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Written by: Stephen Turer, Senior Vice President and Head of Insurance Solutions at Lincoln Financial Group
Stocks, bonds and cash — they've long been the classic building blocks of asset allocation. But with historic shocks to the bond market — and intertwined long-term implications for stocks — even the savviest wealth managers are concerned about the forecast for these portfolio stalwarts.
That's because we've been seeing a troubling trend in correlation between stock and bonds, along with deeper systemic challenges. As Forbes notes, “…the pain in the bond market is far beyond what many could have imagined…This decline in bond values has shattered the classic 60/40 portfolio and put tremendous pressure on leveraged borrowers.”
There are, of course, always an exotic array of alternatives, and that theme has intensified in 2023, with a scramble for obscure assets that “…can deliver differentiated sources of return relative to traditional stock and bond investments…[since] correlation between the two asset classes may stay elevated.”
As you can imagine, most of the sophisticated solutions proposed require a level of risk and hands-on tactical management that is beyond the scope of your typical American investor who is just aiming for a comfortable retirement and a legacy for the kids.
How can regular American investors weather the storm?
Since our founding in 1905, we at Lincoln Financial Group have been dedicated to protecting investors and families from the sometimes-dramatic movements of the market and ensuring that our clients have the confidence to build a long-term plan with their financial professional and stick with it, no matter what they are seeing in the headlines.
And we are still looking out for your clients today, with tailored plans for risk management so they can take on the coming challenges that make volatility even more problematic — things that traditional portfolio theory doesn't account for, like longevity risk and sequence of returns risk while taking income. Investors who are more confident are more likely to stick to their plan.
Volatility — a tradeable asset class?
Of course, volatility in itself isn't bad — for savvy investors, it can offer many opportunities. The trick is in harnessing its power. It's interesting to note that volatility is being positioned as an asset class of its own by some commentators. Most recently, it was touched on in Barron's this past summer:
“It's quite likely that your portfolio contains an asset that you aren't managing to the fullest. That asset is volatility. Until recently, I didn't believe that volatility was indeed an asset … But we now have a range of tools that allow us to invest in, trade, or hedge the market's omnipresent volatility.”
The article brings to mind another discussion currently taking place in the marketplace of financial ideas. If volatility can be thought of as an asset class, can protection from volatility also be an asset class? The idea merits some consideration.
Considering protection from volatility as an asset class
In June of 2023, Wade Pfau published an article for the Retirement Income Institute titled “Protection as an Asset Class.” Pfau takes a close look at structured annuities — both in the accumulation phase and the income phase — through the lens of modern portfolio theory. He demonstrates that portfolios containing a sleeve of structured annuities may deliver a more efficient frontier than portfolios constrained to just stocks and bonds, potentially delivering higher returns and less volatility.
As Pfau explains, “The emergence of structured annuities provides a new direction for protection by changing the relationship between downside market risks and upside growth potential when investing. In either context, it now is possible to frame an annuity, or the protections it provides, as an asset class for households to help manage market risks and the risk of outliving assets.”
The structured annuities were particularly effective at delivering an efficient frontier when functioning as a bond alternative with a better return-to-risk tradeoff. For very conservative investors, replacing some equities with protected assets also offers a good return potential.1
The biggest problem is, when faced with the challenge of lifetime income — taken over an unknown number of years and at the mercy of an unknown sequence of returns — modern portfolio theory (MPT) effectively breaks down. Pfau notes, “That relationship is more complicated when it is unknown how long the spending must last and when taking distributions from assets amplifies the impacts of investment volatility on the retirement income plan. Simply, MPT does not account for cash flows or longevity risk.”
David Blanchett also has an interesting analysis in Advisor Perspectives on how protected assets, specifically dual-directional strategies, improve portfolio efficiency as well. He concludes by pointing out that “both types of RILAs (traditional and dual-directional) have the potential to improve portfolio efficiency, although allocations to dual-directional RILAs were greater and they resulted in greater risk-adjusted returns than traditional counterparts, likely due to the diversification benefits of the approach.”
