Kyle Tomko

I love the game of blackjack. When I sit at the table, I feel optimistic and in control. However, as time goes on, I start betting larger amounts resulting in more risk. At this point greed takes over and I believe nothing can go wrong. We all know how this story ends though…

To no surprise, it’s not uncommon for blackjack winners to keep playing in the hopes of winning even more. Walking away is an important decision if you want to maximize profits and minimize losses. While investing in the stock market is fundamentally different from playing blackjack, drawing a connection between the two can provide interesting insights.

Both the stock market and blackjack involve risk and uncertainty. In blackjack you make decisions based on limited information, only seeing your own cards and the dealer’s up card. Similarly, investors in the stock market face uncertainties about future market movements, company performance, and economic conditions. Just as managing your bankroll is crucial in blackjack to extend playing time and minimize losses, investors in the stock market practice portfolio management and diversification to protect their investments and minimize risks. Further, both blackjack and the stock market exhibit variability in outcomes. In blackjack, winning or losing streaks can occur due to chance and the changing distribution of cards. Likewise, the stock market experiences periods of growth, decline, and volatility that can affect investment performance.

When it comes to variable annuities, these instruments which are directly exposed to the stock market can be a reliable asset in a retirement portfolio. However, they come with drawbacks such as excessive fees and the potential for account erosion. On average, variable annuities charge around 2.3 percent per year in fees, but this can exceed three percent depending on the policy. These fees are deducted from your balance annually. Considering recent market downturns, it is worth considering “locking in gains” to protect what you have earned and avoid potential losses.

In this article, I will explain why individuals should consider upgrading their variable annuity policy by adopting a flight-to-safety approach. This approach involves moving capital from riskier investments to safer alternatives during times of market volatility or economic uncertainty. One strategy that aligns with this approach is exchanging a variable annuity policy for a fixed indexed annuity policy. This change allows for wealth generation and lifetime income without the risk of capital loss. While variable annuities excel at generating a rate of return, they fall short in generating lifetime income compared to alternative annuity vehicles. Let’s take a look at both the benefits of switching to an indexed annuity policy and the potential drawbacks.

Benefits of Switching to an Indexed Annuity Policy:

• Cost Reduction: Variable annuities often come with various fees, such as administrative fees, mortality/expense risk charges, income rider fees, and sub-account fees, which can average around three to four percent. On the other hand, indexed annuities typically have lower fees or even no fees, eliminating any negative impact on the account value.
• Capital Protection: Indexed annuities safeguard your principal by mitigating the risks associated with stock market volatility. Through the use of hedging instruments, FIAs establish a floor of zero, shielding your investment from market downturns. This feature is particularly valuable for investors who have accumulated significant gains with their variable policy and are now seeking to minimize risk.
• Increasing Income: Fixed indexed annuities offer a solution to address inflation, higher taxes, and medical expenses. These annuities provide income increases whenever the contract earns interest. In contrast, variable annuities only provide a level income that may diminish over time as the cost of goods increases during retirement.
• Higher Cumulative Income at Life Expectancy: Indexed annuities prioritize the extraction of income from the asset by utilizing income riders, allowing the policyholder to retain the underlying asset. While the initial income may be lower due to a reduced withdrawal rate, indexed annuities can potentially provide more lifetime income at life expectancy due to the income step-up each year when the index returns are positive.
• Enhanced Death Benefit: By exchanging your variable annuity policy for an indexed annuity, you gain the advantage of an enhanced death benefit from day one. Indexed annuities often offer premium bonuses to the income account value, enabling beneficiaries to choose between a lump-sum payment or receiving the benefit over a five-year period.

Drawbacks of Replacing Your Variable Annuity Policy:

• Lower Income at the Beginning: Indexed annuities, with their increasing payouts, generally offer lower income during retirement. Depending on the timing of when income is needed, variable annuities may be better suited for providing level income. Factors such as current age, expected income horizon, life expectancy, and the breakeven age should be considered to assess viability.
• Limited Growth: Indexed annuities provide the opportunity to participate in market upswings, but they can have limited returns due to caps, pars, and spreads. While this trade-off ensures that your asset is secured and protected, it also means that the focus shifts from accumulation to distribution.
• New Surrender Schedule: When replacing a variable annuity policy, the new contract will be subject to a new surrender charge schedule. This means that surrendering the contract outright will incur significant charges. Although not an additional fee, this change in the surrender schedule should be taken into account.

