Investing in Tax-Deferred Long-Term Bonds without Interest Rate Risk through the Use of No-Commission Annuities

February 17, 2022

Original article published at Advisor Perspectives

In a low-yield and rising interest rate environment, advisors need to use financial planning tools like no-commission annuities to improve after-tax, after-advisory fee bond returns.

A large bond allocation has long been the staple diversification tool for advisors to hedge market risk in their equity portfolios – especially for clients nearing retirement. In high-yield environments, this is an excellent tool. Advisors can either hold the bonds to maturity and benefit from the high fixed income yield, or they can sell the bonds as yields decrease, thereby allowing for capital appreciation on the assets. In a high-yield environment, bonds are great assets by themselves, independent of the diversification benefits they provide.

But in a low-yield environment, the value proposition is the opposite.

Low yields don’t justify the AUM fees advisors charge on them. Furthermore, the high ordinary income taxes owed on bond gains makes the net, after-tax, after-advisory fee yields for the client abysmal – particularly if this client is the ideal HNW client in a high tax bracket. In the low-yield environment we’re in, after the client pays taxes and fees, he or she makes significantly less for owning the asset and taking all the interest, credit, and liquidity risk than the RIA earns for managing them.

Net After-Tax, After-Advisory Fee Client Bond Returns vs RIA AUM fees

Gross Bond YieldClient Tax-Rate on Bond GainsClient After-Tax Bond Yield (Before RIA Fee)RIA AUM feeClient After-Tax, After-Advisory Fee Bond Yield
2%50%1.00%0.75%0.25%

Example of After-Tax, After-Advisory Fee Client Bond Yields vs RIA AUM fees:

In a low-yield environment, RIAs are making 3-5 times more money managing clients’ bond assets than the clients are actually making owning the assets and taking all the interest, credit, and liquidity risk.

As a result of this low-yield, high tax-rate dynamic, clients have a better chance of meeting their retirement goals (and passing more money to the next generation at death) using a 100% equity strategy than a 60% equity/40% bond strategy.

Chance of HNW client meeting 4% withdrawal rate in retirement at different Equity/Bond allocations

Equity/Bond Portfolio CompositionSuccessful Monte Carlo SimulationsMedian After-Tax, After-Advisory Fee IRR of all SimulationsMedian After-Tax, After-Advisory Fee Portfolio Value of Successful Simulations at Death
100%:0%42%2.65%$3,119,150
80%:20%32%2.18%$1,895,766
60%:40%21%1.63%$1,311,808

Meeting 4% withdrawal rate in retirement at different Equity/Bond portfolio allocations:

For HNW clients, large bond allocations actually decrease their chance of meeting their retirement goals due to the low yields and heavy taxation on bond portfolios in this low-yield environment.

Modeling assumptions:

  • Married, 65 year old couple, $5M investable assets
  • Equity Portfolio: 8% mean IRR, 15% standard deviation
  • Bond Portfolio: 2% mean IRR, 3% standard deviation
  • Taxes: Long-Term Capital Gains (37%), Ordinary Income (50%)
  • Advisory Fee: 0.75% of AUM

Retirement solutions

What strategy addresses the high taxes and lack of diversification that bonds pose in a low-yield environment?

One strategy is asset location, which is to put all of the client’s bonds and tax-inefficient equity strategies into retirement funds like 401(k)s or traditional/Roth IRAs. Retirement accounts allow for two key benefits for advisors and their clients on the bond portion of client portfolios:

  1. Earnings grow tax-deferred or tax-free.
  2. Advisors can charge fees on a pre-tax basis instead of on an after-tax basis, thereby reducing the tax liability of client and increasing the client’s after-tax return.

As the table below shows, an advisor charging an AUM fee on client bond portfolios on a pre-tax basis can more than double the client’s net after-tax, after-advisory fee return in this low-yield environment!

