As you near retirement you’ll likely be looking for an investment that is A) safe and B) consistent. While you can accept fluctuations as a 20-something, you can’t accept volatility as a 60-something. Luckily, annuities provide both safety in securing your original investment, consistency in their returns and are flexible enough to find a spot in any retirement portfolio.
So why are annuities safer than stocks?
To understand why annuities are safer than stocks, we first have to understand the basis of the risk to reward ratio. Annuities do not perform to nearly the same degree as stocks, but as a result they are considerably safer and more consistent. Keep in mind, you should never buy an annuity to create wealth, annuities are meant to preserve your current wealth well into retirement.
Annuities are backed by the full faith and credit of the issuing party, typically a life insurance company, and many have very little to do with how good or bad the stock markets are performing. Rather, the insurance company establishes a life expectancy, a reasonable amount of capital appreciation, then gives you a quote for monthly payouts based on your first investment amount. Whereas the insurance company traditionally bets that you’ll live a very long time with life insurance policies, they’re betting that you won’t live as long to collect on your annuity payouts. Annuities are a way for these companies to balance their risks.
One more hidden benefit is that annuities can be government guaranteed up to a certain maximum investment value. Before investing, consult your local and state laws as well as someone familiar with the products to see if the whole of your investment will be secured by the government. Just like bank accounts, annuities are normally protected up to a certain amount each, rather than the whole. So three $25,000 annuities may have better protection than one $75,000 annuity.
Market Mechanics and Safety
Indexed annuities, those that base returns on the change in the stock market, are built to provide greater safety than the stock markets even while tracking traditional indexes like the S&P 500. An equity indexed annuity based on the S&P 500 would buy a 1-year option on the S&P 500 index each year. If the S&P 500 drops in that one year term, nothing is lost, and the option is left unexercised. However, if the S&P 500 were to rise, then the option would be sold, and the profits allocated to the annuity. In this case, you get all of the upside, with no risk to the downside.
Such safety does come at a cost. The broker selling the annuity should advise you of the earnings cap per year. This cap allows for a maximum amount of earnings in good years of anywhere between 6-10%. Should the S&P 500 rise 15% in one year, and you have a cap of 7%, your annuity will only appreciate by 7% instead of the full 15%. The insurance company uses the excess to pay for the cost of the options as well as their costs in administrating the annuity. The earnings cap, however, is a very small price to pay for security, especially when you’ve little time to make up principle losses.
Annuities provide safety, plain and simple. They offer consistent payouts, protection against stock market dips, and payout rates that are far higher than one could achieve with fixed income alone. For this reason, annuities have prevailed as the investment of choice for aging investors who want all of the benefits of a well rounded investment portfolio without all of the risks and headaches associated with volatile stock markets.