Both of these articles make a strong mathematical case for protection in portfolios, but there is also a strong case to be made from an investor psychology standpoint as well.
Creating resilient portfolios — and confident investors — with protected strategies
Volatility is a fact of life when it comes to investing, especially over the past few years. It's tough enough to navigate the rate, volatility, and inflation risks that are disrupting portfolios. But managing deep client anxiety that results from this volatility is a matter that merits serious consideration as well.
As our friends at Capital Group explain, you have to consider both the math and the psychology: “Volatile periods…can result in emotional distress and may lead investors to succumb to decision-reversal risk, potentially abandoning their chosen investment program at precisely the wrong time — that is, at the point of maximum loss. But losses hurt mathematically as well as psychologically.” They can have a serious negative effect on an investment's long-term growth due to an effect known as volatility drag.”
Basically, to get back to par after a loss, you need an exponential amount of gain. If you have $100,000 and have a 50% loss, and your account falls to $50,000, you need a 100% gain to break even. A 50% gain would just leave you with $75,000. With wave after wave of volatility eroding your asset, it's very difficult to generate the returns you need unless you protect your asset from erosion in the first place.
When your bottom line is protected by structured assets, volatility drag is mitigated — your client doesn't have to worry about doubling their results just to get back to the baseline. And in some cases, such as dual direction strategies, they can continue to grow in the face of adversity. How many products out there guarantee you positive returns in a down market? It's a powerful component of a portfolio.
And just as importantly, it keeps your clients focused, because they know their retirement income has a layer of protection.
Our strategies allow you and your clients to dial their portfolio in to a particular risk tolerance that you can't get with raw stock, bonds and cash. You have access to dozens if not hundreds of combinations to finely tune a tailored portfolio risk management. Risk tolerance is a very personal, and not always rational, decision. You know what's generally best for your client is to benefit from equity growth for the long term. But people have an internal panic button that essentially tells them to “break glass in case of emergency.”
As my colleague Henry Cheng, FSA, MAAA, notes, “Protected annuities, especially with dual direction strategies, are a great addition to retirement planning. They can enhance risk-reward profile of traditional investment portfolios, reduce sequence of return risks for decumulation, and perhaps most importantly for some, provide a peace of mind that help stay the course through topsy-turvy markets.“
A layer of protection helps give investors the fortitude to stay on course with their plan. We strive to help ensure better mathematical results, and more confidence. That's the power of resilience.
To read other blog content like this, visit Lincoln's informed financial professional blog.
Related: The Costly Consequences of Blank Beneficiary Forms With Chris Price
1 Naturally, there have been some questions around Pfau's conclusions, most notably Alan Roth's critical, but thoughtful, response in Advisor Perspectives. Roth challenged the bond assumptions and concerns not addressed in Pfau's article, while not dismissing protection as an asset class.
Investing involves risk including the risk of loss of principal. Asset allocation and diversification cannot guarantee a profit nor protect again loss.
Any strategies discussed in this publication are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. The information is not intended to provide investment advice. The information included in this publication has been developed using industry sources deemed reliable. Any opinions expressed in this publication reflect a judgment at this date and are subject to change.
Lincoln annuities are issued by The Lincoln National Life Insurance Company, Fort Wayne, IN, and distributed by Lincoln Financial Distributors, Inc., a broker-dealer. The Lincoln National Life Insurance Company does not solicit business in the state of New York, nor is it authorized to do so. Contractual obligations are subject to the claims-paying ability of The Lincoln National Life Insurance Company.
Contracts sold in New York are issued by Lincoln Life & Annuity Company of New York, Syracuse, NY, and distributed by Lincoln Financial Distributors, Inc., a broker-dealer. Contractual obligations are subject to the claims-paying ability of Lincoln Life & Annuity Company of New York.