Pros and Cons of Fixed-Index Annuities Over Bonds

Advisers, according to conventional wisdom, should shift their clients' portfolios from stocks into bonds as they reach retirement. Doing so de-risks the client's portfolio, preserves wealth, and locks in a desired lifestyle in retirement.

Today, however, there's an alternative to consider: uncapped fixed-index annuities (FIAs) instead of bonds.

So says Roger Ibbotson, the chairman and chief investment officer of Zebra Capital Management, the creator of one of the most popular books in the financial services industry, Stocks, Bonds, Bills, and Inflation (SBBI) Yearbook, and author of a just-published whitepaper, Fixed Indexed Annuities: Consider the Alternative.

Ibbotson's latest research suggests, among other things, that uncapped FIAs help control equity market risk, mitigate longevity risk, and have the potential to outperform bonds in the near future.

According to the study, a FIA is a contract issued by an insurance company that provides the opportunity to earn interest based on positive changes in an index such as the S&P 500 Price Index. Regardless of index performance, indexed annuity contract values are not impacted by negative index returns; the investor earns either an annual minimum rate, or the return of a stock market index (such as the S&P 500), reduced by certain expenses and formulas.

A FIA is not, however, a stock market investment and does not directly participate in any stock or equity investment.

"Bond returns in today's historically low-interest rate environment may be insufficient in meeting the anticipated retirement needs of U.S. investors, potentially placing many at risk of outliving their retirement savings," Ibbotson wrote in the whitepaper.

In collaboration with Annexus, the researchers used S&P 500 Index dynamic participation rates (which ranged from about 23% to about 125%) to simulate FIA performance over the past 90 years and presented the results in similar fashion to Ibbotson's SBBI chart. The subsequent data, which considered historical volatility, interest rates, and dividend rates, indicated:

Uncapped FIAs would have outperformed bonds on an annualized basis for the past 90 years.

It is highly unlikely bond investors will realize as high a return from capital gains in the coming 10 years as they have realized in the past 10 years. In fact, if rates rise, capital gains in the future will be negative (capital losses).

Uncapped FIAs offer a more tailored risk profile than bonds, capturing a portion of the growth offered by large-cap stocks, while lowering overall market risk.

Source: Fixed Index Annuities: Consider the Alternative

In the study, it's also worth noting that Ibbotson simulated the net growth of an FIA with a large-cap equity index based upon 30 three-year holding periods, the price return of a large-cap equity index, a minimum three-year net return floor of not less than 0.00%, and uncapped dynamic participation rates (net of assumed fees).

In an interview, Ibbotson noted his study sought to show the benefit of using FIAs when saving for retirement versus for current income. FIAs, he said, have two stages. "They have the accumulation stage where you actually build up your wealth and then they have a, they can be annuitized into a payout stage where you actually potentially cover your longevity risk," he said. "And one of the great features of this type of annuity is its insured so that you're getting some equity exposure on the upside and on the downside, you're protected typically over three-year periods, you have to have at least a positive return."

Listen to Powell's  interview with Ibbotson.

Ibbotson said he used uncapped FIAs in his study rather than the more common capped FIAs for a reason. With a capped FIA, the investor would earn no more than the cap, say 6% or 10%, even if the market rose a greater percent. "You can't earn higher than (the cap) in a given period," he said. "And there are some very high returns in the stock market, so if you're participating in the stock market in these up years, in an uncapped way, you're getting the whole participation rate on it. You're not being capped out."

Said Ibbotson: "I think actually that's a nice feature of a fixed index annuity -- having it be uncapped -- because sometimes a big chunk of your return actually comes in the very best years, and if you capped those best years you're being capped out of it."

Ibbotson said another benefit of FIAs is that investors get to protect their principal in ways not possible with, say, stocks and bonds. "I think that's something that's very important for people as they start approaching retirement because they would like to participate in the equity market, but people are worried about what's happening in equities today," he said.

Ibbotson said investors could certainly purchase an income rider with an FIA, but it's probably better for to wait to get income in the payout stage, not the accumulation phase.

So, who should consider buying an FIA? In short, someone who might be their 60s but doesn't need the money for another 10-15 years. In fact, Ibbotson said it's important that the right sort of person buy a FIA because there is a liquidity risk.

"It's just really designed for the long-term investor who is accumulating capital as they approach retirement, and then can be converted at the end of the contract into a payout annuity," he said, noting that there are stiff penalties for investors who have to withdraw money before the FIA term ends.

So, what do experts have to say about the study? Should those saving for or living in retirement consider shifting the bond portion of their investment portfolio into uncapped FIAs?

Some experts viewed Ibbotson's research in a positive light, noting that it advanced the body of retirement-income planning knowledge and strategies.

"I do think it's very interesting and noteworthy that one of the founding fathers of the 'commercial asset allocation industry' is shifting his own focus from bonds to fixed indexed-annuities," said Moshe Milevsky, a finance professor at York University who, in the interest of full and fair disclosure, worked and wrote with Ibbotson about annuities and insurance for the CFA Institute. Read Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance.

