How financial advisors can help clients weather market turbulence

By Al Dal Porto

As consumers seek advice from their financial advisors regarding rising interest rates and inflation’s impact on their investments, many are closely monitoring the direction of these volatile market conditions.

With more rate hikes from the Federal Reserve expected for the rest of this year and into 2023, advisors have the opportunity in order to rebalance client portfolios to better position them for ongoing turbulence. Checking in with clients and getting a good read on how they are faring is especially important as we look to the second half of 2022.

Inflation has supplanted COVID-19 as the major concern for many retirement savers’ portfolios.

This is in addition to other concerns such as the Federal Reserve’s rate increases, the war in Ukraine elevating geopolitical risks, and serious supply chain issues. The expected shift in the

Fed’s monetary policy has created fears that the Federal Open Market Comittee’s actions could cause a recession later this year.

Many asset classes have been impacted by the Fed’s moves to fight inflation, including stocks, bonds, real estate investment trusts and cryptocurrencies such as Bitcoin. Corporate profits, consumer spending and the labor market have been resilient but could wither during the stream of rate increases.

Although bonds often have provided a ballast for portfolios in the past, offering stability in the face of equity volatility, they are facing a treacherous environment. As rates rise, prices decline, so most bond sectors have been in the red this year. What options do advisors have to offer clients?

Among other products, fixed indexed annuities can deliver principal protection and appreciation (in the form of interest credits) that are linked to the performance of an underlying index. The contract owner holds the FIA for the contract period, although principal withdrawals are available (surrender charges may apply).

But unlike a bond, an FIA accumulates interest on a tax-deferred basis throughout its life, enhancing accumulation potential. In addition, the upside for an FIA is not driven by yield — as it is in fixed income — but rather the underlying indices that are available. The contract maintains an account value throughout its life too, allowing advisors to consider the FIA in their clients’ asset allocations.

FIAs can be a reliable vehicle for clients to continue to accumulate assets for retirement, even during times of uncertain market conditions. At each annual reset period, the original principal value, plus any accumulated interest credits, is locked in.

“An FIA contract can provide significant benefits since the account value is updated annually,” said David Byrnes, head of distribution at Security Benefit. “This aspect of FIAs is especially critical given the losses most bond segments have experienced so far in 2022. Essentially, FIAs provide advisors the ability to de-risk a portion of their clients’ retirement portfolios.”

Choosing the underlying index account allocations allows advisors to adjust portfolios to changing market conditions. Advisors need to educate clients on the range of FIA options available and ways in which they can seek to take advantage of them. As with portfolio asset allocation in general, diversification can be helpful.

Today’s FIAs often offer a broad range of traditional and alternative indices for linking, including various U.S. equity segments, Treasuries, commodities, volatility controls, factor-based indices and more. FIAs also feature fixed accounts, which can be used as a hedge against equity-focused index accounts.

Consider capped and uncapped FIAs

To guarantee principal in contracts, issuers design options on interest credits through a combination of account parameters including caps, participation rates and spreads. These parameters often include both uncapped and capped options. One strategy often preferred by advisors and their clients is allocating funds between both options.

A cap is essentially the maximum credited rate your client can earn during the index term, regardless of the change in the underlying index. For example, if the cap is 5% and the value of the chosen underlying index rises by 10% during the contract period, the cap amount of 5% would be credited to your client’s contract. However, if the index rose just 2%, the contract would be credited only 2%, as that is lower than the cap.

Uncapped strategies typically involve a volatility control mechanism with the target volatility set at a relatively low level (as compared to the volatility of a typical equity index). This lowers the cost of the derivative used to back the index credits and allows the insurance company to offer the potential for larger interest credits versus having a cap on the return. It also tends to stabilize the cost of the derivative used as well and can result in more consistent renewal parameters around index crediting from period to period.

Capped strategies typically involve indirect exposure to a straight equity index (such as the S&P 500). There is usually less expense built into an index, but a cap is often needed as the cost of the derivative to back the index credits would be too expensive without introducing the cap. This is because the volatility of straight equity indices is usually higher than those that have a built-in volatility-controlled mechanism (such as uncapped strategies).

Buy the dip

What’s more, given the recent drop in market values, clients can “buy the dip” using an FIA — especially with caps on the rise. Due to increasing interest rates, insurance carriers are able to earn higher yields on their general account portfolios. This in turn allows some to offer higher cap rates on certain index accounts — commonly traditional indices like an S&P 500 annual point-to-point strategy, for example.

The S&P 500 Index recently hit bear market levels. So in an FIA, the index starting value is significantly lower than at year-end 2021. When a client purchases the FIA, they get the most recent S&P 500 Index value with the chance to earn up to what may be the new, higher cap rate. Afterward, you can work with your client and reassess annually. So, the FIA “buy the dip” strategy comes with principal protection and possible interest credits, versus “buying the dip” in the stock market.

Market turbulence can reduce risk tolerance

As we enter the second half of the year, financial advisors have an opportunity to work with their clients and rebalance retirement portfolios amid the market’s shifting conditions. Gauging risk tolerance and goals for accumulation during the rest of the year is critical, as volatility can spike the fear of asset loss, which may reduce their risk tolerance.

Considering products like FIAs may be one way for concerned clients to maintain their accumulation efforts while protecting the principal invested and potential interest credits down the line. An annual rebalancing discussion is advisable to make clients aware of how closely their financial goals and accumulation are matching. However, having more frequent discussions in the current economic environment may allow advisors to address client concerns in a timelier fashion.

Misconceptions do exist around FIAs that can often hold buyers back, and advisors too. Costs and complexity are among the issues, but today’s annuities have been able to successfully simplify these products and offer a number of innovations to help make them cost-effective options for many client portfolios. Plus, reducing risk by reallocating a portion of a portfolio to FIAs helps create a greater sense of certainty for clients given the challenges so many asset classes are facing in this rising rate environment