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Market volatility like we’ve seen so far this year can be particularly unnerving if you’re nearing retirement. Just one week into 2016, the S&P 500 lost almost 6% of its value — its worst opening week yet.
Exposure to the stock market allows pre-retirees to accumulate enough savings for retirement, but times like this remind us of the need for diversification and low-risk investments.
Income annuities, a type of insurance that acts like a fixed-income investment, are one option. Life annuities provide you with a fixed paycheck for as long as you live. These include products such as qualifying longevity annuity contracts (QLACs), deferred income annuities (DIAs) and single-premium immediate annuities (SPIAs). Others, called period certain annuities, have different conditions.
Income annuities can provide income and diversification, and have the added benefit of protecting against longevity risk — the possibility of outliving your savings. My firm provides such retirement income products and we always tell clients that guaranteed income in the form of income annuities should never be the entirety of your nest egg, but these products can play an important role in retiree portfolios. Income annuities can:
1. Add diversification
Many investors save for retirement using 401(k)s and IRAs, which are often heavily invested in the stock market. This can mean huge potential gains — or potential losses. And these losses can be catastrophic if you’re nearing retirement during a down market.
Using a portion of your portfolio to purchase an income annuity will ensure that you have a steady paycheck in the future to supplement your Social Security or pension payments, if you have them. This not only makes planning easier, but insulates you from market volatility.
2. Reduce sequence of returns risk
Sequence of returns risk should be a major concern for pre-retirees. To understand the concept, think of your portfolio as a basket of 100 shares, worth $50 each. To meet your expenses each year, you’ll need to withdraw $100, or two shares. However, if the value of those shares drops to $25, you’ll need to withdraw four next year. In the future, you’ll continue to withdraw more shares from a smaller number of shares overall. This risk can be devastating to the recently retired, because they don’t have as much time for their portfolios to grow if and when the market bounces back.
Guaranteeing a portion of your future income reduces your exposure to sequence risk by removing it from the volatility of the market.
3. Provide psychological comfort
We all know that investing for retirement can be mentally and emotionally taxing. That’s another reason why some retirement savers use a portion of their assets to buy a fixed paycheck. A 2012 study from consulting firm Towers Watson showed that retirees with annuitized income were happier overall than those without.
When you have an income annuity, you have a fixed paycheck that won’t run out. Allocating some of your assets to an income annuity today can buy you peace of mind for the future.
Understanding the trade-offs
Before you buy an income annuity, be sure you fully understand the downsides associated with these products, including the cost of inflation protection and a lack of liquidity.
In today’s market, most insurance companies offer options to include inflation protection — an annual cost-of-living adjustment to your annuity payments — with your income annuity, but it can be pricey, so it’s crucial you understand the mechanics and the costs associated with this option.
Additionally, most income annuities don’t let you access the capital before your first scheduled payout. Ensure that you have enough liquid funds to cover unforeseen expenses until then.
Finding trusted advice
If you’re considering purchasing an income annuity, get quotes from several insurance companies. You should also make sure that your agent is committed to acting in your best interest. Insurance agents must be licensed to sell annuity products and receive a flat commission on each sale. Asking each agent to disclose his or her compensation on the products enables you to evaluate the advice and make the decision that’s best for you.
This article also appears on Nasdaq.
Image via iStock.