Annuities can certainly strengthen your retirement plan even while interest rates are low. Among other things, they can add more predictability and stability to what you already have.
But what can you do when interest rates are at rock-bottom? In response to the economic fallout from the coronavirus pandemic, the Federal Reserve has dropped the target rate for its benchmark federal funds rate (its overnight lending rate to banks).
Now the target range for this rate is zero to one-quarter percent. The last time the Fed did this was during the financial crisis. In 2008, it dropped the rate to the same target range, and this didn’t change course until December 2015.
The pandemic had an unprecedented impact on the economy. It put tens of millions of people out of work in just weeks and left many sectors basically on standstill.
What Might Happen to Interest Rates Going Forward?
There is no telling as to what exactly might happen with interest rates in the future. After all, things are different from what happened in 2008.
According to research by Professor Alejandro Previtero of Indiana University, people tend to buy annuities when equity markets decline.
But with interest rates now at zero, do annuities really make sense for retirement? What if interest rates go up? Then you would be locked into the lower interest rates of when you bought your annuity.
Are Annuities Good When Interest Rates Are Low?
According to Dr. Wade Pfau, the widely-respected retirement researcher, they do make sense. In fact, they are particularly useful if you are considering a deferred annuity that will provide protected lifetime income as part of your retirement holdings mix.
Unlike bonds, annuities have risk-pooling components built into their payouts. The life insurance company assigns expectations of mortality to every annuity policyholder it serves.
Of course, some people will live longer than what the insurance company estimates. Others will live for shorter times. The insurer spreads the risk across all of its thousands of annuity policy owners. This risk-pooling component is called “mortality credits.”
While not the most glamorous topic in finance, those mortality credits reduce the insurance company’s risk exposure to interest rate risk. Not only that, bonds and other interest-earning instruments can’t duplicate this risk control by themselves. Nor are they protected in the same way.
Because of this, bonds and other fixed-interest investments will often be more costly for funding retirement than annuities will when interest rates increase. Hence the annuity can often be a better deal for providing a certain amount of monthly income than other investments you might consider.
What If Interest Rates Changed?
If interest rates were to change, exchanging bond positions in a portfolio wouldn’t be a simple matter. As Dr. Pfau writes:
“As well, if we consider changing interest rates and their associated risk, increasing interest rates would mean capital losses for bonds. One could not simply sell bonds for their earlier value to take advantage of the higher annuity rates. While waiting for rates to rise, if that happens, the retiree will be spending their principal when spending exceeds interest and dividends. The likelihood of needing to dip into the principal increases.”
The bottom-line? Life insurers manage the risk of annuities in ways that individual investors can’t replicate on their own.
Choices for Receiving Income
In a low interest rate environment, annuities might well cost less than other fixed-income alternatives for funding your retirement. They will require a lesser upfront cost for you to get a guaranteed lifetime income. Also, the amount of income you receive from the annuity won’t change with equity market drops.
You have a large variety of options for receiving income with annuities that you don’t with other instruments. You can receive guaranteed payouts for a certain timespan, for the rest of your life, or the lifetimes of you and your spouse.
Bonds and CDs can only pay the interest that they generate, regardless of your lifespan or income needs.
Want Flexibility in Your Guaranteed Payouts?
Would you like some wiggle room in your annuity payments? Many fixed indexed annuities give you flexibility for receiving lifetime income so you don’t have to annuitize the contract and give up control of your money.
Annuitizing the contract requires you to basically surrender all control of your money in order to receive a guaranteed lifetime stream of income. But many annuity contracts available in the marketplace today have guaranteed income riders that you can turn off and on at your convenience (and with certain conditions, of course).
What is the upside to these riders? You can receive the same guaranteed income but still have access to your principal if you ever need it.
A Strong History of Financial Protection
Life insurance companies have a very strong record of meeting their contractual promises for income and asset protection for decades and decades. Don’t lose faith in them now!
The life insurance industry bailed out the banks during the Great Depression and held the economy together. It’s unlikely that they will fail now. They have hundreds of billions of dollars in cash reserves and form the base of the U.S. economy in many ways.
In any case, annuities have often provided higher growth for retirement savers than bonds have, except perhaps junk bonds. They are realistically secure, just as Treasury securities or CDs or savings bonds are, because the insurance carriers are required to have at least one dollar in cash reserves for every dollar of outstanding annuity premium.
The insurance industry can’t levy taxes or print money. But it doesn’t really matter, because they already have the money to back their guarantees.
Explore Annuities Even in Low Interest Rate Conditions
Annuities can provide a competitive level of income even in a zero interest rate environment. Fixed indexed annuities can let your money grow above certain minimum interest rates. What’s more, their rates for growth will improve as interest rates start to rise again.
If you want a predictable rate of growth, fixed annuities might be worth a look over. In times past and even now, their guaranteed rates have tended to be higher than what you will find in a bank CD.
Putting Your Financial Well-Being in the Driver’s Seat
Talk to your financial advisor today about the advantages that annuities can provide and how they can benefit you. It could potentially make a real difference for your retirement years.
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