Due to many investors’ uncertainty about today’s market, I’ve seen many people opt to move entirely to cash and take investing off the table, but I’ve also had many investors approach me with questions about how to protect their investments and guarantee income. At the end of the day, the right investment for you entirely depends on your financial goals, time horizon, risk tolerance, and alternative options you are considering. Here is information on how guaranteed income may fit into your financial picture.
Considering Your Choices
When investors are fearful, I often see them do one of a few things:
- Stay the course and maintain their existing portfolio.
- Move toward cash and cash alternatives.
- Make speculative bets on specific sectors, individual stocks, and alternative asset classes.
- Move toward protective solutions like annuities and structured products.
If your asset allocation is well-diversified and consistent with your risk tolerance and you can remain disciplined, most of the best advice indicates that if you can stand it, to go with the first option.
Moving toward cash and cash alternatives in the moment can feel satisfying in the moment but will ultimately diminish your purchasing power and reduce your lifetime income potential.
Making speculative bets can easily result in losing your entire portfolio. I recently asked an investor how he landed on his investment portfolio because it did not appear to be following a cohesive strategy, and it was losing badly to every benchmark. He responded, “Youtubers and vibes.” While that has some entertainment value, I don’t recommend that sort of strategy for anyone who wants to reach a financial goal like retirement.
There are several types of annuities and structured products, but I’d like to focus on indexed annuities and variable annuities because they can solve for longevity risk, inflation risk, volatility risk, interest rate risk, and taxation risk for the right investor.
A variable annuity is a long-term financial product designed for retirement purposes. In essence, an annuity is a contractual agreement in which payment(s) are made to an insurance company, which agree to pay out an income or a lump sum amount at a later date. Typically, variable annuities have mortality and expense charges, account fees, investment management fees and administration fees. In addition, annuity policies have exclusions and limitations, early withdrawals may be subject to surrender charges and, if taken prior to age 59 1/2, a 10% federal income tax penalty. Variable annuities are subject to investment risks, including possible loss of principal.
An indexed annuity is a type of insurance contract that pays an interest rate based on the performance of a market index. It differs from a fixed annuity, which pays a fixed rate of interest, and a variable annuity, which bases its interest rate on a portfolio of investment options chosen by the annuity owner. Indexed annuities are sometimes referred to as equity-indexed or fixed-indexed annuities.
Longevity
One of the biggest questions when determining your retirement income need is how long you might live. According to Flowing Data, using information from the Social Security Administration, a female 40-year-old has:
- A 33% chance of living more than 50 additional years
- A 35% chance of living 40 to 49 more years
Essentially, the odds are highly in your favor of making it past age 80. This can present a problem when you try to make your money stretch potentially over 40 years.
Because annuities are designed to pay out for someone’s entire life, regardless of what happens in the market, this can be particularly attractive to those with a family history of longevity. According to a 2024 BlackRock study, 97% of annuity owners say their annuities cause them decreased stress about running out of money.
Inflation
Over the last 100 years, inflation has averaged about 3% per year. That means that every year, to live the same lifestyle, your cost will go up. Let’s say your fixed expenses are $2,000 per month today. In 10 years, assuming 3% inflation, that monthly expense would be almost $2,700 per month. If you are considering sitting in cash, you will be losing purchasing power each year.
While some annuities just pay a fixed amount every year, others can grow your payment amount each year through some combination of market returns or a guaranteed roll-up.
Volatility
When you are still in your accumulation phase without a thought of near-term withdrawals, you may be able to easily handle portfolio volatility. However, when you end up needing distributions, volatility can be a serious problem. Let’s go through two examples:
Investor A has a portfolio value of $1,000,000 and an income need of $50,000 per year:
- Year 1 returns: +10%, withdrawals $50,000, ending value $1,050,000
- Year 2 returns: -5%, withdrawals $50,000, ending value $947,500
Investor B has a portfolio value of $1,000,000 and an income need of $50,000 per year:
- Year 1 returns: -5%, withdrawals $50,000, ending value $900,000
- Year 2 returns: +10%, withdrawals $50,000, ending value $940,000
Even though they started with the exact same amount, needed the exact same income, and had the exact same average return in two years, Investor B is in a significantly worse position because they started with a negative year instead of a positive one. If you take extend these small differences out 40 years, Investor B is more likely to run out of money than Investor A if they start in a worse market but ultimately achieve the same average return.
Guaranteed income products attempt to eliminate that risk of timing issues leading to depletion of retirement savings.
Interest Rates
In retirement, I often see investors turning to money market funds, CDs, and fixed income investments. All of these are subject to interest rate risk. In the not-too-distant past, investors were getting between 0-2% on these types of investments, not even keeping up with inflation.
Annuities are designed to provide some stability and predictability with guaranteed rates, making retirees less susceptible to interest rate risk.
Taxes
In nonretirement accounts, guaranteed income products offer tax-deferral during the accumulation phase. This means that unlike in brokerage accounts where you pay taxes every year on interest, dividends, and rebalancing, you will only pay taxes on the growth when you distribute funds.
Choosing For Yourself
There is a good reason that annuities of the past have had negative associations. Not all guaranteed income products are created equal and it’s essential to speak with a qualified financial professional, about your goals and if a guaranteed income product is the right fit for a piece of your financial picture.
Conclusion
In today’s uncertain market, adding guaranteed income product offerings like annuities can address risks such as longevity, inflation, volatility, interest rates, and taxes. However, it’s crucial to consult with a financial professional to ensure these products align with your unique goals and circumstances, enhancing your financial security and future planning.