If historically low interest rates remain historically low, should advisors reconsider their clients’ allocations to bonds? What factors are most important when a planner is debating whether a client would benefit from an annuity? And which type of annuity might be best? Financial Planning put these questions and many more to leading experts in a panel discussion called Bonds vs. Annuities that was nearly always illuminating and occasionally provocative.

The panel was composed of four CFPs: Kimberly Foss of Empyrion Wealth Management in Roseville, Calif.; Allan S. Roth of Wealth Logic in Colorado Springs, Colo.; Tom Orecchio of Modera Wealth Management in Westwood, N.J.; and David Blanchett, the retirement research chief at Morningstar Investment Management. We challenged the panelists to offer specific strategies advisors and clients can use in constructing portfolios.

Watch the videos:

Here’s an edited transcript:
Fed Chairwoman Janet Yellen essentially says the central bank will do whatever is needed to aid the economy. Nonetheless, interest rates will logically ascend over time — of course, no one knows for sure how quickly or when. If clients ask, 'Why not minimize the bond position in my portfolio?’ how do you counter that? Can bonds still perform when rates are rising?

Foss: I do believe that. I think there are four essential elements to having bonds in the portfolio. First, and noteworthy: No one can forecast interest rates. We just don’t know when interest rates are going to rise. We thought this back in 2009 and we’re still in this environment. No. 2 is that it’s not to say that we can’t go back to normal any time soon. Japan’s been at its normal for 15 years. No. 3 is that bonds perform differently in portfolios than stocks, so I think that it’s really important, as a diversifier, that we keep bonds in the portfolio, even though they’re at the lows right now.

Fourth is there’s no guarantee that, even if interest rates rise, long-term bonds would underperform short-term bonds. Dimensional Fund Advisors did a study from 1976 into 2007, and there were periods in which they saw interest rates rise, and the end result was that, in all of those four periods, the Barclays indexes all rose except from 1976 to 1980. I think it’s really essential that we do have bonds in the portfolio.

Roth: Top economists have a track record of predicting the direction of rates less than a coin flip, and the purpose of the bond portfolio is that of the shock absorber. Amid all this talk about a bond bubble, people have to remember that stocks are riskier in a day than bonds are in a year — high-quality bonds, anyway.

Orecchio: I would add that clients are worried about volatility and we use bonds as a volatility dampener. Keeping them in there on a day where the market moves 200 points in either direction, the bonds really dampen that volatility. That’s more important to us than the income that they generate.

Roth: Being the argumentative person that I am, I completely disagree that bond rates are near an all-time low, because if you go back to 1981, you could get 12% on a CD, which meant after taxes you had 8%, inflation was at 15%, so you had 7% less spending power. Rates are much better today.
And all that really matters are after-tax returns, right?

Roth: After-tax, real inflation-adjusted returns.

Blanchett: After fees.

Orecchio: One more thought on the inflation issue: Yellen was talking about the concerns of deflation, and in a deflationary environment, bonds with low yields perform very well.

The bond market, of course, is really multiple markets: Treasuries and munis and corporate debt, developed market debt and emerging market debt, all sold as individual bonds and bond funds. Should a balanced portfolio hold all of these?

Orecchio: We believe in broad diversification, so we think they should — all of those and more. By including different dimensions of risk, you dampen the volatility of the portfolio.

Roth: I have a different solution that I’ve been using for the last 15 years. Probably 70% of my own fixed income is in certain CDs directly with banks and credit unions that have easy early withdrawal penalties, and that acts like a put. If rates do rise, you pay that small penalty and reinvest at the higher rate. I do have some bond funds and it’s a complete myth that bonds are less risky than bond funds. The net present value of the decrease of the cash flow of holding a bond to maturity is equal to the amount that the bond fund falls when rates rise.

Orecchio: Can I argue that point? There is an additional risk in a bond fund that you don’t necessarily have with an individual bond. With an individual bond, no one can force you to sell that bond, but in a fund if there is an exodus, a quick one, and there’s not enough cash on the sidelines, the fund manager may be forced to sell bonds at an inopportune time to create that cash. And we don’t want our clients to be caught up in that.

