Better Than Bonds? A Look at Uncapped Fixed Index Annuities

For safety and performance, it could be time to consider including them in your retirement portfolio to diversify your asset allocation.

(Image credit: Abel Mitja Varela)

Most people have three basic hopes for their investments.

They want growth. They want safety. And they want liquidity.

Unfortunately, it’s next to impossible to find any one investment that offers all three. Usually, if a product or strategy is particularly strong in one category, it’s lacking in another area. If an investment has huge growth potential, for example, it’s usually pretty risky. If you settle on one that’s considered especially safe — with little or no risk of loss — you’ll likely have less growth and/or liquidity.

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So there’s the challenge. Finding the right portfolio balance has become increasingly important for investors — especially those who are near or in retirement. But without discipline regarding diversification and asset allocation, it’s difficult to accomplish.

When the stock market is consistently strong — as it was in 2017 — some investors forget about keeping that balance. They see the market going up and up, and they want their investments to reflect that prosperity. If their portfolio doesn’t show the same gains as their friends’ or neighbors’ portfolios, they feel as though they’re missing out or doing something wrong. Then, when the market gets a little shaky, as it has been recently, those same investors become anxious about having too much risk.

Of course, both greed and fear can lead to emotional decision-making and mistakes that result in losses.

How Market Losses Take a Toll on Portfolios

How much do losses matter? A few years ago, financial researcher and author Jack Marrion did an interesting study to address that question.

He chose a 50-year time frame — from Jan. 1, 1960, to Jan. 1, 2010 — and compared how a $1,000 investment in the S&P 500 would have performed under three different scenarios: with no dividends, with dividends, and with no dividends and no losses.

The first two scenarios followed the ups and downs of the market. The third, however, followed the pattern of an indexed annuity, which is not invested in the markets, doesn’t include dividends, and credits interest based on how a market index performs. (Interest is credited when the index value increases, but the interest rate is guaranteed never to be less than zero, even if the market goes down.)

The results were amazing.

  • In the first scenario, with no dividends, the $1,000 investment resulted in an ending balance of $18,615.
  • In the second, with dividends included, the ending balance was $84,260.
  • And in the third, with no dividends but no losses, the end balance was $179,624.

That’s a huge difference. The third option more than doubled the second, which represents how the markets usually work. The answer to Marrion’s question, obviously, is that losses matter a lot.

This is why fixed index annuities are often suggested as a bond substitute these days — especially for retirees. They protect your principal. They avoid the losses bonds can experience and provide reliable income — especially in times of increasing market volatility.

Annuities vs. Bonds: New Research

In March, economist Roger Ibbotson, a 10-time recipient of the Graham and Dodd Award for financial research excellence and professor emeritus at the Yale School of Management, unveiled new research analyzing the emerging potential of fixed index annuities as a bond alternative in retirement portfolios. Working with Annexus, a leading designer of indexed annuities and indexed universal life insurance, Ibbotson and his research team used S&P 500 dynamic participation rates to simulate fixed index annuity performance over the past 90 years.

The results? During that time, uncapped fixed index annuities would have outperformed bonds on an annualized basis. To better understand these findings, it’s important to know some annuity basics.

How indexed annuities work:

An indexed annuity is a contract — focused on retirement income — issued and guaranteed by an insurance company. The funds contributed into the account are not invested, therefore providing protection against down markets. Interest is credited based, at least in part, on the movement of an index (e.g., the S&P 500® Index), and, in some cases, a guaranteed level of lifetime income through optional riders.

Caps vs. participation rates:

At each contract anniversary the owner chooses from several allocation option strategies, including some with a “cap” (limiting the upside amount to be credited) and some with a “participation rate” (the percentage of the annual growth of an index). The participation rate does not have a cap, so there is no upside limit other than the percentage of credit, which is most commonly between 30% and 60%, but can, in some indexed annuities, be considerably higher.

An uncapped fixed index annuity:

A fixed index annuity that uses the participation rate strategy is known as an uncapped fixed index annuity.

