I recently attended a lecture with Roger Ibbotson, an emeritus finance professor from Yale business school, and had the opportunity to speak with him afterward. Ibbotson recently completed extensive historical research on the performance of bonds versus uncapped index annuities.
Traditionally, index annuities placed caps or limits on upside performance. Uncapped index annuities do not place an upside limit on the returns of the annuity and therefore may allow contract owners to receive higher returns. Based on that research, he made the following conclusions: The first was that given today’s low-interest-rate environment, bonds that derive returns from interest payments and either capital gains or losses are unlikely to perform as well in the next 10 years as they have in the past.
Moreover, if interest rates rise, the return from bonds could be negative. Secondly, over the last 90 years, uncapped fixed index annuities would have outperformed bonds on an annualized basis. Finally, these annuities offer a narrower risk profile than bonds as they capture a portion of the upside offered by large cap stocks, without investment risk.
Ibbotson, who is CEO of a hedge fund called Zebra Capital Management, said that his research also indicated that large cap stocks that are “less popular” tend to have less volatility and higher returns then stocks that are getting more notoriety and have higher trading volume. His company has created a rules-based index comprised of stocks with less popular names and lower volatility.
As far as appropriate asset allocation, Ibbotson said that he still believes in 60/40 portfolio designs but that “the 40 percent isn’t necessarily bonds because bonds could have poor performance going forward.” He concluded that index annuities allow for low risk equity participation with principal protection. Therefore, investors should consider using uncapped index annuities instead of bonds as the conservative portion of their portfolio.
The S&P 500 consists of 500 of the country’s largest publicly traded companies. These companies include the following sectors: energy, technology, consumer staples, consumer discretionary, financials, health care, industrial, materials, telecommunication, utilities and real estate. At first glance, this seems like adequate diversification. However, the S&P 500 is market cap weighted, which means that the larger companies make up a bigger percentage of the index than the smaller companies.
Technology companies currently make up about 25 percent of the entire index and the largest five tech stocks (Apple, Microsoft, Google Amazon and Facebook) accounted for 14.4 percent of the entire index as of the end of February 2018.
Since the beginning of 2015, the technology sector has returned 18 percent per year vs. 10.2 percent for the S&P 500 as a whole. This recent out-performance has contributed to the tech sector’s overweight in the index. What does this mean for the S&P 500? It means that if technology stocks continue outperform, then that bodes well for the S&P 500. However, if the sector falls out of favor, the S&P 500 will likely under-perform.
If you own the S&P 500 index or an actively managed large cap mutual fund, which on average consists of 30.3 percent technology, then you are essentially making an oversize bet on the technology sector.
If you would prefer to be a more diversified investor rather than an unwitting sector bettor, there are some viable alternatives. For instance, the Guggenheim S&P 500 equal weight index allows investors to own an equal share of all 500 stocks with quarterly rebalancing. For value investors, the Barclay’s Shiller Cape Index allows investors to own only the cheapest sectors of the S&P 500. This index has significantly performed the S&P 500 as a whole over the last five years with significantly less volatility.
One of the major benefits of a deferred annuity is the ability to delay paying taxes on all of the gains. By kicking the tax-liability can down the road, you are essentially utilizing an interest-free loan of the government’s tax cut while you continue to enjoy compounding growth within your annuity. Moreover, the IRS allows your beneficiary spouse to stand in your shoes at your death and continue to defer taxes for their lifetime without any required minimum distributions. Even your children, if they are designated as your beneficiaries, are permitted under current tax law to take only relatively small amounts out each year from their inherited annuity based on their life expectancy. This concept is known as a non-qualified stretch annuity. If structured correctly, an annuity can be used to defer taxes over several lives.
However, if your annuity’s beneficiary is a trust, all of the funds in the annuity must be distributed to the trust, (and taxes paid) within five years of the owner’s death — even if the spouse is the trust beneficiary. Unfortunately trusts are taxed at the top tax bracket after only $12,500 of income.
Many of you paid good money for your trusts and you like maintaining some control over how trust assets are distributed after your death, but you are essentially going to have to decide what is more important to you: minimizing the tax bite for your family or controlling how your kids spend their inheritance. Since a spouse isn’t even required to take required minimum distributions as the beneficiary, I usually recommend putting the spouse as the beneficiary of one’s annuities. For those looking to minimize taxes for their kids and still maintain some control, certain insurance carriers allow contract owners to create restricted beneficiary designation for their children.
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