Most investors use a mix of stocks, bonds, mutual funds, and ETFs to build the assets they need to have a successful retirement. But even after a lifetime of using traditional investments like these, you'll want to take a close look at a completely different kind of investing vehicle once you actually give notice and retire for good.
Give annuities a chance
In this month's new issue of the Fool's Rule Your Retirement newsletter, Fool retirement expert and Certified Financial Planner Robert Brokamp examines the role that annuities can play in a retirement portfolio. To help him delve into the topic, Brokamp brought in annuity expert Michael Kitces, who's also a CFP practitioner and the author of The Annuity Advisor.
Annuities don't have the best reputation among many investors. Although they offer some valuable features you can't find anywhere else, including guarantees that protect your principal and ensure a base level of income no matter how long you live, the insurance companies that offer annuities charge pricey fees to provide those guarantees. And in some cases, getting annuitized payments can leave nothing for your heirs, even if you die shortly after starting to receive money from your annuity.
It's incredibly hard to protect against those types of risks on your own. Even the insurance companies don't always get it right. Back in 2008 after the market meltdown, AXA Financial, Hartford Financial (NYSE: HIG ) , and Lincoln National (NYSE: LNC ) reported significant losses trying to hedge their investment portfolios against the risk that principal-protection guarantees created. Even big insurers like MetLife (NYSE: MET ) and Manulife Financial's (NYSE: MFC ) John Hancock had to take a variety of steps to reduce their risk, such as raising fees or scaling back product lines.
Certainty in an uncertain world
The temptation is to take the money you'd put in annuities and invest it yourself in the stock and bond markets. Bonds don't pay enough income to compare with what an immediate annuity would generate. Some dividend stocks come close, though. Stalwarts Johnson & Johnson (NYSE: JNJ ) and Procter & Gamble (NYSE: PG ) combine dividend yields well above what you'd get from a 10-year Treasury bond with the security of a solid business. The 3% to 4% they pay doesn't compare with the 7% or so an immediate annuity can generate, but they give you a lot more flexibility, and their steady dividend growth over time does a better job of helping your income keep up with inflation than most annuities do.
The problem, though, is that even the most steady companies can hit rough patches. BP is a perfect example of how relying too much on a dividend stock can end up costing you significantly. Its recent oil spill has pressured the company to suspend its dividend and face tens of billions of dollars in cleanup costs. And remember, five years ago, few would have foreseen that a financial crisis would ever force megalithic Bank of America (NYSE: BAC ) to cut its generous payouts to pennies.
Moreover, during the market meltdown in 2008 and early 2009, even strong companies saw their share prices decline sharply. For investors who could afford to take risks and raise their allocations to the stock market, the ensuing rally showed the wisdom of grabbing those bargains while they were there. Yet if you were already retired, taking on even greater risk after seeing a big portion of your life savings go up in smoke wouldn't necessarily have been prudent.
Certainty is only one benefit that annuities bring investors. In his interview, Kitces points out some of the favorable tax aspects of annuities. Annuities give you tax deferral, which may be worth enough to you in some cases to outweigh fee considerations. Any income from the annuity, however, gets taxed at ordinary rates when you withdraw it. So in general, you'll want to make sure you're maximizing tax-favored retirement accounts before using fixed or variable deferred annuities to accumulate wealth.
In addition, various other traits, including death benefits for surviving family members, can make certain types of annuities a smart move. There's a lot more in the full interview in Rule Your Retirement, which you can access even if you're not a current subscriber by taking our free trial offer.
Annuities aren't for everyone, but they're not the monsters that many people believe they are. As part of a well-balanced portfolio, annuities can serve a valuable function that will help you guarantee at least a portion of your retirement income as long as you live. In these uncertain times, that's definitely worth something.
To retire rich, you have to start early. Nathan Alderman has some great stock ideas for young investors.