These insurance products offer the promise of guaranteed income, an attractive proposition for many retirees in a volatile market. Variable annuity sales rose 16% in the first quarter over the same period last year.
In simple terms, an annuity is a contract between a customer and an insurance company. The customer makes a lump-sum payment (or sometimes a series of payments). In return, the insurance company sends the customer a regular monthly payout that’s guaranteed and typically continues for the rest of the customer’s life (as long as the insurance company remains in business; it’s important to buy from a highly rated carrier). The trade-off is the loss of liquidity for a portion of your portfolio. And if you liquidate those other investments now to buy the annuity, you lock in losses by selling when stocks are down.
Annuities come in three types: fixed, indexed, and variable. The differences lie in the details of how your insurance company invests your money and determines your monthly payout. The most basic type, a fixed income annuity, pays a specified, guaranteed interest rate on your lump-sum payment. An indexed annuity pays an interest rate that’s based on the performance of a market index, such as the S&P 500. Variable annuities pay out sums that vary based on the performance of an underlying mutual fund portfolio.
Even with those costs and limitations, a simple annuity can be a good tool for people near or in retirement, with investment portfolios that might not return enough to continue paying their essential monthly expenses.
An annuity is preferable to taking uncomfortable risks with a portfolio that isn’t quite big enough, says Joshua Knauss, a financial planner in Lewisburg, Pa. “It can be a good tool if you don’t have quite as much saved as you’d like or you don’t want to reach for both growth and income,” he says.
Why might a simple annuity be helpful in retirement? For many households, the guaranteed income from Social Security (and a pension, if you’re lucky enough to have one) won’t cover 100% of basic living costs. A popular strategy to fund that essential-spending gap has been to move a chunk of money into cash and/or bonds to cover those living expenses for a few years.
Experts call this the “bucket approach,” with the money for near-term expenses parked in cash or cash equivalents and rest of your money in stocks. That way, you won’t have to worry about stock fluctuations affecting your ability to pay your bills in the near term, yet you can still capture stocks’ long-term growth to help your portfolio outpace inflation over time.
Pfau also threw a bit of cold water on another popular retirement income strategy: investing in stocks and bonds with the intention of only spending the income they throw off. Retirees are often loathe to tap their principal, but they shouldn’t be, he says.
“When you invest for income, you start tilting to riskier parts of the market….you might have a higher dividend rate but you might be more exposed to capital loses and ultimately a lower sustainable income level.” Pfau suggested that a total return approach to retirement income could be a better way to go.
Fresno portfolio advisor– Soutas Financial appreciated these points: In simple terms, an annuity is a contract between a customer and an insurance company. The customer makes a lump-sum payment (or sometimes a series of payments). Even with those costs and limitations, a simple annuity can be a good tool for people near or in retirement, with investment portfolios that might not return enough to continue paying their essential monthly expenses. Why might a simple annuity be helpful in retirement? For many households, the guaranteed income from Social Security (and a pension, if you’re lucky enough to have one) won’t cover 100% of basic living costs. A popular strategy to fund that essential-spending gap has been to move a chunk of money into cash and/or bonds to cover those living expenses for a few years.
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