If you haven’t noticed, bond interest rates have been inching up over the past year. The U.S. Treasury 10-year index hit a 52-week high of 2.83% on Friday, up 1.29%, or 84%, from the 52-week low of 1.54% on Aug. 31, 2012.
Given the fact that market prices of bonds move inversely with interest rate changes, increasing interest rates generally translates to decreasing bond prices. An example of this is the Barclays U.S. Aggregate Bond Trust, which, after increasing 7.84% in 2011 and 4.21% in 2012, is down 3.27% year-to-date as of Friday.
Recent bond interest rate increases, combined with the prospect for continued interest rate hikes, have gotten the attention of investors, resulting in reduced bondholdings in many cases. Replacement investments have included dividend stocks. While this has provided an alternative source of income, i.e., dividends, it has also resulted in increased equity risk exposure, which may prove to be more problematic than simply remaining in bonds.
Many investors in the past few years have discovered a different strategy for a portion of their bond portfolio that retains the fixed income nature of bonds while offering protection from bond and equity market declines. It’s called fixed-index annuities, or “FIAs.”
What is a fixed-index annuity?
A fixed-index annuity is a fixed annuity that offers a minimum guaranteed interest rate and potential for higher earnings than traditional fixed annuities based on the performance of one or more stock market indexes. When purchased with non-retirement plan funds, unlike bonds, earnings grow tax-deferred. If a minimum guaranteed withdrawal benefit (“MGWB”) isn’t built into the contract, a FIA can be paired with an income rider to give the annuitant(s) the ability to activate a lifetime income stream.
There are two types of FIA’s — single premium and flexible premium. A single-premium FIA is a one-time investment whereas a flexible-premium FIA allows for subsequent investments after your initial investment. With both types, you need to allocate your premium, or investment, between a fixed account and one or more indexing strategies. The fixed account pays a fixed rate of return for one or more years that’s generally higher than a similar-duration CD.
Indexing strategies provide the opportunity to earn interest based on the performance of a defined stock market index each contract year, with the Standard & Poor’s 500 Index being the most prevalent offering. Unlike a direct investment in an index where you participate in gains as well as losses, there are two basic differences when you allocate funds to an indexing strategy within an FIA:
1. If the index’s return is negative, no loss is posted to your account.
2. If the index’s return is positive, interest is credited to your account subject to a cap.
In other words, unlike bond and equity investments, you won’t participate in losses, however, you also won’t fully participate in gains to the extent that the performance of a particular indexing strategy exceeds that of a defined cap.
When do fixed-index annuities make sense as a bondholding alternative?
FIA’s offer several distinct advantages over bonds, including protection from market declines, elimination of bond default risk, participation in positive performance of stock market indexes, tax deferral in non-retirement accounts, sustainable lifetime income with a MGWB or income rider, investment management simplification, and elimination of investment management fees on the portion of a managed portfolio that’s invested in FIA’s.
They aren’t without their disadvantages, however.
First and foremost is duration. FIA’s require a long-term commitment since investors are subject to a declining surrender charge on annual withdrawals that exceed a specified percentage of their investment value, which is typically 10%, during the term of the FIA. FIA terms generally range from five to 10 years, however, longer terms are available. The advantage of a longer term includes higher cap rates and/or availability of premium bonuses. While duration is an important consideration, it shouldn’t be problematic for long-term investors who don’t require short-term liquidity and normally maintain long-term fixed income positions as part of their portfolio.
Like all long-term investments, the financial solvency of the issuer needs to be evaluated. While annuities enjoy an excellent overall track record, FIA’s should only be purchased from life insurance companies that have strong Best, Standard & Poors, and Moody’s ratings. This is especially important when pairing a FIA with an income rider where lifetime income is the main objective. Income is guaranteed subject to the claims-paying ability of individual life insurance carriers with limited recourse provided by state guarantee associations. It may make sense to diversify the FIA portion of your fixed asset class allocation among two or more FIA’s for larger investment amounts.
When held in nonretirement accounts, taxation of FIA distributions is another important consideration. Annuitization of a nonretirement FIA provides favorable tax treatment since part of each payment is considered to be a nontaxable return of principal with the earnings taxable as ordinary income. If, instead, distributions are taken from a MGWB or income rider, they are treated as withdrawals, with “last-in first-out,” or “LIFO,” tax treatment. As such, 100% of all distributions are taxable as ordinary income until all earnings have been received at which point all future payments are nontaxable as a return of investment.
While it’s understandable that investors are concerned about the direction of bond interest rates and the affect on the valuation of the bond portion of their portfolios, it should also be recognized that bondholdings play an important role in most diversified portfolios.
Given their advantages, fixed-index annuities purchased from highly-rated insurance carriers may provide a suitable alternative for a portion of a bond portfolio for investors who are able to commit to their long-term duration.
DISCLOSURE: Robert Klein is licensed as a Resident Insurance Producer in California (License #0708321).
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.