It is important to note that the option to replace a policy does not automatically mean it should be done. Several factors come into play when determining the appropriate asset allocation model, including retirement timeline/age, risk tolerance, and identified goals. After reviewing the most recent quarterly statement, it is essential to conduct a year-by-year comparison to consider hurdle rates, crossover points, and income payouts. Assuming the flight to safety approach is deemed suitable, there are certain dealbreakers that need to be considered.

First, it is crucial to determine if the policy has been in effect for at least three years. Selling a policy within the first three years is unlikely to be justified, as most states mandate a three-year hold period for consumer protection purposes. Secondly, if the surrender charge exceeds three to four percent, it becomes challenging to overcome this hurdle rate, particularly if the goal is focused on income generation or accumulation. In such cases it is generally advisable to wait a year or two for the surrender charges to decrease. Lastly, it is necessary to evaluate if the new contract can provide a higher income base value from day one. Depending on the income horizon, carriers typically prefer to see the new contract start with a higher income base, often aided by the premium bonus offered. If this is not the case, a detailed letter of explanation may be required although success is not guaranteed.

In conclusion, the discussion of variable annuities in relation to blackjack and the stock market highlights the need for individuals to review their financial strategies and consider alternatives that provide more stability and protection. Upgrading from a variable annuity to a fixed indexed annuity, which offers wealth generation and lifetime income without the risk of capital loss, can be a wise decision, particularly during times of market volatility or economic uncertainty. By adopting a flight-to-safety approach and prioritizing the preservation of gains, individuals can secure their financial future and minimize potential losses. For advisors who have a book of variable annuities, now is the time to start the audit process with each client.

Financial advisors have had it easy.

While this statement may come as a shock given the lack of substance, please let me explain before you take offense. Since 1981, the 10-year treasury touched 15.84 percent at its peak and has since trended down close to zero percent in 2020 and 1.88 percent since writing this piece. That is 40 years of interest rate decline all while the cost to borrow continues to remain near historic lows.

The first question to ask ourselves is whether low interest rates qualify as good news. Let’s look at three parties. To borrowers looking to borrow, good news, no, great news actually! To lenders looking to lend, not really—due to reduced margins. To conservative investors seeking income, bad news, as the rate you earn is less than the percentage increase in the cost of goods. In addition, if you are counting on fixed income investments as a primary source of retirement income, you may have more risk in your portfolio than you realize.

And if interest rates go up? The opposite is true…for most. Borrowers will end up paying more interest over time extending their personal liability. Lenders will reap the benefits of increased spreads from what interest is paid to customers and interest that banks can earn by investing. However, the fixed income investors seeking safety are put in a bind.

While I certainly don’t have a crystal ball to predict what’s going to happen in the future with interest rates, I do believe the writing is on the wall on where they’re likely headed. I want to hold advisors accountable in providing their clients all viable options for when the current bond bull run ends and a new interest cycle begins (in the opposite direction).

Back to my original statement that financial advisors have “had it easy.” The reasoning is simple and no fault to anyone. For the longest time, advisors have been properly allocating a percentage of clients’ money (usually derived from a risk or time-based allocation approach) in a combination of cash, bonds, and equities. Older the client, more weight in bonds. Younger the client, more weight in equities. This is ultimately a way of managing the client’s risk versus return appetite and hedge against stock market volatility. While simple at its core and different among individuals, this conventional wisdom may not always be appropriate going forward. Reason being, we have a whole new set of circumstances. The rise of the 10-year treasury from its bottom which can significantly impact retirees and their nest egg. Let’s take a closer look.

