In a previous installment of our Market Mini posts, we introduced the idea of replicating an equity index annuity. In this edition, we will propose different ways to replicate features of a variable annuity. This post is intended to provide strategies to financial advisors, not financial advice to investors.
The sales growth of variable annuities is driven by two forces we’ve previously touched base on: the gold medalist and the person running from a German Shepherd. The gold medalist is looking for higher returns while the person running from the German Shepherd wants to guard himself against any downturn in the stock market.
In order to attain the guarantees, insurance companies require that individuals be locked into a contract for several years. Certainly, this arrangement with the annuity companies may not be for everyone. Here are two ways that financial advisors can create the benefits that variable annuities espouse.
Generate a Portfolio of Stocks and Bonds to Reduce Risks
The first strategy comes from Allan S. Roth, who recently wrote an article titled, “Investing Trick: Build Your Own Annuities,” in Financial Planning magazine. He advocates constructing a portfolio of stocks, bonds and exchange-traded funds (ETFs) and keeping the stock market exposure low—around 40—to reduce the volatility risk that often concerns people.
This strategy allows financial advisors to buy and sell the components at any time to create liquidity for the client.
Roth suggests using a combination iShares Aggregate Bond (AGG), 0.08% expense ratio; Treasury Inflation Protected Bond (TIP), 0.2% expense ratio; Vanguard Total Stock Index (VTI), 0.05% expense ratio; and Total International Index (VXUS), 0.14% expense ratio. He recommends that VTI and VXUS make up no more than 40% of the portfolio.
If the client is holding onto these combinations over a set time period, he or she is likely to have similar, if not larger, returns than the variable annuity but will still have all the liquidity wanted. The downside to this is that there is more volatility risk.
Invest in Certificates of Deposit for Greater Protection
The second option is the SWAN: Sleep Well At Night portfolio. This was devised by Ted Schwartz, founder and president of Capstone. This strategy has more of the principal protection that clients may want, but comes with higher fees.
The portfolio uses a ladder of structured certificates of deposit, although they are called CDs as they are very different in that their interest payments are not actually tied to interest, but rather some index or combination of indices. Examples of reference assets include equity indices (e.g., the Dow Jones Industrial Average and S&P 500 Index), foreign currency exchange rates (e.g., the BRIC Currency Basket), commodities (e.g., oil and gas or gold prices) or a combination of any of these.
The benefits to this strategy are that individuals can attain a greater risk with some principal protection; however, this comes at a cost. I was recently reading a prospectus from Goldman Sachs. The thickness of the prospectus is proportional to the complexity. (As a rule, I usually say the thicker the prospectus, the less favorable it is for investors.)
The Goldman Sachs example is tied to an index the company creates. The index has variables that could move around if volatility increased (a way for Goldman to limit their losses) and a stipulation that the return has to be greater than LIBOR, (the London Interbank Offer Rate) which is what banks charge each other to borrow money. This means that Goldman is trying to find a way to wither pay for the money being borrowed from other banks or that the company is borrowing cheap money at a LIBOR rate and investing it in more risky securities. Second, the initial investment is discounted by 4% to the distributing custodian or broker dealer. However, they make this strategy appealing by making sure it is FDIC insured.
These portfolios can be beneficial but select carefully as some structured CDs come with some “hair.”
Strategize an Investment Plan That Meets Your Financial Goals
Here is an example of a ladder approach to provide some liquidity and income for an individual over seven years.
The objective is to have $30K available annually from an initial investment of $210K over a seven-year period while trying to have as much potential growth to amount and an FDIC-insured principal.
To begin, you should keep $60K in a money market for the first two years. Very short CDs are not paying much more than a money market, so keep that as liquid if possible. This is used to fund the person’s expenses for the first two years. Purchases made in subsequent years may look something like this:
Year 3 (2017) – Buy a $30k fixed CD to fund the third year.
Year 4 (2018) – JP Morgan $30K CD. This is linked to the Efficient Index (made up of stocks, bonds, emerging markets, commodities, real estate and inflation protected bonds). You get 105% of the increase in this index plus the principal if it is down for the four years.
Year 5 (2019) – Barclay’s Bank $30K CD. This has a minimum return of 5% plus principal. It is based on returns of S&P 500 with a quarterly cap on the increase of 4-4.5%. If the S&P goes up 20% next quarter, you are only credited with 4-4.5% and paid only on final calculation in 2019.
Year 6 (2020) – Bank of the West $15K CD. This is linked to Morningstar Stock Pickers Index. There is no minimum return above principal, but you get 115-120% of increase. You may also choose to purchase Goldman Sachs $15K CD in this year. This will earn you a 2-3% fixed return the first year, then 120% of increase of Momentum Index (similar to Efficient above).
Year 7 (2021) – Goldman Sachs $15K CD. This is similar to the Barclay’s CD above, but has a 6% minimum return and a 4.5-5% quarterly cap.
The worst case in all of this is that you have principal protection, which is paid for in fees to the distributing agent, and a positive but paltry minimum return. If markets do well, you could have higher returns while having FDIC principal protection and the proper amount of cash needed each year.
Structured CDs have some limitations as expressed above, but they also provide some liquidity and a way to have some growth with principal protection. No matter what happens in the stock market in years to come, you can devise a plan that can provide growth and protection to your clients.