Is Your Current Asset Allocation a ‘Lose-Lose’ Proposition?

“Asset allocation.”  These have been the buzz words for successful investing for at least a generation.  Maintain the correct allocation based on your risk tolerance and your age to maximize long term return and manage risk.  Generally, this means some mix of equities and fixed income assets (stocks and bonds).  A more aggressive investor might have an 80/20 mix of equities to fixed income, a more conservative investor with less exposure to the stock market and more in bonds.

However, there are good reasons to believe that there is now excess risk on both sides of the typical asset allocation coin.  Robert Schiller of Yale maintains a stock market valuation measure (based on 10 year trailing P/E ratios, also called the Schiller PE ratio) that has been highly reliable. It currently finds the stock market’s value has only been higher in 1929, 1999 and 2007.  He points out that the stock market can maintain an elevated valuation for longer than many assume, but eventually there must be a ‘reversion to the mean.’

On the fixed income side, bond returns are at historic lows, which means that not only are we not earning much on fixed income assets, but there is very little room for rates to fall.  Falling rates increase the value of bonds – rising rates decrease their value.  Added to the bleak outlook for returns from fixed income assets are rumblings in the marketplace about penalties for pulling out of bond funds, which are the most common way to invest in fixed income assets.  If rates were to rise precipitously, there would be a ‘run’ by consumers to sell bond funds, and bond fund managers would have difficulty finding buyers for the underlying bonds themselves.  As a result, bond funds are raising the specter of redemption fees or waiting periods to sell during a market disruption.

When your only investment options are stocks and bonds, eventually the market will put you in a ‘no win’ predicament.  So this may be the perfect time to add fixed income annuities to your asset allocation mix, especially if you are within 10-15 years of retirement.  Fixed indexed annuities will increase in value during years when the stock market rises by some agreed percentage of the market’s return, but they can never lose value.  This guarantee of principal is backed by the insurance company’s surplus, and large life insurance companies are among the most financially secure entities in the world.

In addition to safeguarding against loss, annuities have features unlike any other asset class.  First, they shield the appreciation from taxation until it is paid out as income.  Second, in the payout phase only annuities shift the risk of longevity to the insurance company, guaranteeing income for life - no other asset can do this.  Third, you can maintain the tax advantaged status of 401K or other qualified funds by rolling them into an annuity.  Finally, there are numerous other features to meet particular needs like income for long-term care, or in the case of a terminal illness.

The Brookings Institute released a study which concluded that given the value many people placed on having a secure lifetime income, it was irrational not to include annuities in your retirement asset allocation mix.  Since fixed index annuities offer the opportunity for greater returns than bonds, while protecting you from the risk of loss, it makes sense to make annuities a third leg of the asset allocation stool.  And based on elevated risk in the stock and bond markets, now may be a great time to do it.

William Stroud is President of Lawyers Insurance and has managed the NC Bar Association Health Benefit Trust since its inception in 2002. For a quote from the NC Bar Association plan, contact Delores Hunter at dhunter@lawyersmutualnc.com or call us at 800-662-8843.  If you have other questions about our plan you can contact me at wstroud@lawyersmutualnc.com.