How COVID-19 Volatility and Near-Zero Rates Benefit Annuities

DPL Financial Partners hosted a digital roundtable discussion Thursday focused on the related and evolving topics of annuities, record-low interest rates and the COVID-19 pandemic.

Speakers participating in the event included David Blanchett, head of retirement research at Morningstar Investment Management; David Lau, founder and CEO of DPL Financial Partners; Dan Rohlfing, senior financial adviser at Lantz Financial LLC; Shannon Stone, financial planner, adviser and manager at DHR Investment Counsel; and Jason Branning, financial planner at Branning Wealth Management LLC.

The quintet covered a lot of ground during the 90-minute presentation, starting by describing the current fixed-income marketplace and the way that safe assets are no longer holding up their end of the bargain in a traditional balanced portfolio.

“We’ve all see the depressing stats showing that the 10-year U.S. Treasury note is now yielding less than 80 basis points [bps],” Lau said. “This has caused a rift in the traditional approach to retirement planning, which simply saw people transition away from equities and into bonds as the primary means of de-risking their portfolio over time. It is remarkable to recall that, in 1989, you could be invested 25% in cash and 75% in U.S. Treasuries and still generate a 7.5% annual return. To even approach that kind of return today, one has to be basically completely invested in highly risky assets.”

On that point, Blanchett said he is uncertain that even a “fully risked” equity portfolio could be expected to generate a 7.5 % return.

“What does this mean in practice? A lot of things, including that retirement is a more risky proposition than it has ever been, especially if you need to fund income for 30 years or longer,” Blanchett said. “Low rates are an issue for annuities, as well. It is true that annuity payouts are lower right now because of where the markets are with interest rates.”

However, Blanchett and the other panelists emphasized, it is critical to remember that the relative income one can generate via annuitization versus pure fixed-income investing actually increases when rates are down.

“Another way to say this is that it actually makes more sense to annuitize today than it did, say, a year ago, because it is so hard to get a reasonable income level from traditional fixed income,” Blanchett said. “The mortality credits associated with annuities are one source of the relative attractiveness, as is the ability to tie various types of annuity products to growth on the equity side of the market.”

The speakers noted that retirement investors should not try to wait for rates to increase in order to buy annuities—though, again, annuities would pay more if rates were to go up. Two reasons not to wait are, first, that rates could always go lower, and, second, that investors cannot afford to sit by and keep their assets in bonds that are actually paying a negative real rate of return after inflation is considered.

“In a sense, low rates staying low improves the relative value of an annuity,” Blanchett said. “We could be looking at depressed rates for five or 10 years or longer.”

The advisers on the call admitted that, up until a few years ago, they were pretty skeptical about annuities, in large part because of the compensation framework and the wide use of commissions.

“That has shifted over the last few years as the product set has diversified and improved,” Stone said. “Another critical message we are bringing to our clients is that annuity purchases and payouts can actually ease pressure on the equity side of the portfolio. If you have a certain income baseline guaranteed, that allows you to think a lot differently about risking the remainder of your assets in the equity markets.”

Stone said the advancement of financial planning software has helped her firm demonstrate this idea to clients.

“If you show them the right information, investors really get the purpose of an annuity when you frame it as a partial solution, one that will help balance the risk they take with their growth assets,” Stone said. “Investors also respond well when we emphasize how the annuity product set has improved so much. Of course, we still need to carefully analyze and understand what we are buying. There are still products out there that are poorly constructed and overly expensive.”

Branning added that annuitization can help investors behave more rationally during periods of market stress.

“Having that annuity income baseline can really help clients to navigate the storms, whether from COVID-19 or a future black swan event,” Branning said.

“As a retirement income practice, we have done a lot of research about the impact of volatility,” Rohlfing said. “As a retirement investor, volatility is your best friend on the way up, but once you’ve saved your last dollar, it can become your worst enemy. Our research shows having an income floor gives people much needed comfort and a sense of security that helps them remain more rational during the market swings.”

The speakers all said they are optimistic about the future development of the annuity product set—especially commission-free products that should, in theory, fit in well with fiduciary retirement plan advisers’ existing compensation structures.

“Advisers should be asking about commission-free products,” Lau said. “They are available and, in fact, they are superior for your clients. Frankly, if there is no financial incentive behind the recommendation to purchase an annuity, clients are more likely to feel comfortable with that decision. They should also benefit financially from lower fees and/or greater returns.”

The speakers said advisers should take time to learn about the nuts and bolts of annuity structures and pricing. In particular, they said it is important to understand that many annuities used right now actually pay out income via specially negotiated “riders,” rather than as a core feature of the annuity itself. What this generally means in practice is that more liquidity and withdrawal capability are maintained for a given investor buying a given annuity than is commonly assumed.