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Investing Specialists

Are Annuities More Efficient Than Bonds?

Financial expert David Lau discusses how annuities could lead to higher returns in retirement.

On this episode of The Long View, David Lau, founder and CEO of DPL Financial Partners, discusses annuities, retirement planning, and DPL’s newest insurance products.

Here are a few excerpts on annuity types, risk mitigation, and efficiency from Lau’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Annuity Types

Benz: We wanted to dig into some different annuity types to pick your brain a little bit. Many advisors, many RIAs, financial planners are willing to take a look at the very basic income annuities that you referenced earlier, the SPIAs, or single premium immediate annuities, and maybe deferred income annuities as well. Does the DPL platform include those products or are advisors who are inclined toward them better off going straight to the insurance company if they’re looking at products like that?

Lau: We definitely have those types of products. We’ve got every type of annuity product. And you’re generally going to get the best available products through DPL. So, what we see is, while many advisors think of those products, the immediate annuities or deferred income, and people talk about them, but they’re pretty much wildly unpopular products. They’re a tiny part of the annuity marketplace. It’s something like 3% or 4% of annual sales in immediate annuities or deferred annuities. So, most advisors are looking toward variable annuities, or fixed, or fixed-indexed annuities. And now, these buffer annuities that are relatively new to the marketplace, been around maybe seven, eight years.

And the reason most advisors think of SPIAs and DIAs is, one, those have always been the lowest-commissioned products, so there’s better value in those, but also because they have a very limited point of view on how you would use an annuity or why you would use an annuity. And mostly, in that case, you’re just thinking, OK, I’m trying to use the annuity to protect longevity risk within a financial plan. And therefore, most advisors will say, “I don’t use annuities all that much because I’m only thinking about them for clients who could potentially run out of money or outlive their assets.” But actually, the best use cases for annuities are really for risk management and just general income.

So, when you look at the academic study around annuities and academics universally, and you can’t say that about many things, universally in support of using annuities and financial plans for retirement income. The reason is because they generate the income more efficiently than traditional fixed income does. When we talk to advisors, we’re educating on those use cases. One, let’s look at income. If your client is going to take income from their portfolio, it’s likely that the annuity can generate that income far more efficiently than your fixed income. So, let’s look at allocating some portion of your fixed income to an annuity when the client is getting near retirement. And the other is risk management. Particularly in markets like this, and you look at historic strategies for risk management for advisors who are only using investments, it’s really diversification; diversification of asset classes and geographies and other things to create risk management within the portfolio. But there’s so much more correlation today than there used to be between all those different asset classes that when stocks are going down, so are bonds and now, so are crypto. Some people talk about using crypto as a diversifier. Crypto is going down, too, with the market. So, insurance is a way to truly bring risk management into the portfolio and have assets that are protected from downsides regardless of what’s going on in the market. Those are really the two big use cases we talk to advisors about.

How Are Annuities More Efficient Than Bonds?

Ptak: You used the term “efficient” before and how annuities boast greater efficiency than bonds in certain circumstances. Can you just talk about what you mean by efficiency in that context?

Lau: The annuity has, again, some structural advantages, and an annuity is a product that when you’re using an annuity that’s designed for income, that is a product particularly and specifically designed for income. And so, the annuity is going to enjoy the benefit of risk-pooling with the carrier, pooling the risk of many, many lives and adding that benefit of risk-pooling on top of effectively the interest rate that is available through investments. So, Wade Pfau, who is a well-known retirement researcher, he has a chart that shows, in historic interest-rate times, where the 10-year is yielding 5.2%—or whatever the average is, something like that. An annuity is going to generate about 22% more income, meaning 22% more efficient in that kind of interest-rate environment. That’s the benefit of that risk-pooling. In low-interest-rate environments like we’re in today, even though rates have been rising, you’re looking at more like a 40% benefit. So, we’ve got a tool, and this is one of the things our members get access to, is our technology. We’ve got a tool that will allow you to compare your fixed-income strategy to an annuity.

In this kind of marketplace, what that 40% more efficiency means, if you have somebody who you’re looking to fund income in retirement—say, you want to fund $50,000 a year for 30 years, that’s your retirement. If you want to fund that through fixed income at, like, 3%, that’s going to take about $1.2 million, $1.3 million in your fixed-income allocation. You can fund it with an annuity for $750,000. So, you’re looking at a massive difference in efficiency in funding that income need. And then, what that creates—and again, this goes back to the academic research and the academic recommendation on how to think about annuities—is now you have a surplus. So, you have a gap of $400,000 or $500,000 that you didn’t need to allocate toward that income goal, which you can now invest for legacy or discretionary spending. So, you get so much more efficiency and true liquidity within the portfolio.

Income Production and Risk Mitigation

Benz: I’m hoping we can talk a little bit about specifics for each of those use cases that you mentioned. So, you’re talking a little bit about income production and how an annuity could fit there, and I want to also talk about risk mitigation. But let’s talk about specific annuity types. If an advisor is saying, or an individual investor is saying, “I am not going to earn much from my traditional bond allocation,” and we’re also seeing a lot of volatility in the bond market, what’s the annuity prescription in that instance?

Lau: If you’re looking at your accumulation phase, you look at products that can provide a bondlike return. And for us, that’s MYGAs—multi-year guaranteed annuities—those are basically just a fancy name for fixed annuities that the rate is guaranteed for more than one year. Those products right now, we have four-year products paying 4%. So, you’re getting a really good interest rate and you’re getting it tax-deferred, which is again the advantage of the annuity when you’re talking about fixed income. Because one of the common concerns advisors have about annuities is the taxable nature of them, which is that they’re taxed at ordinary income rates when you take withdrawals or get payments out. But for fixed income, that’s always also taxed at ordinary income. So, when you can tax-defer ordinary income, that’s a smart thing to do.

We see the use of fixed annuities and MYGAs and then fixed-indexed annuities, which are, again, fixed products that have downside protection. So, for the individual or the client, they can’t lose assets in the policy due to the market. And within those products, you basically have two investment options. You’ve got the fixed account, and again, our fixed accounts in those products are paying 3% to 3.5%, I believe, right now. And then you have indexes that you can invest in, like the S&P 500 index. You can get a diversified source of return for your fixed income. So, if you allocate to that index, you’re going to get a cap, but you’re also getting that floor, so you can’t lose money in that regardless of the performance of the index. But you could get a cap up to 6%, or I think even 9% are some of our higher ones right now. So, you can get a return in fixed income if you’re going to the fixed account of 3%, 3.5%. Or you can put it in the index where you’re going to get, call it, a 0% to 9% return. And so, those are really great risk-mitigation products in a portfolio because they’re truly uncorrelated to the market.