Volatility is the enemy of investors in retirement. You can ride the market’s waves with relative ease as time tends to erase all losses. However, when your timeline is shorter and you’ve already started to withdraw funds from your portfolios, volatility and its decay can wreak havoc on a portfolio. It is to this end that many investors load up on bonds during their later working years and in retirement.
However, that portfolio ballast may not seem secure these days. With rates rising, bonds are becoming a bit more correlated with stocks.
And that’s why annuities may make sense for many investors these days.
Thanks to their steadfast guarantees, fixed annuities may offer the ballast and income generation that investors need and crave in the current high volatility environment.
Be sure to check the Retirement Channel to learn more about investing strategies to build up your nest egg.
Correlated Asset Classes
One of the biggest investing beliefs is that bonds can be used to hedge a portfolio of stocks. Their coupon payouts can provide a cushion to the volatility of equities. It is the reason why older investors tend to own more bonds to help preserve their wealth and generate steady returns. This has been the case since the late 1990s. Stocks and bonds have had a negative correlation, i.e. they move in opposite directions of each other.
However, that relationship is not always true. And in fact, throughout most of history, it has not been.
Bond price volatility is subjected to interest rates and the Fed. When investors buy individual bonds and hold them to maturity, bond price changes are an afterthought. However, for 99% of us, including many institutional investors, that is not how we own bonds in our portfolios. We own bond mutual funds and ETFs. And that subjects us to price changes and the whims of interest rates because funds need to constantly roll-over their holdings to meet their mandates.
Here, bonds are actually shockingly correlated with equities. That is, they move in the same direction. The common denominator happens to be higher interest rates and periods of higher/more normalized inflation, just like we have today. This helps explain why bonds have continued to fall along with stocks.
Don’t forget to check out this article to learn how the SECURE Act can impact annuities.
A Potential Solution
So, if bonds and stocks are moving in the same direction—albeit at different rates than each other—then bonds’ ability to be portfolio ballast is called into question. For retirees or near-retirees, this is a huge problem. If the portion of your portfolio designed to be safe loses money, you may not have the time to recover those losses.
This is where fixed annuities can come into play.
Like any annuity, a fixed annuity is a contract with an insurance company. In this case, investors are promised a guaranteed interest rate on their contributions to the account. So, they invest $10,000 and, for the next five years, the insurance company will pay 4% on the investment.
The beauty in using the fixed annuity rather than a bond fund is that investors do not have to worry about principal amount initially invested. You know that $10,000 will be worth just over $12,000 in the five years. The same cannot be said for the bond fund. For someone in or near retirement, this guarantee is a huge win, particularly given the currently positive correlation between bonds and equities and how rising rates are hurting bond prices.
As an annuity, there are other benefits as well. If the annuity is bought with non-qualified money, taxes can be deferred until the contract matures or investors start taking distributions from the contract. Those taxes can be beneficial as well. Only the annuity’s return on investment is taxable, what investors have paid in is considered tax-free. And as an annuity, investors have options on just how they want to take those distributions: lump sum payouts, rolling over the contract into another fixed annuity, or annuitizing it for lifetime payouts. This last action also creates ballast in the portfolio.
Investors can even make a fixed annuity ladder to ensure they have a portion of their money maturing at certain intervals throughout their retirement.
In addition to the ballast potential of a fixed annuity, returns generation and success rates tend to be higher than bonds as well. To generate the same amount of income, it generally takes less initial money when choosing the annuity versus a bond portfolio. Meanwhile, research by DPL Financial Partners shows that fixed annuities can help mitigate sequence-of-return risk. By allocating 20% of a fixed-income allocation in a 70/30 portfolio to a fixed annuity, the success rate of not outliving your money would jump to 72%, up from about 60%.
Adding a Fixed Annuity
Given the positive correlation, downward trending bond prices, and overall market volatility, a fixed annuity may make a ton of sense for bond investors. By allocating some capital to a fixed annuity, investors can lock-in a return for a set number of years. This can be incredibly important and create the needed ballast in a portfolio. Adding in the tax benefits and ability to generate an income stream from this money in retirement, the win gets stronger.
The Bottom Line
Like any annuity, it pays to shop around before deciding. Crediting rates, inflationary kickers, and costs vary per issuer. By shopping around, investors can choose the correct product for their needs. And in this case, that’s gaining ballast and bond-like returns.
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