Reduction in client tax liability from RIA charging its fee on a pre-tax basis

(A)(B)(C) = (A) – (B)(D)(E) = (1 – (D)) * (C)(F)(G) = (E) – (F)
Gross Bond YieldPre-Tax AUM feeTaxable Gain on Bond YieldTax-Rate on Taxable Bond YieldClient After-Tax Bond YieldAfter-Tax RIA AUM feeClient After-Tax, After-Advisory Fee Bond Yield
2.00%0.00%2.00%50.00%1.00%0.75%0.25%
2.00%0.75%1.25%50.00%0.63%0.00%0.63%

Charging RIA fee on a pre-tax basis reduces client taxes and improves after-tax bond returns:

The ability to simply charge its fee on a pre-tax basis allows RIAs the ability to more than double after-tax, after advisory bond yields for clients in this low-yield environment.

Unfortunately for HNW clients, they are often limited by their high-income from contributing to these tax-beneficial retirement plans which can improve after-tax bond gains. A workaround for such HNW clients is to use no-commission fixed and indexed annuities to invest millions of dollars into a vehicle that allows the same tax-deferral and pre-tax advisory fee benefits as a traditional IRA with the added bonus of interest-rate risk protection. The interest-rate protection allows for annuities to achieve higher yields than short-term bonds without the interest rate risk associated with long-term bonds. This is particularly valuable in this low-yield environment.

As I’ll show below, clients would be better off having their financial advisor allocate their bond assets to a no-commission annuity and have their advisor charge their AUM fee on the assets than to have that same advisor allocate their bond portfolios to short- or intermediate-term bonds directly. Fixed indexed annuities offer even higher returns by providing equity-linked returns without the full volatility of equity market investing.

However, most advisors have a strong aversion to annuities because of poor experiences with past products that paid agents high commissions and left limited benefit to the client.

Most advisors don’t realize that, at their core, fixed and indexed annuities are investments in tax-deferred investment-grade long-term bonds that provide clients protection against interest rate risk. In exchange for providing these tax-deferral benefits and interest-rate protection, life insurance companies that issue annuities earn a spread on what those long-term bonds are earning versus what they credit to policy owners. When you remove the high-upfront commissions on these products, the after-tax return clients achieve by using these annuities is notably higher than what they would earn by investing in the bonds directly.

Even the pre-tax payout rates of these annuities are highly competitive with pre-tax yields of the underlying bonds as the table below shows.

Current Yields of Bond Indices vs Annuities (5/3/2022)

AssetCurrent Pre-Tax Yield-to-MaturityIndexed Annuity Cap on S&P 500
AGG (Intermediate Term Bond Index)3.51%N/A
IGLB (Long Term Bond Index)4.95%N/A
Commissionable Fixed Annuity2.85%6.10%
No-Commission Fixed Annuity3.50%7.65%
No-Commission 5 Year MYGA
(Multi-Year Guaranteed Annuity)
4.00%N/A

Pre-tax yields of bond indices vs payout rates for annuities as of 5/03/2022:

The above table compares the current yields-to-maturities on two well-known bond indices with a commissionable fixed annuity, no-commission fixed annuity, and a no-commission 5 year multi-year guaranteed annuity (MYGA) from the same company.

Sources: Annuity Rate Watch, iShares

The table above highlights a number of important points:

1. The intermediate-term AGG bond index has a lower yield than its longer-term IGLB counterpart.

However, while advisors can achieve a higher yield by investing in longer-term bonds, they are also taking more interest rate risk. If interest rates rise over the time their clients are holding the bonds and they try and exit the investment, their clients will lose part of their principal. Given the Federal Reserve’s indication that they plan to increase interest rates in 2022 to fight off inflation, this is a real concern.

For this reason, advisors increasingly allocate clients to lower yielding, shorter term bond funds over longer ones.

Loss in Price of Bonds After a 1% Increase in Rates

Bond Term (Years)Immediate Loss of Market Value of Bond Prices on 1% Increase in Rates from 2% to 3%Years of investing at higher coupon rate (3%) to recoup initial upfront loss in valueYears of investing at higher coupon rate (3%) to get back to original 2% yield
10-8.53%410
20-14.88%617
30-19.60%823

In a low-yield environment, bond prices are increasingly sensitive to an increase in the interest rate. Longer term bonds are more sensitive than shorter term bonds. If a client is currently invested in 2% yielding bonds and rates increase by 1%, it could take years to recoup the initial upfront loss and over a decade to get back to the original yield they were expecting to earn before the increase in interest rates.