If we isolate the bond allocation, we normally categorize this portion of the portfolio as a low risk, principal protected and an income bearing asset. But according to the experts, Bill Gross to name one, bonds remain threatened by the inevitable “bond bubble.” Essentially, this is the risk that existing bonds become less and less worthy if interest rates rise. In addition, what about the credit risk of these companies during a pandemic? Will the company be around? Is it investment grade? How is the credit worthiness? The truth is that bonds have risks, and they need to be brought into the light. The core risk is “interest rate risk.” Let’s look at the inverse relationship between bond prices and interest rates.

As an example, the best way to illustrate the fundamentals is to look at zero coupon bonds which do not pay out quarterly or annual payments or “coupons” hence the name. If you buy a zero-coupon bond that is trading at $950 and has a par value of $1000 with maturity in one year, the rate of return is 5.26 percent. Not bad, right? But what if interest rates rose to 10 percent? To attract demand, the price of the existing bond to match the same return would need to decrease to $909. On the contrary, if interest rates decreased to three percent, the existing bond price would increase to $970 because of the demand in people wanting to buy given its yield of 5.26 percent. It’s now clear why advisors recommended bonds over a period of decreasing interest rates. They protected their clients’ money and made them a bunch of money if they sold before maturity. But now back to reality! What about the investors retiring in the next five to 10 years who want to secure their assets, provide a rate of return above inflation, and receive some income payments? Options are limited.

While I’m not suggesting we abandon all hope with bonds in an increasing interest rate environment, advisors should consider reducing overall bond exposure and consider incorporating fixed income alternatives. One financial instrument with similar characteristics to a bond is a fixed indexed annuity issued by an insurance company (A rated of course). This insurance contract will provide an average historical three to five percent annual yield (tied to an external index such as the S&P 500), security providing 100 percent principal protection, tax deferral, lifetime income options with inflation protection and access to money for liquidity. This type of contract offers a unique risk/reward profile for the individual and can allow advisors to plan around a core protected income source. If we look back at history from the years 1966 to 1981 when interest rates increased, you will find this bond alternative strategy will improve the overall risk adjusted return, reduce negative effects of rising interest rates, and eliminate outright downside principal risk.

To the opposition, yes, fixed indexed annuity contracts and the insurance company are mostly backed by bonds but are far different than buying a bond fund or individual bonds. Insurance companies look at a far larger window for owning bonds, which are typically 40 years or so (in comparison to five to 10-year windows). Insurance companies are more critical about volatility control vs increasing yields inside their portfolio. Since they buy in 20 to 40-year bond durations, this increases their chances of avoiding short term bond exposure risk and allows for volatility to be controlled for the company and passed on to the owner.

One major advantage to an indexed annuity are the mortality credits you receive. This is made possible through the pooling of longevity risk across individuals. Insurers use mortality tables that estimate the life expectancy of people at every age which acts as a hedging tool for people living too long and receiving payments. The “credit” is created when an individual dies too soon, thus creating a credit for someone who lives too long.

With credits on the advisor’s side, this allows less money to be allocated towards an annuity than they would need to if it were put into bonds because it can produce more output per dollar or in other words “income.” By generating more income than the bond, because of mortality credits, there would be less need to withdraw assets from a portfolio to meet the spending needs. In layman’s terms, you can retire sooner and with less money while allowing the rest of your portfolio to focus more on rate of return.

Broadly speaking, both bonds and indexed annuities serve their purpose as a fixed income asset class for consumers. But under the new set of circumstances, one may not be as appropriate as before. The truth is that the bond market moves in both directions which we haven’t seen since before 1981. When interest rates rise, bond values go down. It’s a statement like this that is so straightforward but often overlooked and unplanned for. For advisors that allocate by way of status quo, this should be a wake-up call. The idea that we can sit on our nest egg of fixed assets and draw only interest is no longer possible. Taking a step of reducing bond allocation and increasing exposure to fixed indexed annuities with the right tools can dramatically reduce the overall risk of any retirement portfolio.

As William Pollard once said, “To change is difficult. Not to change is fatal.” While I agree fatality is aggressive, we must be willing to consider changes to grow and prosper for our practice and, most importantly, for our clients.