Milevsky says Ibbotson's latest research, among other things, might be a watershed moment for lifecycle management -- yet another legitimization of annuities. And he also agrees that FIAs could be a healthy substitute for bonds, not equity, which is another point that (Ibbotson) is making.

Moreover, Milevsky said, Ibbotson's research continues the industry trend of FIAs gaining traction over variable annuities (VAs) with guaranteed living benefits.

"Retiring baby boomers are facing a bit of a dilemma," said Milevsky. "On the one hand they are told to buy bonds as they age and move into their golden years. But on the other hand, most financial strategists are predicting some rocky years ahead for fixed income. The solution might be fixed indexed annuities, at least as far as bond allocation is concerned."

To be sure, Ibbotson's research does create an opportunity for less-than-well-meaning financial advisers to sell FIAs to retirees for whom the product is the wrong solution. "The danger here is that such research -- and the Ibbotson name -- will be used by anyone that sells any fixed indexed annuity to flog their own commission-laden, capped, floored and averaged product as being better than a cheap bond ETF, which wasn't the point of the study," said Milevsky.

For his part, Ibbotson agrees with Milevsky. "I think that's an appropriate fear," he said. "I wouldn't want to ... have my name used in that way, either. As I said, this is really for the longer-term investor because you are committing, you are contracting to put your money in place, you accumulate your money actually in a tax deferred way. So, it's not for everybody, and I actually view this as part of an asset allocation because if you do need some liquidity, that should be in another part of your portfolio."

Meanwhile, David Babbel, a professor at The Wharton School at the University of Pennsylvania and author of landmark FIA research, took issue with the methodology Ibbotson used in the study.

"(Ibbotson) is assuming pricing of uncapped FIAs based on a very simple measure of volatility that does not give very accurate pricing to FIAs, but his whole concept is more 'notional' and 'suggestive' than intended to be operational," he said.

Babbel also said uncapped FIAs don't have a place in his personal portfolio. "My own insurance agent was trying to sell me some of these 'uncapped' FIAs about six months ago and after looking at them carefully, I demurred," he said.

Among the reasons: Babbel determined that the associated annual fees on the FIA offering from his insurance agent "were such that it really wasn't attractive to me."

According to Babbel, you can get FIAs uncapped, but they don't give you 100% of the upside. "A more typical number is 50% to 60%," he said. "Still, I think such an FIA is preferred to the ones with a firm cap, because otherwise you'll be giving away the upside. The annual point-to-point caps on traditional FIAs have gone from 8% to 10% down to 3.5% to 5%, which in some cases is barely above the guaranteed fixed rate of interest option."

If, however, Ibbotson's strategy can be implemented with pricing structures similar to what he assumes, it seems to be a viable strategy, said Babbel. "Certainly, his overall reasoning and economic environmental assessment are good," he said.

Others also took issue with Ibbotson's methodology. For instance, Geoffrey VanderPal, a finance professor with Webster University and Purdue Global, as well as an ambassador and economist for the Republic of Guinea, pointed to his research on FIAs using actual performance.

"All other studies used hypothetical data and made assumptions for returns which is not accurate nor a fair representation," VanderPal said of his research. "Our study used a sample of actual annual returns from multiple carriers to disclose actual returns. Our study came to the same conclusion, the FIAs can produce returns as good if not superior to bond funds or a combined equity and bond portfolios."

Know What You're Buying

On paper, in marketing materials, and in sales pitches, FIAs can sound like the perfect product: They preserve principal and provide upside potential. But advisers say investors must exercise caution before buying one and make sure they fully understand just how complicated -- what with income riders and call options -- these products can be.

"Many indexed annuities are subject to a cap in order to reduce the insurance carrier's risk. For example, if the market gains 10% and the product cap is 5%, the client's account will be credited with a 5% gain (absent other product features)," wrote Robert Bloink and William Byrnes. "But uncapped does not mean unlimited. While indexed annuity carriers that offer an uncapped crediting strategy do not impose a hard cap on the client's participation in market gains, contracts providing for uncapped crediting continue to limit the client's participation using participation rates, spreads and fees."

Curtis Cloke, the CEO and founder of Thrive Income Distribution System, said uncapped FIAs traditionally come with either a spread of fees that the index must do above the spread line in order to credit a positive return, or have other containments within the hedging of the index that may have varied results from product to the next. "My suggestion is to look for FIA contracts that have the lowest spread and a diversified option of index allocations," he said.

Ibbotson agrees that FIAs are complicated products and that investors would be well served to clearly understand what they are buying. But, he notes, "the product has to be complicated to meet the complicated needs of the investors."

What's more, he said, investors ought to make sure they are purchasing a FIA from a reputable company with a high credit rating and from a representative "who they can trust because you need somebody to help you tailor this to what you really want."

Joe Tomlinson, a certified financial planner in Greenville, Maine, said, "As an adviser, I'd be concerned about recommending fixed index annuities. I don't pay much attention to these products, but the ones I have seen give the insurer the right to change credits and charges after issue. So, the customer doesn't really know what he or she is buying."

