Better Than Bonds?
Bonds are having a horrendous year, down double-digits as interest rates continue to climb. The onslaught could continue as the Federal Reserve battles inflation because one of the only tools they have left is to raise interest rates.
Rising interest rates are both good and bad. During COVID, interest rates were near zero, impacting investors searching for income. The higher rates benefit retirees and savers who can now generate more income from CDs, US Treasuries, and corporate bonds. However, rising interest rates hurt bond valuations because when rates rise, bond prices fall. It's like a seesaw in a park; when one side rises, the other falls.
Bonds are supposed to be boring and safe, but not this year. The iShares 20+ Year Treasury Bond ETF is down 21%, whereas the Dow Jones has fallen 16%. A bond paying 3% offers little comfort to an investor losing 21%.
Another option for bond investors is to consider an immediate annuity. An annuity guarantees an income stream for life or a certain period and won't fluctuate like a bond. When you purchase an annuity, you transfer the risk of owning the investment to the insurance company.
Some immediate annuities currently offer rates of 6% to 7%. For example, you determined you need an additional $50,000 per year to cover your living expenses for thirty years. To produce $50,000 for thirty years at 7%, you must contribute $620,452 today to an immediate annuity. To generate the same income level from a 30-year US Treasury Bond, you must purchase $1.6 million in bonds, almost $1 million more than the annuity.
In this example, a traditional 60% stock and 40% bond portfolio requires a balance of $4 million - $2.4 million for stocks and $1.6 million for bonds. Of course, you can use the dividend income from stocks to help offset the bond income, but more on that later.
If you replace your bond portfolio with an immediate annuity, you can reduce your fixed-income allocation and increase your equity exposure. For example, the annuity only requires an initial investment of $620,452, so you apply the extra $979,548 to your stock allocation. Your new allocation is now 85% stocks and 15% fixed income. The added equity exposure can give your portfolio a long-term boost and potentially provide more income.
Adding an annuity solves two problems. First, you generate an income stream for life; second, you add more growth to your portfolio.
The annuity option sounds too good to be true; what's the catch? If you buy an immediate annuity, your investment and income stream terminates when you pass away, and you can't transfer this asset class to your heirs. You can add joint and survivor payout options to your contract, which means the annuity provides income for you and your spouse for life. Another option is to add a period certain payout, like five or ten years. Of course, your monthly payment will drop with the more features you add to your contract.
Inflation is another downside to the fixed annuity payout. Most immediate annuities don't index to inflation, so a $1,000 payout today is worth $411 in thirty years with an inflation rate of 3%. You can add an inflation rider to your contract, which will lower your monthly income. However, your increased equity exposure can provide inflation protection over time. Since 1997, the S&P 500 has more than doubled the return of a sixty – forty portfolio. The extra equity exposure could offset inflation over time, allowing you to generate more income from dividends, eliminating the need to add an inflation rider to your annuity.
Should you consider an immediate annuity? This strategy could benefit you and your family if you want guaranteed income and are comfortable with increased equity exposure. Also, you must be willing to exclude a portion of your assets from your estate.
July 5, 2022
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management, located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so you can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM's custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets. We have waived our financial planning fee for the remainder of the year, so your cost is $0.00.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren't suitable for every investor.