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Annuities can provide a floor when markets take a freefall

by Joseph Arroyo | Contributor
May 10, 2020

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The importance of asset allocation is revealed during times of stock market declines. Too much exposure to the market can lead to catastrophic losses. Using annuities as part of your retirement plan can mitigate market losses, and even offer the ability to earn high returns.

What are the dangers of being over-exposed to the stock market?

Asset allocation is the act of investing parts of your portfolio in different types of assets. The goal is to maximize investment returns while minimizing losses. Many strategies and stock/bond ratios have been proposed.

A useful tool is the 100 minus your age method: Subtract your age from 100 and whatever the result, that is the percentage of your portfolio that should be exposed to the stock market. Since this number decreases each year, it can be useful to help you pare back your stock market exposure as you get older.

During persistent bull markets, however, many people are tempted to keep too large a percentage of assets in the stock market. Reaching for yield, older Americans suffer the most when the stock market experiences a rapid decline.

A bear market is defined as a decline of more than 20%. There have been 16 bear markets since 1926, and three since the year 2000. Bear markets are almost always described as sudden, or swift. Reducing risk while the bear market unfolds is usually not possible. The loss of 20% or more of your nest egg near retirement is a serious blow; one from which many don't recover.

The most recent bear market, due to the COVID-19 pandemic, has seen some of the fastest declines in history. For the period from February 12, 2020 to March 23, 2020 (28 trading days), the stock market indices lost an average of 32.8%.

If you had a $500,000 portfolio invested in these indices, you would have watched it shrink by $164,000. This is a huge impairment to your savings, with severe consequences for retirement.

How do annuities help mitigate stock market volatility?

Annuities can be an excellent protection against large market losses. Fixed annuities pay a fixed rate of interest (some annuities, as we'll discuss later can pay an interest rate based on stock market returns). However, a fixed annuity protects you from losing money. You cannot lose money due to market declines in a fixed annuity.

Annuities serve a double purpose in your retirement plan. On the one hand, any money invested in fixed annuities is safe from market losses. On the other hand, annuities are designed to pay you a fixed income for the rest of your life.

Fixed annuities have two conditions, or phases:

  • Accumulation phase
  • Distribution, or annuitization, phase

During the accumulation phase, you contribute money to the annuity, and are credited with interest. When you decide it's time to receive income from it, you can "annuitize" it. At this point, the annuity will begin paying you a fixed amount of money for a specified term, usually over the rest of your life, but also sometimes over the life of you and your spouse (joint and survivor annuity). These two features of annuities make them a perfect fit for people within a decade of retirement age.

There are downsides to fixed annuities, to be sure. For one thing, the interest they pay can be very low, so you're not likely to make large investment gains in your traditional fixed annuity.

Also, annuities have surrender charges. This is a fee you pay to withdraw your money in the early years of your contract. Surrender charges can be high, often 10%. You should always buy an annuity with the intention of keeping it at least until the surrender period runs out.

Despite these potential negatives, annuities have always provided peace of mind in two areas: You won't lose money, and you'll have a stream of income for life.

Can I use annuities to have some exposure to the stock market?

Traditional annuities are known for paying a small, but safe, rate of interest. There is a twist on the traditional annuity that may play a key role in your retirement plan. The fixed indexed annuity is a financial vehicle that combines the guarantees of traditional annuities with the ability to earn higher rates of interest.

The specifics of fixed indexed annuities vary, but they all have these things in common:

  • They're issued by insurance companies
  • They allow you to earn interest based on the performance of some investment index or indices
  • They protect your money from losses

These insurance products typically work by allowing you to allocate a portion of your principal to a stock market index, or to several indices. The interest rate the company pays is tied to the performance of the indices you choose. Regardless of how they perform, though, there's a floor (typically 0%) below which your interest rate can't drop. This protects you from losing money.

There are two other terms you'll need to be familiar with in order to understand fixed indexed annuities:

  • Participation rate
  • Cap rate

The participation rate is set by the insurance company, and it sets a limit on how much of the index's performance your money will be exposed to. If your indexed annuity has a participation rate of 75%, this means that your interest rate will not be more than 75% of the performance of your chosen index.

As an example, assume that your annuity has a participation rate of 75%. Your chosen index increased 10% during the policy year. Your interest rate will not be more than 7.5% (75% participation rate X 10% index return).

The cap rate refers to a hard cap that is placed on your interest rate. Some contracts might specify a rate cap of 5%. This means that no matter how well your indices perform, you'll never earn more than 5%. Remember, though, that even if you're rate is capped, so is your possibility of loss; you won't suffer "investment" loss in your indexed annuity.

Some fixed indexed annuities come with no cap rate. These can obviously deliver impressive interest gains, all while protecting you from any losses. A study reviewed on Kiplinger's showed that over a 50-year period, a portfolio that was only exposed to market gains, but never lost money, returned over 200% more than the actual return of the S&P 500, even with dividends reinvested.

The same article showed that looking back over 90 years, uncapped indexed annuities would have earned more than a traditional bond portfolio. The key to both of these findings is the protection from loss, rather than making huge investment gains in any given year.

Just as with traditional annuities, there can be a downside to fixed indexed annuities. For one thing, they also come with surrender charges. Also, they can be laden with fees. Be sure you understand what the fees are, and how long you'll have to keep the annuity before the surrender charges expire.

Should you add fixed indexed annuities to your retirement plan?

Always talk to your investment advisor before purchasing an annuity, or any other investment. Your advisor can help explain the various fees and charges associated with a fixed indexed annuity. They can help you determine what kind of interest you're likely to earn, and how much you'll have to earn to make up for the fees. If you're OK with these aspects of fixed indexed annuities, they may be a good option for your retirement plan, and a great way to safely participate in the next bull market.

Alliance America can help

An Alliance America financial advisor can assist you in maximizing your retirement resources and help achieve your retirement goals. Alliance America's planning process is focused on personalized retirement income planning. As fiduciaries, our advisors are required to act in your best interest, and we are dedicated to helping you achieve the retirement lifestyle you seek. You can request a no-obligation consultation by calling 888-864-2542 today.

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