Advisor Focus: Preparation, Not Prediction

Guarding portfolios against future risk

by Doug Wolff

Financial advisors and their clients should have a continual focus on portfolio preparation, and not so much on prediction, as we look ahead to 2024 and beyond. Protecting clients’ assets by rethinking 60/40 portfolios and utilizing products that offer risk protection can help weather a variety of potential market outcomes. This is especially important for retirees.

A recent study from research and consulting firm Cerulli Associates, for example, found that the biggest fear retirement savers and retirees had was outliving their money. This challenge, also known as longevity risk, is critical for advisors to address with clients both in the accumulation phase and especially those near or already in retirement.

For many advisors, addressing longevity issues could help them attract older clients and grow their practices. As the last U.S. Census revealed, the U.S. population of folks 65 and over has grown at the fastest rate (2010 to 2020) in over a century.

Investment Strategies To Optimize Portfolios

Even in retirement, most client portfolios will include both equity and fixed components that are designed to grow and protect assets. The 60/40 portfolio has been the most traditional for decades, seeking growth potential from stocks and some smoothing stability from volatility via bonds. But it was severely challenged in 2022.

Bond Indices’ Performance in 2022

The challenging interest rate environment led to severe declines across major bond/credit indices over the course of 2022, notably, the Bloomberg U.S. Investment Grade Long Credit Index declined by roughly 25% over the course of the year—more than the roughly 19% loss that the S&P 500Æ Index experienced. For portfolios utilizing bond indexes or bond funds, clients likely suffered market losses across these asset classes last year.

Among the options to consider, fixed index annuities (FIAs) can be used as an alternative to bond funds and bond index funds in the fixed portion of a 60/40 portfolio mix. FIAs offer a range of benefits, especially with today’s higher rate environment translating into better hedge budgets and more potential interest from index strategy performance.

Insurance companies utilize a hedge budget to hedge the index crediting (through purchasing derivatives from investment banks or dynamically hedging themselves) for each index account in an FIA product. The greater the hedge budget, the better the parameters used to calculate the credits for each index account (all else being equal). Factors in enhancing the index crediting parameters include a higher gross earned rate, more efficient derivative hedging, lower or no commissions, and a lower expense model.

The ability of an insurance carrier to base potential interest credits on the performance of an underlying financial market index makes an FIA a powerful tool for retirement planning and gives clients an opportunity to accumulate savings without downside market risk during the life of the contract. Clients are relieved of both stock and bond market risk for assets in the FIA.

Negative index returns will not decrease the client’s account value because index account crediting rates are floored at 0%. To guarantee this downside protection however, the insurance company limits interest credits through a combination of the index account parameters for each crediting period. This includes caps, participation rates, and spreads which are reflected through derivatives purchased from investment banks or dynamically hedged by the insurance company. At the end of each index term (most often, each contract year), the insurance company purchases new derivatives and sets renewal index account parameters. Those renewal parameters may be different from the original parameters because the hedge budget could be different. Even if the hedge budget is the same from period to period, the cost of the options and other derivatives may change due to economic forces that impact the implied volatilities, interest rates, or the dividend yield.

The bottom line for client portfolios is this: in a traditional investment, when equities drop, client assets may take time to recover—but with FIAs, both principal and any past accumulated interest are guaranteed. And because of this, FIAs are predominantly free from sequence of returns risk or the risk of a large market loss very close to or early in retirement.

FIAs generally offer a range of underlying indices, giving advisors multiple ways to position client portfolios depending on how they perceive the direction of the markets. Allocating between different indices within an FIA is often a preferred strategy for diversification within such products. And since these products accumulate tax-deferred, 100% of the accumulated interest is compounded and untaxed until withdrawn.

When looking at options to counter longevity risk, fixed index products can provide a greater level of stability when balancing a portfolio, giving rise to new portfolio strategy combinations—such as 60-20-20 or 60-30-10. As bond exposure is reduced, and a great portion of their assets are guaranteed, clients can rest a bit easier when gauging whether they might outlive their savings.

In addition to the accumulation potential of FIAs helping to counter longevity risk when used within a client’s overall portfolio, some FIAs offer a living benefit rider that guarantees certain payments for their lifetime. This can further protect against clients outliving their income.

The Business of Preparation, Not Prediction

While inflation has slowed, and the veracity of future rate increases is uncertain, financial advisors can use risk mitigation when balancing portfolios. FIAs are viable bond alternatives for accumulation and can be used to de-risk portfolios given their downside protection. They are all-weather, meaning that they are well-suited to volatile market conditions. They can be used to help bolster the 40% fixed sleeve, that typically goes to bonds, with more predictable yields, while adding the benefit of tax-deferred accumulation potential. And in the current interest rate environment, they have the advantage of starting with relatively high current rates / hedge budgets, thus, making them a timely solution.

Looking ahead, advisors should try to refrain from market predictions and instead, put in place necessary preparations including the protections that come from diversified portfolios that include FIAs to help combat longevity, interest rate, and sequence of return related equity market risks.

SBL issues annuities in all states except New York.

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Security Benefit Life Insurance Company is not a fiduciary and the information provided is not intended to be investment advice. This information is general in nature and intended for use with the general public. For additional information, including any specific advice or recommendations, please visit with your financial professional.

Guarantees provided by annuities are subject to the financial strength of the issuing insurance company. Annuities are not FDIC or NCUA/NCUSIF insured; are not obligations or deposits of and are not guaranteed or underwritten by any bank, savings and loan, or credit union or its affiliates; and are unrelated to and not a condition of the provision or term of any banking service or activity.

Fixed index annuities are not stock market investments and do not directly participate in any equity, bond, other security, or commodities investments. and therefore, do not reflect the total return of the underlying stocks. Neither an index nor any fixed index annuity is comparable to a direct investment in the equity, bond, other security, or commodities markets.
Neither Security Benefit nor its representatives offer legal or tax advice. Please consult with your personal attorney and/or advisor regarding any legal or tax matters.