A summary of “Consider the Alternative" by Dr. Roger Ibbotson, PhD By Marco Ginefra
Bonds, a traditional tool for principal preservation and conservative growth are facing new challenges in the face of a rising rate environment. In broad terms, stocks outperform bonds by a large margin over the history of the markets. Allocation to stocks should be highest when we are young and as we move closer to retirement, bond allocations should increase to provide stability for our retirement nest egg. This is long-held conventional wisdom and it certainly makes sense to reduce risk as we near the time when we will rely on our nest egg to provide an income stream. However we are in an era of unprecedented low interest rates. Dr. Ibbotson notes: "Given the current low-yield environment, bond returns for the next several years will likely be based entirely on yield. Although the lower risk may be appropriate as we age, the returns may disappoint or be insufficient to maintain necessary income in retirement."
This presents an opportunity for other conservative investments to fill a void bonds may no longer serve. Ibbotson believes Fixed-Index annuities (FIAs), specifically, are answering many of the concerns retirees once quelled with bonds.
"Recent innovations in annuity product design, combined with an increasingly competitive marketplace, have given individuals preparing for or in retirement powerful and more affordable tools to not only mitigate retirement risks, but also to serve as a vehicle to increase wealth leading up to retirement… a generic FIA using a large cap equity index in simulation has bond-like risk but with returns tied to positive movements in equities, allowing for equity upside participation. For these reasons, an FIA may be an attractive alternative to consider.”
What exactly is a Fixed-Index annuity? In his paper, Dr. Ibbotson reviews the features of a FIA contract: "An FIA is a contract issued and guaranteed by an insurance company. It is a growth and accumulation vehicle leading up to retirement with an option to convert to an annuity in retirement or take systematic withdrawals... A major advantage of a FIA is the ability of the insurance provider to, in part, pool risk among a number of policyholders and “transform” equity returns into a more “tailored” return/risk profile (eliminating downside risk and providing an opportunity for interest earnings based upon a portion of equity returns). During the “accumulation” phase, growth of a generic uncapped FIA is based upon an index subject to a floor and a participation rate. For example, over a 3-year period, the FIA might use the S&P 500® Price Index subject to a 0% floor and a participation rate of 60% of any positive index changes. In a 3-year period where the S&P 500® Price Index gained 10%, the FIA would credit interest at 6.0%. In a 3-year period where the S&P 500® Price Index declined -10%, the FIA would not lose money subject to the 0% floor.”
The downside protection is an appealing aspect of FIA contracts and one that even bonds cannot guarantee. In exchange for the top end growth of equity markets, these insurance contracts provide a guarantee of principal, meaning no returns below 0%.
In his conclusion Dr. Ibbotson summarizes, “FIAs have many attractive features for principal protection, accumulation and as a potential source of income in retirement. In simulation, the FIA had a higher net return than long term government bonds. We showed the FIA had comparable volatility to bonds but with better downside protection. In our study, when bonds underperformed, the FIA performed quite well. It is our view, considering today’s low interest rate environment and our modest expectations for bond returns in the coming future, FIAs are an alternative to consider.”
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