to longevity and fluctuating asset values during retirement. Social Security is an important source of guaranteed lifetime income. With the decline of employer-provided defined benefit coverage, many near and new retirees will not have another source of guaranteed lifetime income unless they purchase a lifetime guarantee with their private savings. This study shows that the presence of a significant guaranteed lifetime income stream beyond Social Security can help. Increased focus on both increased retirement savings and the importance of a guaranteed lifetime income stream will reduce the retirement vulnerability of retirees in the future.5
Mr. Berra's comment may now be truer than ever. America's future glut of retirees faces an uncertain future as the Social Security system braces for the onslaught. The defined benefit pension plan has disappeared from the mainstream, and traditionally dependable sectors of the economy have shown unexpected vulnerabilities. When it comes to income, guarantees are not a luxury; they are a necessity. Indexed annuities -- particularly those offering principal protection, reasonable rates of return, diverse liquidity options, and various income options -- should be considered for every retiree's portfolio as they prepare for their retirement years.

Can the "intelligent man," trained to think one way, actually learn another when faced with such evidence? Indeed, given the impending retirement crisis, there isn't room for product bias on either side of the advisory spectrum. Future generations of advisors must consider what's best for their clients' needs, especially as those needs relate to guaranteed lifetime income and keeping pace with inflation. The conclusion is plain and clear: Guaranteed income needs demand guaranteed income products.

1Municipal Bonds: Derailed, Smart Money, May 17, 2010.
2The New Bond Bubble, Smart Money, January 11, 2010.
3New Post: The Pros and Cons of Indexed Annuities,, April 22, 2010.
4Author's note: the very definition of risk has been challenged by the SEC's proposed rule 151a; the text remarks that FIA contract holders are "confronted with many of the same risks and benefits that other investors are confronted with when making investment decisions," and that "the presence of protection of loss does not, in itself, transform a security into an insurance or annuity contract." Hmmm.
5Retirement Vulnerability of New Retirees: the Likelihood of Outliving Their Assets, Ernst & Young, LLP, July, 2008.

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