An Annuity lowers portfolio volatility thereby improving the risk/return profile of the Efficient Frontier.
The Efficient Frontier (EF) is the envelop of optimal portfolios that provide the best risk-reward tradeoffs. A more detailed view is presented in our blog “Efficient Frontier and Diversification.” Adding an Annuity to a portfolio moves the EF to the left towards a less risky profile. The cashflow from lifetime income, guaranteed by the contract, lowers the overall portfolio volatility.
In the Ibbotosn’s analysis, the right curve is the traditional equity/bond portfolios in different proportions. It depicts risk on the horizontal axis and return on the vertical axis. The left curve includes portfolios with a FIA (Fixed Index Annuity) added to the mix. Besides reducing the risk, the portfolios on the left curve also provide better performance. Compare the position of the 20/80 equity/bond portfolio to 12/48/40 equity/bond/FIA (or the one with a 20% equity) portfolio. The portfolio on the left curve provides a slightly higher performance but at a much lower risk for the same equity portion.
The Pfau’s analysis makes the same point through a modified version of the EF. The horizontal axis is the likelihood of sustaining a retirement income that is 4% of the asset value at retirement. The vertical axis is the asset value at death as a percentage of the asset value at retirement. The left curve includes stock/bond portfolios and the right curve includes stock/FIA portfolios. The top-left portfolio is all equity and the bottom one is all bond or FIA.
The all-equity portfolio provides the largest legacy due to higher returns but also has the lowest probability of meeting the retirement income need because of high volatility. For the left curve, a 50/50 stock/bond portfolio provides the best likelihood of meeting retirement needs while leaving behind 40% of the asset. When comparing portfolios with the same equity portions between the two curves, the stock/FIA portfolios provide a slightly better performance (leaving behind a larger legacy) and a much smaller risk profile (higher likelihood of meeting retirement needs) than the stock/bond portfolios.
Both industry research studies arrive at the same conclusion: adding an Annuity improves the risk-reward profile of a portfolio. To better understand a FIA investment, please read our blogs “How An Annuity Works” and “Annuity Benefits.”
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