2. No-commission MYGAs have higher pre-tax payout rates than the AGG and lower long-term payout rates than the IGLB.

This makes sense given that the insurance company is investing in long-term bonds and taking the interest rate risk in exchange for a spread on the assets they are earning versus the interest they are crediting to the client. The client won’t get a pre-tax yield as high as investing in long-term bonds directly, but they will be saved from the interest rate risk involved from investing in long-term bonds. The pre-tax payout rates of both annuities are higher than the intermediate-term AGG bond fund that advisors would have invested in directly to avoid the interest rate risk of the long-term bond fund.

3. The no-commission annuity had higher pre-tax payout rate and a higher cap on the index than the commissionable product from the same company.

As mentioned previously, by removing the upfront commission paid to an insurance agent, the insurance company is able to provide a much better product to the client. The client is better off having their financial advisor invest in the no-commission annuity as opposed to that advisor allocating that client to an intermediate-term bond index like the AGG.

While the client could achieve higher yields from investing in long-term bonds directly, they would also be taking the full interest rate risk of those bonds.

4. Fixed Indexed Annuities (FIAs) allow higher returns than bond strategies or fixed annuities and less volatility than equity strategies by providing a floor and a cap on the returns of an equity index.

A fixed indexed annuity (FIA) allows for an investor to receive a return based on an equity index subject to a floor on the downside (usually 0%) and a cap on the upside. As an example, by looking at the no-commission annuity in the table above, if the S&P 500 index return is greater than or equal to 6.25%, the investor will only receive 6.25%. However, if the S&P 500 has negative returns, the client’s return is floored at 0% so that they don’t absorb a loss.

FIAs allow clients that would otherwise invest in short-term bonds to achieve higher returns by investing in the equity markets without the full volatility of equity investing since it provides downside protection.

Is investing in an equity index with a floor and cap better over 5-7 years better than just taking a fixed return? While the answer depends on the assumptions of the underlying equity index over that time period, we can simulate the results through Monte Carlo simulations to see the potential added value. As the table below shows, an indexed annuity offers the potential for significantly higher after-tax returns even when the mean return of the underlying index is negative.

After-tax returns of Fixed Indexed Annuity at different underlying mean return expectations

Investment AssumptionMedian After-Tax ReturnStandard ErrorSharpe Ratio
FIA with 8% mean return2.07%0.60%1.37
FIA with 6% mean return1.85%0.58%1.04
FIA with -1.5% mean return1.25%0.56%0.00
Fixed 2.5% gross return1.25%0.00%N/A

The above table compares the after-tax simulation results of a fixed indexed annuity based on an underlying equity index with different mean return assumptions. As the above table shows, even an FIA with a negative underlying mean return assumption outperforms the fixed annuity’s 2.5% gross return on an after-tax basis. Investors in the FIA are able to benefit from the volatility of the underlying index while being protected from the downside through the floor.

Assumptions:

1000 Monte Carlo Simulations
Equity standard deviation of 15%
Fixed annuity standard deviation of 0%
7-year investment period
Tax-deferred ordinary income taxation of 50%

Investors in fixed indexed annuities often fear that the underlying index will underperform or that the caps on those indices will be lowered. However, as the above table shows, the current low yield environment allows for a great risk-adjusted opportunity to capture the benefits of the upside of an equity index while being protected from the downside even if the underlying index were to underperform.

As we’ll discuss in more depth in our article on indexed universal life, choosing to allocate assets to this type of floored and capped equity strategy in combination with the tax-deferral advantages can lead to significantly risk-adjusted after-tax returns than investing directly in bonds—particularly in a rising interest rate environment. For those not aware, annuities afford clients the ability to continually defer taxes on the gains by rolling over the gains from one annuity into another annuity via a 1035 exchange. By waiting until the surrender charge period ends, clients can continually defer gains on their bond investments until they retire and are in a lower tax bracket. All this can be done without exposing clients to interest rate risk. This is something that is not possible by investing in bonds directly via a taxable account.

