Are Annuities a Safe Alternative to Bonds if Interest Rates Rise?

Share This

Are Annuities a Safe Alternative?

Conventional wisdom says that stocks produce greater returns but are riskier. Bonds produce lower returns but are safer. Therefore, a retiree should allocate more of their assets to bonds in order to preserve what they’ve accumulated. However, one of the rules of investing is that when interest rates rise, bond prices fall. This can cause problems for those same investors reaching retirement who need to de-risk their portfolios.

One potential solutions has been put forth by Dr. Robert Ibbotson, Professor Emeritus of Finance at the Yale School of Management, in a January 2018 white paper titled “Fixed Indexed Annuities: Consider the Alternative”. In this paper Dr. Ibbotson discusses the historical returns of stocks and bonds showing that the conventional wisdom I talked about is generally true. However, it might not be the case in a rising interest rate environment. He also points out that at the end of 2016; Long Term Government Bonds were yielding just 2.72%. While Intermediate Government Bonds were even lower at just 1.85%. So what is a retiree to do?

Dr. Ibbotson notes that an annuity, specifically a Fixed Indexed Annuity (FIA), might work better as an asset class than bonds over the coming years.

An FIA is a growth and accumulation vehicle that gives the owner the option to convert the contract’s value for lifetime annuity payments or systematic withdraws. The primary advantage of an FIA is that the insurance company offers the investor a guaranteed floor of 0%. They participate in gains that are tied to an equity market index such as the S&P 500.

The investor’s gains are generally capped by either a maximum rate of return or more commonly a participation rate. For example, an annuity with a 60% participation rate invested over two years where the index returns 10% would be credited 6% (10% x .6 = 6%). If that same index lost 10% over those two years the investor wouldn’t gain or lose any money because of the guaranteed floor of 0%.

So, should investors consider FIAs as an asset class in portfolio construction?

The paper states, “During the period 1927-2016, there were thirty 3-year time frames. We isolated the fifteen 3-year periods when bonds performed below median. Also, the fifteen 3-year periods where bonds performed above median. Exhibit 10a shows the average 3-year annualized performance for bonds during the worst fifteen 3-year periods was 1.87%. During those same periods, the FIA averaged an annualized return of 4.42%. In the fifteen 3-year periods in which bonds performed above median, bonds returned 9.0% on average while the FIA returned 7.55%.”


Exhibit 10a: FIA vs. Bonds – Below Median and Above Median Bond Returns (1927-2016)

Source: 2017 SBBI Yearbook, Roger G. Ibbotson, Duff & Phelps; Zebra Capital; AnnGen Development, LLC

Dr. Ibbotson’s data tells us that when bonds perform poorly FIAs offer a much better alternative to the tune of an extra 2.55% average rate of return. When bonds perform well, FIA investors only fall short of bond returns by 1.45%. Knowing that bonds perform poorly as interest rates rise, and our current interest rate environment has nowhere to go but up, an FIA seems to be a strong alternative to bonds. At the very least an FIA should be included in a portfolio with bonds to provide some downside protection and help stave off interest rate risk.

The paper goes on to analyze 3 different portfolios under a number of different scenarios.

One portfolio includes only stocks 60% and bonds 40%; one consists of stocks 60%, bonds 20%, and an FIA 20%, while a third is just stocks 60% and an FIA 40%. All three portfolios are analyzed in environments where both interest rates and equity market returns vary widely.

The full results are beyond the scope of this blog post, but I did want to mention the stark contrast in the portfolios performance in a higher interest rate environment. In a scenario where interest rates rise 2% over the next 3 years; the 60/40 stocks and FIA portfolio outperforms the 60/40 stocks and bonds portfolio by 1% if equities are down 10% and 3.4% if equities are up 10%. Not only does the portfolio that uses an FIA in lieu of bonds provide more downside protection when equity returns are negative, but also a lot more upside when equity markets are in the black.

The bond portfolio did perform slightly better, 0.7% when equities were down 10% and 0.8% when equites were up 10%. If the interest rate remained unchanged over those 3 years. However, for many retirees who witnessed the last economic downturn the prospect of not being able to lose any of their investment while still participating in the equity market is a very attractive scenario.

In conclusion, bonds have been seen as a safeguard for retirement portfolios that can both bring the investor principal preservation and much needed income.

However, due to the inverse relationship bonds have with interest rates — if rates do move upward investors can experience low returns or even losses on their bond holdings. FIAs can provide many of the same benefits of bonds without the downside risk presented by unknown interest rates in the years ahead. If you’re interested in finding out if an FIA might be right for your retirement plan contact Stolly Insurance Group today!



Ibbotson, Roger G. Phd. (2018). Fixed Indexed Annuities: Consider the Alternative, retrieved from: