Many people buy annuities for protection. But what kinds of protection can they provide? The answer depends in large part on the kind of annuity you own.
At the very least, all annuities can protect you against the financial risk of running out of money in retirement. Annuities counter this hazard by paying you a guaranteed income. Your income can last for a certain timespan or for life. This protection is available with fixed-type and variable annuities alike.
However, fixed annuities also protect the contract owner against downfalls tied to market risk, long-term care costs, and financial risks that can derail your legacy wishes. Here’s a rundown of what an annuity can protect you against in your retirement-saving and post-retirement years.
Protection Against Market Risk
As we draw closer to retirement, it’s generally prudent to, as economist Roger Ibbotson puts it, “derisk” our portfolios.
The question of how much market risk belongs in a portfolio will depend on someone’s risk tolerance and age. In retirement, you will need secure income streams that cover, at the least, the monthly expenses of your retired lifestyle.
So, how much market risk should you have? You will have to do a deep dive into your portfolio, including how it will create reliable monthly income for you, in order to answer this question.
You will likely have income streams from your portfolio alongside Social Security. You might even have a pension as part of your income mix.
A fixed-type annuity does more than just provide reliable income, too. It preserves your principal against market losses, crediting interest based on a preset guaranteed rate or on the movements of an underlying financial benchmark.
Even when the market drops, your principal remains intact, and your money continues to grow with interest uninterrupted. This guaranteed protection of principal is one of the contractual promises that life insurers make to you as a policyholder.
Fixed index annuities also guarantee your principal, but not the amount of interest that you receive. However, in return for receiving a non-guaranteed rate of return, most indexed annuities can earn more interest than their traditional fixed counterparts.
Indexed annuities are usually used as substitutes for fixed annuities or other forms of guaranteed income, such as from Treasury securities or CDs.
Protection Against Sequencing Risk
Even more deadly than the effects of a market drop is a market drop at the wrong time. Sequencing risk is also known as sequence of returns risk.
This is the risk of your portfolio taking a hit in your early retirement or just prior to your retirement. Needless to say, it sets you up for having to play “catch-up” from thereon.
Dr. Wade Pfau has written articles and research papers on how sequencing risk can undo even the best-laid plans. What’s among his prescriptions? Annuities can help guard against this risk with their contractual income guarantees.
What amplifies the effects of those losses in early retirement is the fact that you are taking withdrawals from your portfolio. Over time, those compound the effects of your initial loss from the market drop.
This can raise the risk of you running out of money in retirement. Or, at the very least, you might have to scale back your lifestyle that you have worked hard for and saved to enjoy now.
By providing you with predictable monthly payouts no matter what the stock market does, annuities can stabilize the effects of sequencing risk on your income security in retirement.
Protection Against Longevity Risk
People are living longer than ever. You might well spend one-third or more of your life in retirement.
It’s different from the retirement of our parents and grandparents, with more years of possible living and more long-term financial security at stake. Skyrocketing healthcare costs play a major factor here as well.
Insurance companies pool your annuity premium dollars with those of all their other policyholders. They also include calculations for expected mortalities in their payout estimates. This offers a high degree of security for the payouts you receive from them, whether your payouts last for a decade or for the rest of your life.
You can even choose to continue payments for your spouse once you are gone. But this additional guarantee, called a joint life payout, will effectively lower the amount you receive each month while you are living. That is the trade-off with this additional benefit.
This kind of flexibility and security with income is hard to find with other kinds of income-generating assets. Annuities are the only instrument capable of paying a truly guaranteed lifetime income.
Protection Against Bad Financial Decisions
Human psychology ‘programs’ us to be drawn to what is comfortable and to flee what is discomforting.
Numerous studies show how investors make knee-jerk decisions when their portfolio values fall. If asset values fall too much in a market drop, the investor will emerge with fewer assets since they sold and liquidated assets on a loss.
That is just one common example of bad money decisions. By putting income payments on “autopilot,” annuities help guard against this risk of harmful, off-the-cuff decision-making affecting your financial security.
Protection for Legacy Wishes and Care Services
The vast majority of annuities also usually provide at least a guaranteed minimum death benefit. An annuity owner can use this benefit to provide some legacy to their heirs.
In most cases, this death benefit is the greater of the current contract value or a specified guaranteed amount that is higher.
If you need some sort of long-term care, many annuity contracts also have benefits that you can tap for funding your care needs. These benefits might trigger when you need care in a nursing home facility. You will receive enhanced income payouts for a time to cover the cost of this.
Should you be unable to do a certain number of “acts of daily living,” some annuities also pay enhanced income for home-based long-term care. Again, the enhanced income tends to last for a certain period. Then you go back to the amount of income you were receiving before your care needs.
Check your annuity contract for details of how you might have this benefit. Your financial advisor can also assist you with understanding their innerworkings.
Many types of death and living benefit riders are available in today’s annuity contracts. People have to choose which riders are right for them.
Annuities used to come with a specific package of riders for a given product, but many annuities are now available in unbundled form. This means that the insured gets to choose which riders, if any, are to be used and will only have to pay for those riders.
Annuities Can Protect Your Financial Well-Being
Annuities can provide guarantees against many types of risk, especially market risk and longevity risk. And they are rapidly growing in popularity as a result.
Consult your financial advisor for more information on annuities and what they can do for you. What if you are looking for a financial professional to help you protect your assets so you can retire comfortably in the future?
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