Price hikes were widespread across sectors of the economy in 2021, according to the Federal Reserve’s Beige Book (December 2021). Rising interest rates sent bond prices lower, posting their first losses since 2013, and the prospect of continued rising interest rates could have a negative impact on bond markets in 2022. The Fed’s bond buying support is expected to end in March 2022, furthering the likelihood of rising rates thereafter in 2022 and 2023.
All this comes amid ongoing demographic retirement trends that show retirees are living longer and, in many cases, bearing more of the weight of their income needs; therefore, they need to save more. Additionally, many retirees have considered retiring earlier as a result of broader consumer trends such as the “Great Resignation” as the pandemic continues to spark many to shift their career focus or exit the workforce earlier. With these factors and many more impacting common retirement savings methods, there is a growing concern among investors and their financial advisors. How can they combat the impact of rate increases on fixed income market values and still earn competitive interest to accumulate assets for retirement?
While bonds have traditionally provided a source of stability for portfolios, acting with little or no correlation with volatile stocks, they may be less effective going forward. Fixed-rate bond prices generally drop as rates rise, which can expose clients to loss of principal and poor total returns.
Floating-rate securities offer some advantages, as they adjust periodically to the going market rates. This helps an investor take advantage of rising rates. However, there is not a guarantee that they will move as quickly as the market to match current rates, so investors still face interest rate risk and could underperform the market.
An innovative alternative to floating-rate bonds comes in the form of a new category of fixed annuities that feature an adjustable-rate mechanism. Floating-rate annuities function similar to floating-rate bonds but are tax-deferred products that guarantee clients’ principal while allowing them to benefit as rates rise. Financial professionals should consider the use of floating-rate annuities for the shorter-term portion of client portfolios and funds they are looking to keep “safe” from market and interest rate volatility. Floating-rate annuities could be a complement to CDs, money market funds and interest-bearing bank accounts, along with other more conservative products.
Rising rates can wreak havoc in the stock market too but are not necessarily bad for equities longer term. An uptick in rates could signal strong and growing economic conditions, which could translate to rising earnings and, subsequently, rising stock prices. However, there can often be a lot of volatility along the way, and there’s no guarantee that stock prices will rise in the near term.
When Rates Go Up, Bonds Go Down: An Alternative Approach
From an industry perspective, advisors equipped with the right technology and resources have been able to adapt to the challenges of COVID-19 by shifting to digital meetings and client service. The annuity industry has kept pace and become more efficient as well, with digital ticketing and servicing now the rule instead of the exception. And like floating-rate annuities, other innovations have come to market that serve as viable alternatives in client portfolios.
Advisors and their clients can consider the use of a newer breed of fixed indexed annuities, for example, which provide accumulation potential and tax deferral while still guaranteeing principal. Financial professionals have not sold FIAs as extensively in the past but have been giving them a fresh look as potential bond fund replacements.
When interest rates rise, bond prices drop. As recently as 2018, the last time the Federal Reserve raised rates, the Bloomberg U.S. Aggregate Bond Index turned negative. Given the current economic environment, with inflation at a level not seen in 40 years, we are likely in for a set of Federal Reserve rate increases. And if history repeats itself, bond funds could potentially see the same negative returns. Could financial professionals look to FIAs as a different solution during this next rate cycle?
Rethinking The 60/40 Rule
A traditional 60/40 portfolio, with 60% in stocks and 40% in bonds, has been a common asset allocation for decades. There are several ways in which advisors can use FIAs in rethinking the 60/40 rule.
For example, an advisor working with a relatively aggressive investor could substitute an FIA for bonds or bond funds as a portion of the conservative part of their portfolio (part of the 40%). This would give them greater accumulation potential, as interest is pegged to a stock index and not interest rates. Meanwhile, an advisor working with clients who already are retired or who have a lower risk tolerance can use an FIA to replace or reduce exposure to more aggressive investments out on the risk spectrum that have most likely accumulated substantially over the past few years. This can help bring their portfolio back to an overall equity to fixed income ratio in line with their risk tolerance (back to 60/40 or 50/50, or even 40/60 for those already in retirement who have a shorter time horizon).
The advantage is that a client can have a portfolio with a higher weight on fixed income/conservative investments but still keep some upside potential with FIA returns that are pegged to a market index. This could be a beneficial approach for those who don’t want to take the risk of a pure stock fund but still want some accumulation potential that is related to how equities perform.
FIAs can be a solution that fits a wide range of end-user needs. Of course, in no case would 100% of a portfolio be right for a fixed index annuity, but a decision to move some percentage of client assets into an FIA could prove beneficial to clients now and down the road.
The Potential For Annuity Products Amid Rate Changes
The recent innovations in the annuity space have raised confidence and made these products a viable retirement solution for more advisors in the marketplace. In addition, most bond funds suffer market value losses in a rising rate environment, while most annuities do not (if held for certain time periods). In summary, fixed and fixed index annuities can be a smart option for advisors to make available in their practice, especially when considering:
» The interest rate environment and outlook (current forward rates point to the expectation of rising rates).
» The stock market environment (volatility has increased recently).
» Strategic and tactical approaches to retirement planning.
» Increased efficiencies in the annuity marketplace.