Roth: I agree. You want funds like Vanguard bond funds where investors don’t have a history of moving in and out like Pimco, which lost $41 billion when rates barely ticked up last year.
Blanchett: Regarding munis, they obviously can be an attractive investment for individuals based on their tax rate. We’re more focused on corporates versus Treasuries, and we tend to shy away from corporates because, to everyone’s point, bonds are the safe part of your portfolio, so take risks in equities, not in bonds.

Foss: On the corporate side, we stay triple B or better because in a downturn you want to be sure the bonds are performing.

Orecchio: I may be a lone wolf here because we use junk bonds. We like them as an asset class in our bond portfolio. That said, we treat them more like equities than fixed income because of their volatility. But we like different dimensions of risk.

So you’re chasing yield but acknowledging there’s more risk?

Orecchio: I wouldn’t call it chasing yield because we’re not as interested in the income that it’s producing. We want different dimensions of risk in the portfolio because we don’t know which risk will materialize when, and as a result we want to have broad diversification in all of our asset classes.

Blanchett: To me, it’s paraphrasing Star Trek, where you have to boldly go where we haven’t gone before. Given where rates are, given where the market is, you have to have a diversified portfolio. Adding high-yield is not chasing yield, it’s just saying, 'Hey, what’s going to happen next? We don’t know. Let’s have a little bit of everything to have a diversified portfolio.’

Millions of Americans hold disproportionately large positions in cash following last decade’s financial crisis, the second market meltdown in less than 10 years. What talking points should advisors use with clients to get them to diversify?

Blanchett: People don’t realize that cash is risky. You think of cash as being a safe investment, but if cash is yielding nothing and inflation is 2.5% to 3%, you’re losing money every year; it’s a guaranteed loss over time. If you’re thinking, how do I reposition my assets? Should I look at bonds or annuities? I think either can possibly work. It’s important to note that annuities are priced based upon mortality and yields, so people complain today that bond yields are very low, and so are annuity yields. When I think about what annuities work best, it seems like deferred income annuities that hedge against that longevity risk, but I would say right now, if someone were to ask, 'Hey, David, what do I do? Do I buy an annuity or do I buy a bond?’ I might be tempted to say, buy the bond, then possibly buy the annuity in the future if you want to hedge away that risk.
Roth: When markets do their thing it feels really comfortable to be in cash, but you’re guaranteed to have half the spending power in 20 years by staying in cash. With annuities, on the other hand, the payment is not income — that’s an illusion. Most of it is the return of your own principal. It’s like buying a bond with a duration for the rest of your life. It’s very long term so that, if rates rise, you’re going to see inflation go higher and that payment is going to become less and less each and every year.

Foss: There could be a case for both bonds and annuities in a portfolio, but we believe cash should be fully invested at all times. It’s just breaking it down to how much the duration is. In a 40/60 portfolio with 60% in fixed income, we put 15% each into one-year or less, two-year durations or less and five-year durations or less. We always keep everything five years or less to help. The problem is that with interest rates so low, and they’ve been so low for so long, people are seduced — and advisors too, sometimes, because they want to bring value to their clients — to be allocating more into higher yield or into the stock market. Our job as advisors is to keep our clients disciplined and to bring value to them, even in these difficult times.

Orecchio: That’s true, but I think there’s an important need for cash on the sidelines. The worst thing that can happen is a market turns down, your portfolio starts dropping, you’re withdrawing from a falling portfolio. You all know the saying, don’t try to catch a falling knife. You’re not getting that money back; that portfolio doesn’t have a chance to repair itself. That cash is there for emergencies; you can tap that cash in a downturn, use that for your living needs. That said, you don’t want to have too much because inflation is the silent killer. Clients fear the volatility of the market much more than they fear inflation, but the truth is inflation will hurt them more than that short-term drop in the market.

Foss: Yes, but a lot of advisors haven’t seen the inflation we saw in 1976 to 1980. It was 15%, 16%. I don’t think they understand, and the clients certainly don’t understand, so it’s our job to make sure we keep those durations short so we can be at the top end of the yield curve at all times and not sacrifice principal in the long term.

