Time to Add Some Protection to My Retirement Portfolio by Scott Stolz, CFP, RICP (week 14)

It’s not hard to find negative headlines these days. The casualties in Ukraine and the Gaza strip continue to mount. Here at home, mass shootings at schools and churches are becoming regular events. A trip to the grocery store that results in a cost of less than $100 is now a rare occasion. In the financial world, tariffs continue to create uncertainty, and the economy is clearly slowing. And now we are on the verge of a government shutdown. Despite all of this, the stock market continues to hit one high after another. In the 1950’s, financial journalist Sylivia Porter, famously said that the “stock market climbs a wall of worry.” That is certainly true today. While I’ve seen this phrase become reality many times in my lifetime, as a retiree, today’s environment gives me pause. It’s one thing if the market falls and you have plenty of working years left to wait for stock prices to recover. It’s another thing altogether when that regular paycheck has stopped and you’re relying on your retirement portfolio to sustain your lifestyle. Therefore, I decided it made sense to add some downside protection to my portfolio.

My chosen solution was to buy a Brighthouse Shield Registered Index Linked Annuity (RILA) with some of the funds in my IRA. If you watch professional golf, you have likely seen the Brighthouse ads for this type of annuity. If so and you’ve wondered “what is this Shield thing?”, keep reading. I can already hear the annuity critics. Why buy a tax deferred annuity in a tax-deferred account such as an IRA? The answer is simple. I didn’t buy the annuity for the tax deferral. I bought it as a means to get most of the returns of the stock market while still adding downside protection.

Before I go any further, I should provide some details about RILAs for those that are not familiar with this form of annuity. A RILA provides returns tied to a stock index such as the S&P 500. More importantly (for me), it also absorbs some of the losses if that stock index falls in value, thereby providing downside protection. When purchasing a RILA, you need to make the following choices:

1. The stock index that will be used to calculate your return

2. How long of a time period do you want to select before the final interest is calculated – typically 1, 3, 5 or 6 years

3. How much downside protection you want

4. How much potential upside you want to get based on both the index and the downside protection you selected

I should also note that there are numerous options for each of the 4 choices, therefore a RILA can offer a dizzying number of potential options. For example, the Shield annuity I bought has a total of 64 different combinations.

What I Chose

I chose the following 2 options:

1. 6-year term on the S&P 500 with 15% downside protection (buffer) and a 175% cap on the earnings

2. 6-year term on the Russell 2000 with 10% downside protection (buffer) and a 130% cap on the earnings

Let’s look at how each of these works. On my date of purchase the price of the S&P 500 was 6,339. Six years from that date, Brighthouse will look at the price of the S&P 500. If the price is higher, I will get the percentage difference up to a gain of 175%. For example, let’s say the S&P 500 is 8,500 – an increase of 34%. Because the return is below the 175% cap, I will earn the entire 34%. Therefore, that $75,000 segment would be worth $100,567. If the S&P 500 increases in price to 17,432 or higher – a change of 175% or more - then my return is limited to “just” 175%. Needless to say, I would be thrilled with such a return. Who wouldn’t be? But I’m not expecting that. Remember, I’m essentially trading off potential upside for protection should the market fall in price over the next 6 years.

So, what if the index does fall in value? That’s where the protection from the buffer comes into play. As long as the price of the index is not down by more than 15% six years from now, I would not suffer a loss. I would still have my full $75,000. If the index price falls 20% to 5071, I will incur a 5% loss – the percentage change above the buffer. Brighthouse absorbs the additional losses. In this situation, my $75,000 investment in this segment would be worth $71,250.

The $75,000 I put into the segment tied to the Russell 2000 would work the same way. The only difference is that only 10% of the downside is protected rather than 15%. And the most I can earn is 130% rather than 175%.

At this point, I should mention that the returns are calculated only based on the actual price of the indexes I chose. Any dividends paid on the stocks in the index are not included in the earnings calculation.

Why I Chose The 6-Year S&P 500 Segment with the 175% Cap and 15% Buffer

There are pros and cons for each of the 64 different options available in the contract. I’m not trying to make the case that my two choices are better than the others. I chose those two because I believe they match best with my financial goals as well as my risk/reward profile.

I chose 6-year periods because the stock market goes up over time. Losses are always over shorter time periods. For example, while the stock market dropped almost 60% during the financial crises of 2007-09, it had fully recovered 6 years after it peaked on October 9, 2007. Therefore, since time is essentially a form of protection, I’m building in protection just by selecting a 6-year period rather than a 1- or 3-year period. Had a chosen a shorter time period, I would likely need more downside protection than just 15%.

If you run historical 6-year time periods on the S&P 500 through iCapital’s Index Strategy Backtesting tool, you learn that over the last 60 years, the price of the S&P 500 would have been lower 6 years later approximately 1 out of every 8 times. These are the periods I’m trying to protect against. By adding 15% downside protection, I would have protected myself against a loss in over 98% of all 6-year periods. Put another way, the S&P 500 had dropped in price by more than 15% during only one out of every fifty 6-year periods.

Why Only a 10% Buffer on the Russell 2000 Option?

First, given how the S&P 500 has come to be dominated by a handful of stocks, it made sense to me to diversify my investment by also choosing an alternate index. As for why the Russell 2000, I’m back to iCapital’s Index Strategy Backtesting tool to answer that question. The tool tells me that since the index was introduced in 1984, it has declined in price over a 6-year period only 2% of the time. Therefore, I concluded that I didn’t need more than 10% buffer on this index. Had I chosen the 15% buffer on this index, my cap would only be 90%. In this case, I concluded that the additional protection was not worth the potential upside I would be giving up.

Summary

Prior to buying this annuity, the money used to fund the annuity was invested directly in a S&P 500 ETF. That investment has performed very well over the last 5 years, but it provides no downside protection. In my lifetime I’ve experienced 3 significant drops in the stock market – the crash of October 1987 (down 20.5% in one day and 33% overall), the tech crash of 2000-2002 (down 49% on the S&P 500 and 83% on the NASDAQ-100) and the fore mentioned financial crises of 2007-09. Who knows when the next crash will be? Hopefully, it’s still years away. However, I will note that it’s now been 16 years since the last one. While I know that stocks have always recovered, now that I’m 65 and retired, I simply don’t want to take a chance that my retirement portfolio will take a significant hit. I want some downside protection. And in my view, that’s exactly what a Registered Indexed Linked Annuity delivers – upside potential with downside protection.

A Few Final Thoughts on the Purchase Process

I elected to buy my Shield annuity through Charles Schwab. After spending most of my career focused on the annuity purchase process within the Bank and Broker/Dealer community, I was curious to see how a firm like Schwab was going to handle this order. After all, I had already chosen the product from their list of available annuities. No one had to sell me anything, and no one at Schwab was going to earn a commission on the sale. Since Schwab was not soliciting the sale and had no conflict of interest as a result of the transaction, I had some expectations that the suitability aspect of the sale should be somewhat minimal. However, since the industry still works from outdated annuity suitability guidelines, I was prepared for a lengthy and complex purchase process. I was pleasantly surprised to find that this was not the case. The Schwab annuity specialist asked me a few basic questions including “why are you interested in this particular annuity”. The questions were followed by some disclosures she read from a script. Once that was completed, she said my order was going to the annuity supervision team. Two days later my order was approved, and I received an electronic application that required just a single electronic signature. I electronically received the policy from Brighthouse the very next day. Overall, the process was amazingly simple and easy. Which is exactly how it should be for an annuity that pays no commission and therefore carries no conflict of interest.