Grow and protect retirement principal
Two strategies for cautious investors to help balance growth with protection of principal.
- FIDELITY VIEWPOINTS
- – 08/25/2015
Fear of loss is a powerful motivator, as the recent market selloff reminded us. But fear like greed is a dangerous sentiment for investors. In the wake of the financial crisis, many clung to the seeming safety of cash, only to miss out on a six-year bull rally. Beware of letting nervousness over the current volatility derail your long-term investment plan
“Money and investing are very emotional things,” says Tim Gannon, vice president of product management at Fidelity Investments Life Insurance Company. “Many people tend to approach investing the way they approach other personal and emotional parts of their lives—they try to protect themselves from potential loss.”
Excessive fear of loss—which behavioral economists call loss aversion—causes many investors to act counterproductively. For example, many investors who fled the markets during the worst of the 2008—2009 bear market still haven’t fully reinvested,3 so they missed most of the current six-year bull market. “There is a segment of the investor population that would like to hold stocks, and who need that growth potential, but are too afraid to take that step,” explains Tom Ewanich, vice president and actuary at Fidelity Investments Life Insurance Company. “They are afraid of the consequences of losing their money in a down market.”
It’s natural to want to protect yourself from loss. That said, most investors need exposure to certain asset classes, like stocks, for investment growth. A diversified portfolio of different asset classes—stocks, bonds, cash—is a time-tested approach to providing growth potential while managing volatility. But given the combination of volatility in both the stock and bond markets, some investors have instead opted for the sidelines to protect their investments. Fortunately, you don’t have to treat growth and protection as mutually exclusive. Certain strategies can help you benefit from market gains, while protecting you on the downside.
The fiction of market timing
Equities are volatile by nature. During the 10 years ending December 31, 2014, the S&P 500 lost 1% or more in about one out of every seven trading days.4 Avoiding the down days would be a great strategy. Trouble is, it’s highly unlikely. No one ever has successfully and consistently predicted stock market returns. In fact, the strategy of jumping in and out of the market, known as market timing, is one of the main reasons the average equity investor underperformed the S&P 500 by 4.2 percentage points per year over the past 20 years.5 Investors trying to time the market typically sell after their investments have lost money, and buy only after stocks have recovered—selling low and buying high.
Avoiding stocks altogether has major drawbacks, too. Stocks provide the potential growth nearly every long-term investor needs to stay ahead of inflation. With life expectancies on the rise, most retirement-focused investors have longer time horizons than they think—even after they enter retirement.
Cautious investors with long-term saving goals—those who will not need to access a portion of their assets for five to 10 years—may benefit from strategies that allow them to protect principal while exposing some of their assets to the stock market’s growth potential. If you fit that description, consider the following strategies: the anchor strategy or the protected accumulation strategy.
Anchor strategy
An anchor strategy involves dividing your portfolio into two parts, a conservative anchor and more growth-oriented investments. The anchor portion of your portfolio uses investments that offer a small return, such as certificates of deposit (CDs) or single-premium deferred annuities (SPDAs). These assets have a set lifespan, and the amount you invest is designed to grow back with interest on your original principal. This portion of your portfolio acts as your anchor, while your remaining assets are invested in more volatile, growth-oriented securities such as stock mutual funds or ETFs.
A true anchor strategy protects your entire starting principal. For example, say you have $100,000 in assets and a five-year investment period. You could invest $90,000 in a five-year CD yielding 2.25%. When that CD matures it will be worth $100,591—more or less your original principal—leaving you free to invest the remaining $10,000 in stocks without risking any of your principal. “The anchor strategy can remove the negative outcomes cautious investors fear,” Ewanich says. “Even if the markets fall, your anchor makes sure you at least have what you started out with. Keep in mind, though, that inflation can erode the purchasing power of your original investment over time and that this strategy generates taxes each year in a taxable account.”