Low yields create a relatively certain low return, increasing the potential of a negative return. How should that factor into portfolio construction?

Blanchett: If you’re using a long-term average as your estimate for returns, you may be kidding yourself because there’s this thing called sequence risk for retirees, where your first returns matter a lot. If, for example, your clients are buying bonds that yield 2% or 3%, or you’re assuming a long-term return of 4% for bonds, you’re kidding yourself because those early returns won’t be as high as future returns. You’re not painting the right picture for how clients are actually going to do.

Roth: I think people who look at historic bond returns and do forecasting are making huge mistakes because rates would have to turn negative in order for those returns to still happen. Will anyone here lend me $100 if I promise to pay back $98 next year, please?

I’ll pass, thank you. Looking at some of the changes in the marketplace lately, we’ve seen the introduction of more low-cost annuities. Will that change your view on using them in a portfolio?

Orecchio: Costs are a drag in any investment, so the more you can minimize that cost, theoretically the better the performance will be, all other things being equal — so it’s very important for us. If we can control the cost, we give more back to the client.

Roth: We can disintermediate the insurance company and the agent, and build our own annuities — for instance a TIPS ladder with a 20-year DIA later on, which minimizes that insurance, and even an equity-indexed annuity, now rebranded as a fixed indexed annuity. 

Blanchett: Annuities are a form of insurance, and insurance is not a positive net present value vehicle. You shouldn’t expect to make money from insurance on average, but what annuities do is hedge against a really bad event happening. If you look at a Monte Carlo simulation from the lens of what is the worst one in 10 possible outcomes or the worst two in 10, those different percentiles, that’s where they really shine — because they show that regardless of what happened with the market, you’re going to be OK at some level.

Foss: You have to remember, too, that annuities are just transferring the risk to an insurance company, so you’re going to pay a price for that. Sometimes that price is actually a value-add for the advisor and for the client, just to have that and know that. A lot of times the clients want that. Meanwhile, I think the free markets are at play and you’ve got demographics and you’ve got taxes, and I think that’s going to push more competition.

Orecchio: I would agree that there will be more demand, but our experience is that investors don’t buy annuities so much as they’re sold them, because they’re a complicated product that people don’t understand. They certainly don’t want to talk about their death or their longevity; it’s just not a topic people are comfortable talking about. As a result, I think there’ll always be a place for the agent to do the explaining, plus the insurance world is fraught with a lack of transparency.

Blanchett: That’s why I’m a fan of simplicity, if you can get it. A SPIA is very simple, relatively easy to compare. Some of the more advanced products, like variable annuities, they can be great for clients but it’s really hard to compare them apples to apples. With a SPIA, you know the payout and the quality of the issuer; that’s about all you need to know.

It’s been argued that the best single premium immediate annuity a client can buy is to delay Social Security benefits. Allan, since you’re a proponent of that, please elaborate.

Roth: I priced out a couple delaying Social Security for four years versus what they could buy, a deferred annuity that started in four years, and it’s like buying it at almost half price. It’s backed by the U.S. government, and rather than a fixed percentage increase, it’s a CPI-U percentage increase. It’s not a close call.

Blanchett: There are tax benefits, there are survivor benefits. Social Security is the best — I don’t want to call it this — but it’s the best investment around today, in my opinion.

Orecchio: I’m in total agreement. The only thing I would hedge is you have to weigh the client’s longevity and family history because delaying means there’s a crossover point down the line where it made sense to delay. If they don’t reach that crossover, though, then obviously it’s money out of their pocket, so you have to take their health into consideration.

Blanchett: I get that, and I’m a big quantitative guy, but just to be honest, if you pass away and you’re 75 years old, your kids are probably going to be OK, right? I think it makes sense to do those kinds of net present value calculations, but true risk in life is not about maximizing the estate to your heirs when you’re 70; it’s having nothing or having to have them take care of you when you’re 85, 90 years old.

Scott Wenger is group editorial director of Financial Planning, On Wall Street, Bank Investment Consultant and Money Management Executive. Follow him on Twitter at @ScottWengerFP.

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