Best Income Strategy: Bonds or Annuities?

MAY 29, 2014
9:20am ET
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Blanchett: People donít 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%, youíre losing money every year; itís a guaranteed loss over time. If youíre thinking, how do I reposition my assets? Should I look at bonds or annuities? I think either can possibly work. Itís 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?í 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 youíre 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 ó thatís an illusion. Most of it is the return of your own principal. Itís like buying a bond with a duration for the rest of your life. Itís very long term so that, if rates rise, youíre 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. Itís 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 theyíve been so low for so long, people are seduced ó and advisors too, sometimes, because they want to bring value to their clients ó 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: Thatís true, but I think thereís an important need for cash on the sidelines. The worst thing that can happen is a market turns down, your portfolio starts dropping, youíre withdrawing from a falling portfolio. You all know the saying, donít try to catch a falling knife. Youíre not getting that money back; that portfolio doesnít 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 donít 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 havenít seen the inflation we saw in 1976 to 1980. It was 15%, 16%. I donít think they understand, and the clients certainly donít understand, so itís 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 youíre using a long-term average as your estimate for returns, you may be kidding yourself because thereís 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 youíre assuming a long-term return of 4% for bonds, youíre kidding yourself because those early returns wonít be as high as future returns. Youíre 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?

Comments (2)
Great article, thanks for the dialogue!
Posted by William R | Thursday, May 29 2014 at 2:00PM ET
indeed a nice article and the video links you mentioned are really very helping to understand.really an informative content.thanks for the upload.
Posted by fifo c | Friday, June 13 2014 at 12:03AM ET
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