3 Reason to Consider Annuities in Your Retirement Portfolio
The annuity is often a misunderstood piece of a well-developed financial plan. Annuities are insurance contracts that transfer the risk of outliving your assets to an insurer, who in return provides a stream of income for life or a specified fixed period. Annuities give investors the opportunity to create a stable income stream from their accumulated assets -- that is, the ability to annuitize their retirement assets.
In many cases, annuities are understandably written off as complicated, expensive, and unnecessary. Typically, these instruments are accompanied by high fees, confusing riders, and everyone's favorite: the pushy salesman. While I don't want to be convinced to buy an annuity, I do find that it's important to understand what annuities are and the instances in which they may be appropriate. Equipping yourself with the right knowledge can help you become a more informed buyer, and avoid making decisions based on the poetry of a clever cold caller.
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Below, you will find some of the most common circumstances that may call for the purchase of an annuity:
1. Most of your assets are not annuitized
If you are approaching retirement and you have small percentage of annuitized assets (say, less than 20%), you might consider annuitizing a modest portion of your portfolio. This means that you lack a meaningful portion of assets representing new and predictable payments. This might occur if you have a large 401(k) combined with a limited or no pension and lean social security. An annuity, in this instance, can help create a predictable income stream within the portfolio, and it essentially behaves like an employer-provided paycheck. Diversifying your income streams is paramount throughout your investing life, in addition to your investments and tax exposures.
One way to do this is through a single premium immediate annuity (SPIA), which allows the buyer to convert a portion of his or her assets to an income stream beginning immediately upon purchase. Often, these payments will last until the owner's death, but there are variations that last for a predetermined period of time and some that will continue to the insured's heirs. SPIAs are just one example of the many products that exist in the annuity universe, but tend to be one of the simpler options available.
2. There is a reasonable chance you will live to 100
Longevity risk, or the possibility that you outlive your money, has more recently become an important concern. This risk is dependent on several variables, some of which you have control over and some you don't -- but the idea that we're collectively living longer does create an opportunity for financial planning. In the event that the global markets take a steep dive in the early years of your retirement, there is a more-than-remote probability that it may take several years or even decades to recover. If you're dependent on the stock market for all of your income, this creates a dangerous situation that can certainly result in portfolio failure.
By annuitizing a portion of your assets, you can be sure that there will be a check waiting for you every month, even if the remainder of your portfolio has been spent or eaten by the stock market. The beauty of this is that even if you live well beyond your life expectancy, you will still receive payments at no additional cost. If the annuity is funded with after-tax money, a portion of each payment is considered a return of principal and is not taxed. If you are healthy and expect to lack a reliable income stream in retirement, it definitely makes sense to investigate annuities.
3. Psychology of steady, dependable income
Humans have a tendency to want to avoid uncertainty and make as much of the future as knowable as possible. As an annuity is an insurance contract, knowing you are covered under a range of circumstances provides an additional feeling of comfort around retirement -- an already anxiety-inducing subject for many people. Simply knowing that a portion of your portfolio will feel like a paycheck -- one that will be there regardless of unpredictable market returns -- provides one more stake in the ground when planning a very important period of your life.
While there are many reasons to avoid annuities early in your career, it's important to keep them in the back of your mind as a consideration when you are approaching retirement. It's equally important to educate yourself on how they can fit into your total financial picture, and the instances in which they may be suitable. Given the global turmoil we've had to endure, it's even more critical to build in sources of certainty to your finances -- in a retirement portfolio, annuities provide this assurance.
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