5. The 5 year Multi-Year Guaranteed Annuity (MYGA) offers the opportunity to lock-in the highest yield.

As seen in the table of annuity rates above, the no-commission multi-year guaranteed annuity (MYGA) offers the highest yield. In fact, the 5 year MYGA yield of 4.00% is only 95 basis points less than the long-term bond (ILGB) yield of 4.95%. By locking in the 5 year yield of the no-commission MYGA, the client gets a significantly higher yield than the no-commission annuity (3.5%) which only locks the yield for 1 year at a time.

It’s worthwhile noting that in a rising interest rate environment, the later year yields of the no-commission annuity may be higher than the 5 year locked in rate of the no-commission MYGA. However, the higher later yields most likely won’t make up for the loss of yield in the early years that the MYGA would provide. Furthermore, clients always have the ability of withdrawing up to 10% of the annuity each year without a surrender charge. Therefore in a rising interest rate environment, clients can take 10% of the annuity out without penalty or absorbing interest rate risk losses and invest in higher earning annuities as rates rise.

For fee-only RIAs considering no-commission annuities or MYGAs, it’s important to note that the no-commission annuity allows the RIA to deduct its fee from within the product (thereby reducing the taxable gain), but the no-commission annuity does not. Any withdrawal from a MYGA to pay advisory fees is considered a taxable distribution. So while the MYGA may be better for the client, it may not be so operationally efficient for the advisor.

5. The client is better off investing in bonds through a high-commission annuity and paying a one-time upfront commission than investing in the AGG through an advisor and paying an ongoing AUM fee.

For advisors who critique annuities as not being in the best interests of the client, the above table shows that the commissionable annuity has a yield that is only 0.66% less than the AGG. Advisor fee on assets is typically higher than 0.66%. So if a fee-only advisor allocates client assets to the AGG and then proceeds to charge their full fee on the assets, clients would get a lower pre-tax yield than if the client were to just purchase a commissionable annuity instead of going through a financial advisor. And the an AGG allocation still exposes the client to interest rate risk in a rising interest rate environment.

Therefore the client is better off purchasing a highly commissionable annuity as a vehicle to invest in bonds and paying a one-time high upfront commission than they are hiring a fiduciary advisor to invest those assets in a low-yielding bond index to reduce interest rate risk while charging a high ongoing AUM fee relative to low-yielding assets.

Conclusion

No-commission annuities offer clients the ability to achieve better after-tax, after-advisory fee solutions than current bond strategies. Furthermore, annuities are clearly products that clients want. Over $250 billion dollars was invested in fixed and indexed annuities in 2021 alone. This is potential AUM that these advisors are missing out on.

The problem is that most fixed and indexed annuities are the high-commission ones that have lower payout rates and index caps. If fiduciary advisors truly understood how to utilize no-commission annuities, they would be able to provide better retirement products and risk-adjusted, after-tax, after-advisory fee portfolio solutions to their clients and grab a larger portion of this market share they’re missing out on.

If advisors don’t start implementing better after-tax, after-advisory fee solutions for clients’ bond portfolios, clients will quickly do the math and do one of two things:

  1. Just let advisors manage the equity portion of the portfolio and stick the bond portion of the portfolio in a low-cost bond index fund themselves to avoid paying the advisor’s fee on this portion for limited value they receive in return.
  2. Take all of their assets to an advisor that is implementing better after-tax, after-advisory fee solutions for them for their entire portfolio.

1 LIMRA.

Rajiv Rebello

Rajiv Rebello

Author

Rajiv Rebello, FSA, CERA is the Principal and Chief Actuary of Colva Actuarial Services and Colva Capital. Colva helps family offices, RIAs, and high net worth individuals create better after-tax and risk-adjusted portfolio solutions through the use of life insurance vehicles and low-correlation alternative assets. He can be reached at [email protected].

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