Investing heavily in equities may be smart when you’re in your 30s or 40s. But excessive stock-market risk exposure is hazardous when you’re close to or in retirement.
The stock market seemed invincible until it plunged when COVID broke out. But it soon came back stronger than ever. No worries! But this past year, inflation and higher interest rates have sent the markets spiraling.
What goes up comes down eventually. Many companies that looked like the wave of the future no longer do. For instance, Meta, the parent company of Facebook, has seen its shares plunge about 65% in 2022.
Emotions are your enemies in investing. If you’re too heavily invested in stocks, you’re more likely to sell during a market bottom. If you’re less exposed, you’ll have less stress and more confidence to play the long game and can wait markets out.
The old wisdom still holds. As you get closer to retirement, move a significant portion of your savings from equities to principal-guaranteed products, such as bank certificates of deposit and fixed annuities. If there’s a significant downturn in the market, your retirement plans are safe and remain intact.
The best allocation varies for each individual and family. Someone collecting a generous pension and perhaps getting other sources of income, such as rental income, can probably take more risk. But people who depend on their savings should be more cautious. You don’t want to be forced to sell stocks during a bear market, particularly early in retirement.
Retirement portfolio can vanish in “death spiral”
Consider a retired couple with a $1 million stock portfolio. To support their lifestyle, they need to withdraw $40,000 a year, a level that in theory should be sustainable. However, during their first year of retirement, the market drops 26% and they make a $40,000 withdrawal at the end of the year. Now their portfolio is down to $700,000.
In year two, the market is up 4%, but after another $40,000 withdrawal, their portfolio shrinks to $688,000. Unless there’s a big multi-year market rally soon, their portfolio could enter a death spiral. Even several years of good returns won’t stem the decline, and it can vanish eventually.
If an investor enjoys strong returns during the early years, his or her portfolio will continue to grow despite withdrawals and can withstand future bear markets. But it’s a roll of the dice whether a down market will strike early or late in your retirement. You don’t want to rely on luck.
CDs and fixed-rate annuities offer safety and income
What are your options among guaranteed-principal products?
Bank CDs are popular because they pay a set rate for a fixed term, and are backstopped by federal insurance. Until recently, rates were very low, but in 2022, they’ve climbed substantially. CDs are completely safe, but retirees and pre-retirees should consider an attractive alternative, the fixed-rate deferred annuity.
This product, technically a multiyear guarantee annuity (MYGA), is sometimes called a CD-type annuity. It also pays a guaranteed rate of interest for a set term. However, it additionally offers tax deferral until you receive income from it, and you can defer those payments indefinitely. Your money can grow faster free of federal and state taxes until you need it.
Rates have increased substantially in recent months, and today some fixed-rate annuities pay well over 5.00%. Here is a database of annuity rates.
Issued by insurance companies, annuities aren’t federally insured like CDs, but life insurers have a solid track record of meeting their obligations and state guaranty associations offer a level of additional protection. Check the A.M. Best rating of the issuing insurer before you buy.
Annuity interest withdrawn before age 59½ is subject to a 10% IRS penalty.
Create a private pension with an income annuity
Not a savings vehicle, an income annuity offers a different approach to retirement security. You turn over your money to an insurance company in exchange for a contract that pays guaranteed income for your lifetime or a certain term. Because the lifetime plan is far more popular, we’ll limit our discussion to it.
The downside is that there’s little flexibility. Typically, once you’ve paid your premium and are past the “free-look” period, you can’t get your money back. An income annuity typically has no cash surrender value.
But the big benefit is creating a lifetime private pension. Many independent economists and financial experts say this is a deal worth taking. Whether interest rates rise or fall, stocks or bonds rise or fall, your payments will keep coming like clockwork, even if you live to 100 or beyond. This can help remove financial worries from retirement.
An income annuity is the only financial product that guarantees lifetime income. It serves as “longevity insurance.” Payments include both taxable interest and tax-free return of principal.
Income annuities come in two varieties.
A deferred income annuity pays a stream of income starting on a future date you choose. You typically pay a single premium for this contract. It is a straightforward, simple, and predictable product. You know exactly what your income will be starting on the date you’ve chosen.
You can buy either a single-life annuity or a joint-life annuity to cover both spouses. With the joint-life product, the surviving spouse will continue to receive the same income for life.
An immediate income annuity is the other type. It works the same way, with similar options, but income payments start between one month and one year after purchase. It’s a good solution if you need more income right after you retire. Some people buy one so they can retire early and plug an income gap before their Social Security benefits begin.
Creating an optimal asset allocation takes thought and planning. While no one likes inflation, higher interest rates have brought one good thing. Guaranteed products, including annuities, now offer significantly higher payouts than they did several months ago.
Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.
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