Take A Second Look At Guarantees

Income uncertainty continues to fuel a flight to safety

by Grant Kvalheim

“Nobody knows anything,” might have been the downfall of certainty in Hollywood when screenwriter William Goldman wrote it in 1983, but in the financial services industry uncertainty is expected. And we know the best way to manage for uncertainty is to plan for it. If you’re worried about market volatility, you certainly aren’t alone.

Today’s market volatility should serve as a reminder of the importance of diversification within your investment portfolio. Investing is a long game and for the millions of Americans planning for their financial future there will be ample time to rebuild your finances.

But for those on the verge of retirement, who don’t have decades to rebuild their personal finances, it’s important to look beyond traditional financial tools. That’s why annuities, a retirement savings tool often overlooked by both individual investors and financial professionals, deserve a second look this year. While these products aren’t a cure-all for the financial turmoil the future may hold, annuities have an important role to play in the retirement portfolios of millions of Americans.

The Right Time For Annuities?

Depending on how you define “annuity,” this retirement savings method has been around since the days of ancient Rome, when citizens could make a one-time payment to a seller, guaranteeing them fixed income payments for a period of time. Thousands of years later, the sophistication and flexibility of annuities have grown, but the essence of the product remains the same: people pay a premium, entitling them to regular returns from the buyer.

In the United States, annuities enjoyed increased popularity during the Great Depression, when confidence in the banking system’s ability to deliver returns reached its low point. Life insurance companies, by contrast, offered purchasers of annuity contracts a dependable source of income shielded from a stock market that had just collapsed.

But as the market recovered during the middle of the 20th century and became a more attractive place for investors to place their money, the shortcomings of basic annuities became more apparent. Regular, fixed payments completely independent from stock market performance may sound like a good idea when Wall Street is in shambles, but when a booming economy can give investors returns that easily outpace inflation, it’s a different story.

The favorable conditions that have defined the stock market for the past 50 years have helped make retirement savings instruments with direct market exposure—such as 401(k)s and IRAs—more popular. And, these accounts should almost always be a part of an individual’s retirement portfolio.

But today’s environment demands that responsible planners diversify their saving plans with an account that provides security and dependability. Consider the following:

• During the next decade, tens of millions of Americans born after World War II will begin entering retirement.
• The employer-sponsored defined benefit plan almost completely evaporated from the private sector during the careers of these soon-to-be retirees. The rise of the defined contribution plan has come with a shift in responsibility for retirement income from employer to employee.
• Perhaps not coincidentally, the Federal Reserve Board reports fewer than 4 in 10 active employees feel their retirement savings are on track.

Given the current forecast of slowing economic growth (the International Monetary Fund’s World Economic Outlook report in January predicts a continued slowdown of the American economy) and the stock market volatility so far this year, the onus is on annuity skeptics to argue why annuity products shouldn’t play a larger role in Americans’ retirement planning.

Delivering Value

Financial professionals and their clients had legitimate reasons to hesitate with annuities in the past. The cost of premiums, the complexity of some products and the fear of inflation devaluing payouts all presented real barriers to greater utilization of these contracts. But many of today’s annuities help mitigate the drawbacks that characterized older annuities. In particular, fixed index annuities (FIAs) and registered index-linked annuities (RILAs) come with the flexibility and the opportunity to participate in market-driven gains that people may want in their retirement portfolios.

Fixed Index Annuities

The fixed index annuity was created in the mid-1990s to provide individuals with a product with the advantages of a mutual fund minus the risk of market exposure. These annuities are benchmarked to a specific index, such as the S&P 500, and each year the purchaser of the annuity receives a return based on that index’s performance. One common misconception of fixed index annuities is that they expose the purchaser to market risks. But the safety of the FIA is that the insurer guarantees your principal, even if the index has a negative return. As far as the purchaser is concerned, FIAs offer no downside risk, only upside benefits.

Registered Indexed-Linked Annuities

The elimination of market risk makes the FIA an ideal annuity for a person nearing retirement or anyone with a low tolerance for the possibility of losing some of their principal. For those focused more on accumulating income, registered indexed-linked annuities allow for larger returns when the index performs well but the purchaser assumes some of the downside risk if the index does poorly.

While RILAs do not offer complete principal protection, they still partially offset drawdowns in equity markets while offering significantly higher upside than fixed indexed annuities.

Insurers typically structure RILAs so the purchaser either has a “buffer” or a “floor” to limit their exposure to loss. A buffer is a percentage (usually 10, 20 or 30 percent) of downside protection. In other words, if the index declines by 30 percent and the RILA’s buffer is 20 percent, then the purchaser only assumes a 10 percent loss. With a “floor”, the purchaser is fully exposed to loss up to an agreed percentage, after which they incur no loss. For example, if the index declines by 20 percent and the RILA has a floor of 10 percent, then the purchaser only incurs a loss of 10 percent.

Every Tool In The Kit

Better standards of medical care and physical health have led to increased longevity meaning today’s retirees can expect to live for another 20 years or longer. In addition, Social Security payments (a form of annuity familiar to most Americans) will provide less income to retirees in the future. These factors combined with cycles of market volatility have made planning for retirement more complex. Without careful planning and management of their finances, some retirees could have trouble keeping pace with the expenses of their later years.

The key to managing these risks is to create a diversified retirement portfolio that contains different types of investments that offer accumulation and guaranteed income components. That’s why annuities deserve serious consideration, the security of principal protection and the peace of mind that comes from guaranteed income for life.