As interest rates rise, are you wondering if the bonds in your portfolio are still the wise investment you once thought?
If you are having second thoughts about bonds, you aren’t the only one. In the latter part of 2021, even Bill Gross, known as the “Bond King,” said that bonds belong in the “investment garbage can.”
Bonds typically have an inverse relationship with interest rates, meaning when interest rates rise, bond values decrease. With interest rates currently rising, plenty of people are wondering what they can put in their portfolio in exchange for bonds.
For many years, bonds provided something of a safe haven to balance the risk portion of a portfolio, especially for those approaching retirement. For example, if your mix was 60% stocks and 40% bonds, what should you do with that 40% if bonds no longer provide the security and stability they once did? Some adjustments may be in order, but how do you get growth potential without assuming too much risk?
One possibility is a fixed-indexed annuity (FIA). People often think of an annuity as something that pays a guaranteed fixed amount of monthly income for your lifetime, much like a pension. This can be the case, but it also can be restrictive because once the amount of income is fixed, it is unlikely that it can be changed.
However, there are FIAs that are focused on accumulation (i.e., growing your money) rather than providing guaranteed income. Investing in this manner means you don’t have to lock into a fixed monthly withdrawal, but rather you generate retirement income by withdrawing gains and/or principal. This is much like withdrawing from a traditional stock and bond portfolio by using dividends and gains to create income. The major advantage is that the principal and gains are protected and cannot decrease, unlike bonds. Factors such as the economy, stock market declines, etc., will not create losses within these types of annuities.
That’s one of the great things about annuities — their upside is potentially growing when markets are up (with limitations), but when the markets go down, FIA values stay put. This eliminates risk and makes FIAs a good option for those seeking a bond replacement. Two studies do an excellent job of making this point, each explaining in detail a potential way forward for investors looking for that portfolio alternative.
Annuities and Bonds: The Very Long View
Let’s look at one of those studies. A few years ago, economist Roger Ibbotson researched nearly a century’s worth of market results to create a hypothetical model comparing how FIAs would have fared against bonds from 1927 to 2016. Remember that 1927 is a couple of years before the 1929 stock market crash that carried us into the Great Depression.
What he and his team of researchers found is that, net of fees, FIAs had an annualized return of 5.81%, compared with 5.32% for long-term government bonds and 9.92% for large-cap stocks in this period of both rising and falling yields.
In some years when the bond yields were especially low, a FIA would have helped investors even more, Ibbotson found. In other words, a 60/40 stock and bond mixture was good; a 60/20/20 mixture of stocks, bonds and annuities was better; and a 60/40 mix of stocks and FIAs was best of all.
A more recent study by BlackRock corroborated Ibbotson’s findings with three main conclusions:
- Adding FIAs to a portfolio added greater upside potential in more average stock market return years.
- FIAs improved outcomes in balanced portfolios during extremely bad market years.
- Incorporating FIAs can provide more certainty around future portfolio values in general.
BlackRock pointed to the importance of sequence of return risk, which is how the order of investment returns affect a portfolio when withdrawals are being taken. If no withdrawals are being taken, the order of returns does not matter. But when distributions are being taken, early losses can have a devastating impact on a portfolio’s longevity, whereas those same losses later would not be so detrimental. By using FIAs as a bond replacement, BlackRock found better long-term outcomes because the FIAs protected against potential losses early in retirement.
BlackRock further mentioned that some investors have high cash positions to avoid potentially selling out of the market during a loss. They suggest that the FIA is a good cash replacement because it “retains its ability to guard against negative outcomes, while providing a sizable increase in potential upside capture.”
Figuring Out What’s Best for You
What should you do if you want to consider an alternative to the bonds in your portfolio? Making the best decision for your situation is especially important if you are in the “Retirement Red Zone” — the five-year period on either side of retirement. That’s a period when protecting what you’ve accumulated throughout years of saving and investing should be a priority. As the sequence of return risk shows, a big loss in that time span can be disastrous for the rest of your retirement.
Maybe you will decide to keep some money in bonds after all, or that you don’t want to give up on that 60/40 split (or whatever you have) because it’s what you’ve known all these years. Perhaps you go with the 60/20/20 mix, edging slightly out of bonds but not completely. Or, maybe you decide to ditch bonds altogether to see what fixed-indexed annuities hold for you.
Ultimately, it will be your call, but your financial professional should be able to provide information and advice that will help you weigh the options in a more informed manner.
That way you can enter retirement with more confidence — and with a better chance of achieving the secure future you seek.
Ronnie Blair contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
Kurt Fillmore is founder and president of Wealth Trac Financial, an independent financial services firm based in Bingham Farms, Michigan, specializing in customized wealth management and retirement planning. He is an Investment Adviser Representative and licensed insurance professional.
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