Gannon points out, “Interest rates are so low today that you will either need to commit more to the anchor portion of your plan or go with longer-duration products to get a higher yield.” In higher interest rate environments, the anchor strategy might become a more attractive option.
Protected accumulation strategy
The protected accumulation strategy takes advantage of principal protection features—commonly referred to as guaranteed minimum accumulation benefit (GMAB) riders—on variable annuities. Your assets are invested in a portfolio that typically has a larger equity position than the 10% stake outlined in the anchor strategy above. For a fee, the GMAB rider guarantees that at the end of the annuity’s investment period—typically 10 years—you’ll have at least the same asset value you started with. The main benefit over the anchor strategy is that more of your assets are likely to be exposed to growth. Based on current market conditions, you might have equity stocks represent 10--15% of your anchor strategy, compared with the GMAB holding 60% or more in equities. “The GMAB doesn’t guarantee growth but it provides a way for you to expose more of your assets to real growth potential,” Gannon says. Recognize that a similar investment portfolio held outside the annuity would have higher returns in up markets without the cost of the guarantee, though you would sacrifice the protection (see chart below).
Another potential benefit is that most GMAB riders let you reset the level of principal protection each year if your investments have grown in value. If you do lock in a higher balance, the investment period resets and your balance is guaranteed for another 10 years. It is possible that your fee may increase if you elect this option and annuity features will vary by the issuing company.
For example, say you originally invested $100,000 in a variable annuity with a GMAB rider. After the first year, the annuity’s underlying investments grew to a value of $105,000. Locking in that new balance guaranteed that you would have at least $105,000, regardless of how the markets performed after a new 10-year period. If the underlying investments lost value in that first year, you could be comforted by the knowledge that your original $100,000 was guaranteed.
Making a choice
Determining which strategy may make more sense for you will depend on a number of factors, including your investing goal, fees on your investments, your time horizon, and your tolerance for risk. First consider if you might be better off investing in a diversified portfolio, because either of these strategies (anchor or protected accumulation) may limit your upside growth potential—and the diversified portfolio may offer a greater long-term benefit. But for those who are just not comfortable exposing their investments to stocks without some kind of loss protection, one of these approaches might be worth considering.
You also need to consider when you will need access to these assets, because both strategies might penalize early withdrawals. For instance, redeeming a CD before it matures typically means forfeiting some or all of the interest earned, while variable annuities may levy a surrender charge representing a percentage of the account value. So if your goal is less than 10 years away, the protected accumulation strategy is not a good fit. “You want to make sure you invest only the money you need for that specific goal,” Ewanich says.
The anchor strategy is generally considered the more conservative of the two strategies, as it has less potential for growth than the protected accumulation strategy. That said, investors who are more comfortable with some volatility in their portfolio could adapt the anchor strategy by protecting only a portion of their principal. That approach would free up more assets for growth in the equity portion of the strategy in exchange for a lesser degree of principal protection.
Also consider the cost of each plan. You can assemble a very low-cost combination of CDs and stock funds. However, the protected accumulation strategy can carry fees of more than 2.5% annually, which will lessen the potential return on your investments. While both strategies are designed to protect principal, that principal will lose purchasing power over the applicable investment horizon.
The decision may well come down to your investor personality. With your principal protected from loss, would you gain the confidence to invest more aggressively than you are today? The protected accumulation strategy requires little action from you aside from your initial investment and an annual decision whether to lock in any growth. The anchor strategy requires that you invest the assets that are left over after establishing your anchor. Those may or may not be decisions you’re interested in making. “All these factors hit on the same point,” Gannon says. “What kind of investor are you? What are you going to be most comfortable with? And, most importantly, what will let you sleep better at night?”
1. S&P Dow Jones Indices; three-year average annual return through April 2, 2015.
2. Strategic Insight Simfund Federal Reserve Bank.
3. The New York Times, May 2012.
4. S&P Dow Jones Indices.
5. DALBAR2014.
Posts
