The Late Emergence Of Financial Anxiety

New Perspectives On Income Adequacy

Managing longevity risk with structured products

by Jason Barsema

Mr. Barsema is the Co-Founder and President of Halo Investing where he leads the team and product vision. Visit https://haloinvesting.com/

Financial anxiety is a bigger concern than ever with a sharply rising cost of living and volatile financial markets. Retirees, in particular, feel the pinch. Historically-low bond yields and savings account rates make earning an adequate income from an investment portfolio much more challenging. The good news is that financial advisors today can use technology and innovation to offer clients defined-outcome solutions and products that are focused on attaining a desired income yield and portfolio result.

A Top Concern

Longevity risk and running out of money are perennial top fears among today’s retirees. While life expectancy fell this year and last, due to the awful impact of Covid-19, it’s reasonable to assume that with advancements in medicine, health care products, and technology, the longer-term trend of living longer will return. That means retirees should be ultra-aware of the risk that their nest egg must endure through the decades, not just years, ahead.

Life Expectancy Should Recover Post-Covid

Backing out the shorter-term effects of Covid, the average life expectancy at age 65 of a woman in America is 85.7 years, according to the Social Security Administration’s Period Life Table. The typical male’s life expectancy is 83.1. For a married couple (non-smokers in excellent health), that means there’s a more than 70% chance one spouse will live to age 90. Thus, those nearing and in retirement must have financial plans designed to bring stability and security for a long time.

Life Expectancy Probabilities

DB Plans Dwindling

Making longevity risk even more real is the fact that so few workers now have access to defined-benefit retirement plans. Long ago, Congress crafted a new type of retirement plan for workers: the 401(k). Corporate America caught on that this piece of legislation could be a big win for them as It shifted the burden of saving for retirement to the employee. Not only that, with lower market interest rates in the decades that would follow, workers could no longer count on a sizable monthly check from their former employer. Findings from the LIMRA Secure Retirement Institute show that 51% of the Silent Generation— those currently age 77+, have a pension. Fast forward to the Generation X cohort, and less than a quarter of households have such a plan.

Percentage of Households with a Pension

Reaching for Returns

Investors are seemingly forced into higher-risk assets like stocks if they want to achieve their financial goals. Consider that the yield on the Bloomberg Barclays U.S. Aggregate Bond Index is under 4%, according to iShares. The U.S. 10-year Treasury rate, at just slightly above 3%, remains exceptionally low versus history. By contrast, inflation over the past year, as of early September was a stunning 8.5%. In short, inflation-adjusted yields have dealt a devastating blow to savers – and the trend of lower rates has been going on for decades. So  those in traditional portfolios of stock and bond funds can either accept low yields or take on more risk in the stock market. Neither solution sits well for risk-averse individuals. As evidenced in 2022, risk is significant for investors in cookie-cutter 60/40 allocations amid volatility in stocks and rising interest rates.

U.S. 10-year Treasury Rate (1963-2022)

A Challenging Investing Landscape

Saving for retirement and investing throughout retirement is more challenging than ever. Throwing all the above realities together (people living longer, fewer defined-benefit pension plans, historically low bond yields), today’s retirees are in a precarious position. Financial anxiety is high. New ideas and solutions are required so that individuals and couples can feel secure about their future.

What Are Structured Notes and How Can They Help?

Structured notes feature flexibility in risk-return options, making this investment vehicle ideal when tailoring a financial plan for a specific client. We find, though, that it’s common for advisors to get overwhelmed by so many choices when it comes to notes. It is important to understand how notes work and how they can be used to mitigate longevity risk so that you know how to navigate all your options.

For starters, structured notes are investments issued by banks, designed to give clients a level of downside protection. Structured notes’ core component is a zero-coupon bond issued by a bank with a derivatives package. Having the characteristics of both capital protection and upside potential, structured notes can be quite diverse and cover a wide range of portfolio objectives.

Notes used to be accessed mainly by institutional investors or the ultra-wealthy in the private banking world. Today, though, with the aid of competitive marketplaces, retail investors can own notes via advisors. Platforms can ease the process of researching, transacting, and owning notes, while providing transparency and reducing overall fees.

The Makeup of Notes

You might wonder what exactly a structured note is. Maybe you have only heard about their risks in the past. Well, a structured note is a straightforward product. There are four components:

1.) Maturity. The period over which a structured note is held. Maturities range from six months to 20 years, and in most cases, are between two and five years.

2.) Underlying Asset. The performance of a structured note generally tracks the performance of an underlying asset – an index, stock, group of stocks, commodity, or foreign currency – over the maturity period.

3.) Protection Amount/Type. The amount an investor is protected against from price declines in the underlying asset. If the underlier is not down further than the protection amount, investors get their principal back and are not exposed to further losses. This protection can come in the form of either hard protection or soft protection.

4.) Return/Payoff. The amount the investor receives over the term of the note if certain market conditions are met. There are two basic types of return/payoff structures that cover most note types: income and growth. The former provides investors with a fixed return and periodic coupon payments. The latter offers investors upside market participation on the underlying asset.

When combining the four variables above, an investor can create a note for almost any investment objective, but advisors use structured notes in four primary ways:

  • Provide downside market protection.
  • Provide upside (or enhanced) market participation.
  • Provide regular payments/income in the form of coupons if certain market conditions are met.
  • Provide a payout/return at maturity if certain market conditions are met.

How Advisors Can Enhance Their Value Proposition with Notes

Structured notes are an ideal way to offer clients protection against longevity risk. Here’s how: Suppose a couple has a modest portfolio and cannot afford to take much market risk. They are in a low-cost 60/40 stock/bond index portfolio and have seen the market and inflation eat away at their nest egg. They don’t know what to do. An advisor can assess their situation and develop a strategy that still uses the couple’s low-cost index fund portfolio but adds structured notes.

A hypothetical scenario would be to take a portion of the equity allocation and put it towards income and growth notes. An income note provides a higher yield than a standard fund’s dividend rate or a traditional bond’s coupon payment. Unlike stocks and bonds, though, an income note generally offers a measure of downside protection.

Income Note Payoff Chart

While an income note is focused on collecting coupon payments, a growth note provides the opportunity to participate in the enhanced upside of the market. This is critical right now if we see stock market returns recover following big losses in 2022. We recently detailed an Equity Repair Strategy using notes. Growth notes are often tied to an underlying stock market index while also featuring the potential for downside protection.

Growth Note Payoff Chart

There are many ways to use structured notes to manage longevity risk. We find that advisors sometimes prefer to use a laddering method similar to bond laddering. This approach manages maturity dates and reduces the timing risk of the underlying asset at maturity. Below is a simple example of a laddering plan that creates a new liquidity event every six months, starting in the 24th month.

Ladder Strategy

This cadence can continue in perpetuity, assuming the issuer of the notes can pay out the terms of the note. By spreading out the maturities by six months, the risk of “breaching” the downside protection across your structured note allocation is reduced.

The Bottom Line

Managing clients’ longevity risk is more important than ever. Life expectancy should revert higher, market yields could remain depressed, and fewer workers have access to defined-benefit retirement plans. Structured notes and a broader suite of protective investments (such as annuities and buffered ETFs) are available through advisors and give everyday investors confidence that they will not outlive their money.