Tomlinson said if someone is offering an FIA where all the pricing parameters are locked in at issue and guaranteed for life, so the buyer knows exactly what they are buying, he'd be interested in hearing about it.

Tomlinson also said, however, that he doesn't like the complexities built into FIAs. "I much prefer simple products like single premium immediate annuities (SPIAs), in which you pay X dollars up front and receive Y dollars per month for life," he said.

According to the Insured Retirement Institute, an immediate annuity is an annuity purchased with a single premium on which income payments begin within one year of the contract date. With fixed immediate annuities, the payment is based on a specified interest rate. With variable immediate annuities, payments are based on the value of the underlying investments. Payments are made for the life of the annuitant(s), for a specified period, or both (for example, 10 years certain and life).

In general, Tomlinson said he tends to prefer a mix of stocks and safe, simple fixed income investments such as SPIAs and Treasury bonds or TIPS. "That gives a clear distinction between risky and safe," he said. "I'm not a fan of products that go halfway like junk bonds for instance, and I would put FIAs in this same halfway categorization."

Buyer Beware: Marketing Claims

Experts point to other problems with FIAs as well. John Olsen, president of Olsenannuityeducation.com, said one of the persistent problems he has seen in the marketing of indexed universal life policies (IULs) and index annuities has been "nonsensical" historical back-testing.

For example, when the manufacturer of a product that offers index-linked interest claims that the product would have produced N% return over prior historical periods, it often does that back-testing assuming that the participation and cap rates currently available would have been used throughout those baseline periods, said Olsen.

"That's absurd," he said.

The whole purpose of cap rates and participation rates is to manage the insurer's risk due to the volatility in the price call options on the index (assuming that is the method used) and ambient interest rates (that affects the price and yield of bonds purchased to back the contract's guarantees, said Olsen. "When call options are expensive and bond prices are high, the insurer can purchase less participation in the index, per dollar of premium, then when option and bond prices are low," he said. "Those variables can and do change, often drastically, over time and cap and participation rates have to be adjusted in order for the insurer to continue to make money on the product and have a competitive product."

Olsen added: "To pretend that in very different market environments, a product's cap and participation rates need not change is simply silly. Unfortunately, a lot of index-linked product marketing is done that way... The bottom line is that the marketing of most all index-linked insurance products stinks. At best, it's misleading, and many product brochures ought to be filed under 'Science Fiction.'"

Why Are FIAs so Complicated?

According to Olsen, many index-linked products are almost byzantine in their complexity, especially those that use "managed volatility" index strategies.

"I refuse to believe that these things have to be so complicated," he said. "Moreover, disclosure in marketing materials and contractual language is often written in what I believe to be deliberately obfuscatory verbiage."

So, what might help? Olsen said he would prefer to see stochastic modeling of projected product performance obligatory, but, where the assumptions used and the methodology must conform to certain standards.

Besides being a complicated product, critics of the study also note that Ibbotson collaborated with Annexus, which develops fixed indexed annuities and indexed universal life insurance products. And that, to some, suggests that the research results might be biased and conflicted.

"It appears that they sponsored this study, which is something that tends to make me wary, although I have always held Roger Ibbotson in high regard," said Tomlinson.

Milevsky noted that Ibbotson has a stake in the FIA game; his Zebra fund is part of the FIA indices and products, Nationwide being one example.

Where to Find Uncapped FIAs

All that said, where might you go to investigate further FIAs? Well, several insurance firms offer uncapped FIAs and there's a website that tracks FIA rates. Those include:

Allianz Life Insurance Company of North America, the Allianz Accumulation Advantage Annuity

Nationwide New Heights Fixed Indexed Annuity ' Nationwide Financial

Genworth Launches New Uncapped Index Crediting Strategy For ...

Today's Best Fixed Index Annuities - ImmediateAnnuities.com

And those who want to learn more about FIAs should read:

Life insurers turn focus to uncapped indexed annuities - InvestmentNews

Treading Carefully in An Uncapped FIA World - InsuranceNewsNet

Questions to Ask

If you do have designs on buying or consider a FIA, here questions to ask the product manufacturer and insurance agent, according to Olsen.

How are you managing the risks to yourself (as product manufacturer and guarantor of the promises in the contract), from volatility in market returns and interest rates, longevity risks, tax risks (due to changes in how your operations are taxed), regulatory changes (such as the next round of Fiduciary Duty requirements)?

How are you determining, periodically, the percentage of the gain to you from investments of the premiums that you will credit to owners of your product?

What guarantees are you offering and under what conditions may those guarantees be changed with respect to existing contracts?

How are you compensating those who market your products? If you offer fee-only products, what requirements do you impose on those who recommend them? If you pay commissions, do you use "breakpoints?" Do you sell directly to consumers, and, if so, how are you dealing with the issue of "the insurer is competing with its own agents?"

Also ask about the strategies, in general, an insurer will employ to hedge its risks. No insurer will divulge precisely how they do this, but it's important to know the general strategies used.

Got questions about the new tax law, Social Security, retirement, investments, or money in general? Want to be considered for a Money Makeover? Email Robert.Powell@TheStreet.com.