Protected vs. Growing: The Split Your Portfolio Actually Needs
When’s the last time you looked at your portfolio and felt genuinely confident it could weather a bad year? For many of us, the answer involves some version of, “Well, I’m diversified – stocks for growth, bonds for safety, so I should be fine.”
That’s the playbook we’ve all been handed, and for a long time, it worked. But 2022 broke the rules. Stocks and bonds both posted double-digit losses at the same time. The “safe” part of the plan turned out not to be so safe after all.
That gut-check sent researchers looking for a third option – one that doesn’t make you choose between growth and protection, but instead, blends the two. On an episode of the HerMoney Podcast, sponsored by LIMRA, we dug into that research with Dr. Wade Pfau, a fellow with LIMRA’s Retirement Income Institute and leading voice in retirement research, and Brad Pistole, President and CEO of the Ozarks Retirement Group and host of Safe Money Radio. Here’s what we learned.
2022: THE YEAR THAT “SAFE” WASN’T
You probably remember the sting, even if you didn’t quite understand why it happened: stocks and bonds losing money at the same time while interest rates climbed. “2022 really made advisors as well as clients and retirees stop and look, saying, ‘Hey, this stocks and bonds mixture didn’t work for me,'” recalls Pistole.
What brought about the difficulty? As Pfau explains, when interest rates rise, they increase the risk of stock and bond losses happening simultaneously. It’s uncommon – but not impossible. Which means it could happen again.
That 2022 scenario is what pushed Pfau to start researching whether “protection” should be an asset class of its own – right alongside stocks, bonds, and commodities. Asset classes, he explains, are pieces of the market that don’t all move in the same direction at once, which is exactly what makes diversifying across them valuable in the first place.
SO, WHAT COUNTS AS “PROTECTION”?
In Pfau’s research, “protection” largely means fixed index annuities – a type of structured annuity where the performance follows (though doesn’t mirror) stock market indexes. With these products, your principal is protected, so you don’t experience losses. The tradeoff is that if the index performs well, you don’t capture the full upside. Instead, you get a piece of it.
Pfau found that adding this kind of protected asset class into the mix can actually improve what’s called an investor’s efficient frontier – bringing about a better risk-adjusted return, not just a more conservative one.
“You have principal protection, unlike with bonds where you can have losses,” Pfau explains. “But on the upside, it can provide a competitive yield compared to other bonds, especially on an after-tax basis.”
Unlike a taxable bond, where you owe taxes on interest every year, a fixed index annuity also offers tax deferral. “You don’t pay taxes on those gains until you distribute them out of the contract,” he adds. “On an after-tax basis, fixed annuities can outperform bonds, and that creates an efficient frontier where you’re not giving up stocks or the stock market growth potential.”
OK, BUT WHAT’S THE RIGHT MIX?
When it comes to a stock-bond portfolio, we’ve all heard of the classic 60/40 split. But does that same ratio apply to stocks and protected income? Not exactly.
According to Pfau, it comes down to your actual goals, including how much spending you want supported by reliable income. As he points out, that “reliable income” bucket already includes Social Security and any pensions you may have – so the real question becomes, once you add those up, how much of a gap is left? That gap is what the annuity is designed to fill.
“It starts to vary person to person just based on how big of a gap there still is,” he adds. In other words, there’s no universal formula; it’s personal math.”
IF YOU’RE FOMO-PRONE, READ THIS
Markets have been on a historic run lately, so it’s fair if part of you is worried about locking your money up in something that could limit your upside (not to mention cause you some serious FOMO). How do you figure out the right balance?
One way to think of it is to consider annuities as a replacement for the money you have in fixed income or bonds – your stock component remains invested. That, he explains, could even set you up for more growth further down the line.
“If you first build a floor of reliable lifetime income, that may give you the comfort to then actually invest confidently on top of that for more discretionary goals so that you can maintain that stock allocation and over the long term potentially leave a much larger legacy at the end of your retirement after also supporting your spending goals more confidently,” Pfau says. Without that sort of protected income, many retirees feel a type of paralysis that prevents them from spending their money.
YOUR NEXT MOVE
If you’re thinking your portfolio could use more protection, start by asking your financial advisor whether they offer products that support guaranteed income. If they don’t – and you need to look elsewhere – proceed carefully.
“Be careful of just being sold something that may or may not fit your particular need and style,” Pistole cautions, adding that you’ll want to work with someone experienced in these specific products, not someone who’s just dabbling in them.
You’ll also want an advisor who understands that retirement investing isn’t the same game as pre-retirement investing. “There are a lot of advisors that are more investment managers, and they haven’t really made the link that the way you invest pre-retirement might be different from the way you want to invest post-retirement,” Pfau notes. “You want to find the advisor who understands the retirement income phase as well. It’s really important.”
Ready to take the next step? Get up to speed on annuity solutions that can help you build a more secure retirement by using this guide from LIMRA.