Income Investing When Rates Rise

Cash is trash, but many investors are afraid of bonds.

You have alternatives. Other vehicles offer higher yields than cash (and many bonds) and provide diversification and safety of principal. Even better, they won’t lose value when interest rates rise.

Cash is trash these days because yields are too low. You lose purchasing power after inflation and taxes. Even if you shop around you’ll find that on a five-year CD you’re going to earn a little over 2%.

You earn a higher yield with longer maturity bonds, but investors fear rising interest rates. Once the Fed starts to raise short-term rates (and perhaps before), other rates will rise. That will reduce the value of bonds and bond funds. A modest rate increase will reduce the value of the bonds by more than one year’s interest income.

When you want higher yields than cash and fear what rising rates will do to bonds, consider putting the safe or fixed-income portion of your portfolio in certain types of annuities.

Note that I’m recommending you consider only particular types of annuities. I’m not recommending the high-fee variable annuities that are roundly criticized. Unfortunately, many critics of variable annuities shorten their advice to, “Don’t buy annuities.” The annuity world consists of much more than variable annuities, and some of the other types of annuities that can increase financial security and should be considered.

In this visit, we focus on three types of annuities.

Deferred fixed annuities. These are a classic, plain vanilla annuity. You make a deposit with an insurer, usually a lump sum but periodic deposits also are possible. Each year the insurer credits a return or yield to your account. Usually the yield is determined by the insurer based on its expected investment returns, expenses, and other factors. Yields on deferred fixed annuities usually are about the yield on intermediate investment-grade or mortgage bonds. There usually is a modest guaranteed minimum yield.

The interest credited to your account compounds tax-deferred until you withdraw it.

You’re likely to have limited access to the money in the annuity. Most insurers limit withdrawals to 10% of the principal per year without penalty for at least a period of time. You probably won’t be able to take your money back or switch it to another insurer’s annuity without penalty for at least seven years.

For example, the yield for the current top-yielding deferred fixed annuity is 3.75% for a ten-year commitment, 3.45% for seven years and 3.30% for five years.  Remember your income is compounding tax deferred.

Insurers offer optional features on deferred fixed annuities, including having more access to your money. But those features generate higher fees and reduce your returns. They generally aren’t worth the cost.

The advantages of a deferred fixed annuity are a healthy yield that rises over time if market rates rise, tax-deferred compounding, and safety of principal. Of course, your account’s value won’t decline as interest rates rise. The main disadvantage is restricted access to your money.

Deferred indexed annuities. In principal these are similar to deferred fixed annuities. The main difference is that with an indexed annuity the return on your account is determined by reference to an external index, such as a stock market index. With a fixed annuity, the insurance company sets your yield each year.

We discussed indexed annuities in some detail in the April 2014 issue, but let’s have a brief review. You don’t earn the full return of the index. Instead, a formula deter-mines the amount credited to your account based on the performance of one or more indices. There are four main formulas and variations for each formula, but we don’t need to go into details here. On top of that there might be a limit to the amount of the index return you receive, known as the participation rate. For example, your account might be credited 70% of the return calculated by the formula. Plus, there’s usually an absolute limit on your annual return, known as a cap, that usually is 8% to 10%.

There are a lot of differences between different fixed indexed annuities on all these details. The result is that when the index rises 12%, some FIAs are credited with a 5% return while others receive 10% and a bunch receive something in between.

An FIA has a guaranteed minimum return, which is 0% for most these days. So, you’re guaranteed not to lose money even if the index does. Then, you have the potential of earning more than a deferred fixed annuity if the index does well, though you could earn less than a fixed annuity if the index doesn’t do well.

For example, one FIA currently on the market will credit your account based on the return of a model portfolio that is 70% invested in the S&P 500 index and 30% in a fixed account currently paying 1%.  While your interest is calculated daily, every two years on the contract anniversary, any gains earned to date are locked in and a new two-year period begins.  If the model portfolio’s performance is negative over the two years, your account is credited with 0%. If the return is positive, you lock in the return and potentially build on that going forward. You have a worst-case result of a 0% return with the best case  depending on the two-year return of the model portfolio.

There are literally hundreds of different formulas for crediting interest to FIAs.  For some perspective, the 10-year returns on FIA’s typically range from 2%-10%.

As with a deferred fixed annuity, there are restrictions on access to your money. If you want to withdraw all your money or transfer it to another insurer’s annuity within seven years, you’ll pay a penalty. You might have access to up to 10% of your account each year without penalty.

The FIAs also can have a number of optional provisions that offer more access to your money and other features such as lifetime income payments and death benefits. These riders in my view usually aren’t worth the extra fees, but you can decide if they meet your needs.

Immediate annuities. The deferred fixed annuity and deferred index annuity generally are for money you aren’t planning to spend in the next seven years or longer. When you already are retired and drawing income from your bond investments, these might not be the best replacements for bonds. Instead, you should consider an immediate annuity.

These are the classic annuities. You deposit money with an insurer, and it begins making guaranteed regular payments to you. The payments last for the rest of your life, the joint life of you and your spouse, or a guaranteed term of years, whichever you select. The payments aren’t purely income. They are both income and a return of your principal. Once you pass life expectancy, payments are all income.

You have limited or no access to money beyond the guaranteed annual payments, depending on the annuity you select, so you should have other assets or income to tap in case of unexpected spending.

The payments vary considerably from insurer to insurer. My research over the years consistently shows that even among insurers with the highest safety ratings the payments to the same person vary by as much as 20%. That’s a 20% difference in your income every year for the rest of your life, so shop carefully.

For example, if a 70 year old male today deposits $1,000,000 with the top-paying insurer and chooses payments to last for his lifetime, he would be paid $79,320 per year for life. If he went with the 10th highest-paying insurer, he would receive only $64,743 annually. That’s more than an 18% difference.

Over the years immediate annuity payout options have become more flexible. Now, for example, you can choose to have your principal returned to your beneficiaries in the event of your premature death.

All annuities are a trade off. You transfer to the insurer the risks of low (or negative) investment returns, unexpected expenses, and, in the case of an immediate annuity, a long life. In return, you have limited access to the money on deposit with the insurer and give up the potential of earning a higher return with that money. In today’s investment world, you also transfer to the insurer the risk that rising interest rates will reduce the value of bonds.

Because of the trade offs, there are few people who should put all or most of their money in annuities. But the right annuities can be a valuable addition to the nest eggs of most people.

If you want to learn which type of annuity and which of today’s offerings are best for you, contact my annuity expert Todd Phillips of Phillips Financial Services. He provided the annuity examples in this discussion. You also can buy today’s Todd’s new book, The Future of Retirement Savings: How to take advantage of stock market linked growth without the stock market risk. It normally costs $9.95, but my readers can purchase it for $4.95, which is his cost for shipping. For details about annuities or to purchase the book, call 888-892-1102.

RW July 2014.