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Annuities as an Asset Class for Fee-Based Advisors l 41 © Envestnet 2022 Finally, traditional risk aversion is the countervailing force for all of this, and this is the factor that may receive the most attention. Though the investment portfolio is a smaller portion of the overall asset base after some of it is sold to purchase the annuity, the retiree must still be comfortable with the greater short-term portfolio volatility that a more aggressive asset allocation will imply. Conceptually this is justified, as we have discussed. But the retiree must accept and understand these points to avoid the potential of panicking and not following the strategy during market downturns. An income annuity is still an asset even though it does not appear on the portfolio statement. To be effective, retirees should view the annuity as part of their bond holdings and adjust their portfolio accordingly. This is also an area where deferred annuities can help with the psychology behind holding annuities. If retirees cannot overcome the psychological hurdle to adopt a higher stock allocation after adding an annuity, the likely outcome will be a reduction in their overall allocation to stocks, which will undermine the effectiveness of a partial annuity strategy. To better make this case, we can also discuss why annuities are "bond" like in their characteristics. First, income annuities provide bond-like returns with an additional overlay of mortality credits. The insurance company providing the annuity is investing those funds primarily in a fixed-income portfolio. For someone wishing to spend at a rate beyond what the bond yield curve can support, bond investments will essentially ensure that the plan will fail. Income annuities are actuarial bonds. They provide longevity protection which is unavailable with traditional bonds. Income annuities are like a bond with a maturity date that is unknown in advance, but which is calibrated and hedged specifically to cover the amount of lifetime spending needed by retirees. Likewise, fixed index annuities that are linked to stock indices will also be more effective for those who treat them as part of their bonds. With principal protection, FIAs have less downside risk than either stocks or bonds. Bonds, of course, can experience capital losses when interest rates rise. But can enough upside be captured with the FIA to beat either stocks or bonds on a risk-adjusted basis? Though the interest they credit may be linked to a stock index, the returns on FIAs will be closer to bonds than to stocks. Owners should not think about FIAs as an alternative to owning stocks but rather as another option for fixed-income assets that protects principal and has the potential to outperform bonds when considered net of taxes and fees. With their principal protection, retirees may even consider increasing their stock allocation when replacing bonds with an FIA. The point is that FIAs provide returns comparable to bonds and can be treated as such even when linked to a stock index. For variable annuities, the discussion is more complex as these annuities allow for stock investments to be held in the subaccounts. But when providing for lifetime spending, the guaranteed living withdrawal benefit serves as a "put option" on the stock market. Put options are financial derivatives that provide upside exposure while protecting from downside risk. When the stock market drops, even though the contract value declines, a GLWB protects lifetime retirement spending from this downside risk. This can allow retirees to feel more comfortable increasing their stock allocation in the variable annuity relative to an unprotected portfolio, or to otherwise view the variable annuity as a bond-like asset when framing retirement risk as the ability to meet financial goals rather than the underlying volatility of assets. If retirees cannot overcome the psychological hurdle to adopt a higher stock allocation after adding an annuity, the likely outcome will be a reduction in their overall allocation to stocks, which will undermine the effectiveness of a partial annuity strategy.

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