Ibbotson’s research indicates that not only did uncapped fixed index annuities outperform bonds in the past, they have the potential to beat bonds in the near future as well. He also found that today, uncapped fixed index annuities can help control equity-market risk and mitigate longevity risk. (These findings were from a report written in collaboration with a company specializing in annuities. While that doesn’t mean they are any less valid, it’s something to keep in mind.)

What This Means for Investors

Shifting market conditions, longer life expectancies and uncertainties surrounding the future of Social Security have an “immense impact” on the U.S. economy, Ibbotson said when the research results were announced. “Conventional wisdom has most investors de-risking their portfolios by allocating more heavily to bonds as they approach retirement,” he said. “However, investors should consider other alternatives, such as FIAs. In this low-interest-rate environment, complacency can be a danger to [investors’] futures.”

Neither Ibbotson nor Marrion is suggesting that anyone put all or most of their portfolio into fixed index annuities. But they are saying that investors should consider the advantages of this type of annuity as a bond substitute.

We stress with our clients the importance of Asset Allocation — NOT investing all assets (especially when approaching or in retirement) in any one asset category. Many investors have only been exposed to market investment options. Indexed annuities are not securities and are not regulated by the Securities and Exchange Commission (SEC) or by the Financial Industry Regulatory Authority (FINRA). However, they are regulated by state insurance departments.

Some Pros and Cons to Consider

So indexed annuities can provide an attractive “non-market” opportunity for investors. Given that market prices of bonds typically move inversely with interest-rate changes, rising interest rates generally translate to falling bond prices. Fixed index annuities don’t suffer those losses, because the funds aren’t invested in the markets. And they have 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 lifetime income rider
  • Investment-management simplification
  • Elimination of investment-management fees on the portion of a managed portfolio that’s in the fixed index annuities

Of course, there are, as with all investment opportunities, a few negatives, when considering index annuities.

  • Index annuities have less liquidity than bonds. There’s generally a fee on withdrawals that exceed a set amount (usually 10% of the contract value) for a designated period of time (usually 10 years).
  • Although that’s 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. And a longer term can come with advantages, including higher participation rates. Some index annuities also include a “premium bonus” — an additional dollar amount (usually a percentage of the initial premium, or deposit amount), that is credited when the contract is issued.
  • The basic index annuity has no fees, which is another important positive. However, there are optional riders — the Lifetime Income Rider is the most frequently added — available, and some come with no fee, and others come with a small annual fee (usually less than 1%).
  • It is also important to understand that once the index annuity is issued, it is a legal contract and must be honored by the issuing insurance company. However, the contract will specify that the participation rates (and caps) can and usually will be adjusted annually.

The Bottom Line for Your Retirement Planning

A fixed index annuity won’t be the only answer to your income needs in retirement — but it may be an appropriate addition to your plan. This takes us back to why a diversified portfolio is so crucial in retirement. Your mix should provide you with income, protection from losses, liquidity and growth — and make you feel less vulnerable when the market does what it does.

That is why we stress frequently asking the question: “How much, if any, of my investments should I have on the ‘markets’ side, and how much, if any, on the ‘non-markets’ side?” For the ‘non-markets’ side, an indexed annuity may be worth considering.

Do your own research and talk to your financial professional to determine if adding a fixed-index annuity to your retirement portfolio is the right move for you.

Kim Franke-Folstad contributed to this article.


This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

David Braun, Investment Adviser Representative
President, David Braun Financial and Insurance Services Inc.

David Braun is an Investment Adviser Representative and Insurance Professional at David Braun Financial & Insurance Services Inc. Braun has more than 25 years of experience in the financial industry, and holds Chartered Financial Consultant (ChFC), Certified Life Underwriter (CLU) and Life Underwriter Training Council Fellow (LUTCF) industry designations. Investment advisory services are offered through Resility Financial Inc., a Registered Investment Adviser. Insurance services are provided through David Braun Financial & Insurance Services Inc. CA #0678292