Before you decide how much of your retirement funds to allocate to stocks and bonds, you may want to add another type of investment to the mix: annuities.
How do you build a portfolio using annuities?
Here’s how the traditional asset allocation approach works: your retirement contributions are divided between stocks and bonds in proportions that align with your risk tolerance, investment goals, and retirement timeline. Based on that, you will determine a sustainable withdrawal rate. In other words, this is the amount you can expect to withdraw each year in retirement without running out of money.
As an alternative, some experts recommend using the funds that would have gone to stocks and bonds to purchase annuities, which provide you with guaranteed income in retirement. This comes in the form of a lump sum or periodic payments.
The third asset allocation model gives you the best of both worlds. Instead of choosing between annuities versus stocks and bonds, you can incorporate annuities alongside stocks and bonds. Or you can replace one asset class in your portfolio with annuities. For example, you might replace bonds.
What are the benefits of annuities?
Your goals should be to reduce the risk of depleting your capital during retirement and to increase your income potential. Annuities, as part of your portfolio, can help you achieve these goals. Here are some ways:
Reducing the risk of income drop: Annuities can reduce the risk of income drop during a market downturn. Within variable annuities, you will often allocate a higher percentage to stocks than you would have if you weren’t using an annuity. But if you have an annuity contract with a guaranteed minimum withdrawal benefit (GMWB) rider, you can feel comfortable doing so. This is because the amount you can withdraw is guaranteed by the GMWB rider, regardless of market performance.
Reducing the likelihood of running out of money: Variable annuities with GMWB and guaranteed minimum lifetime withdrawal benefits allow you to withdraw a certain percentage annually from the total amount you invested for your lifetime. The remaining balance typically extends to the beneficiary after your death. Investors with lower annuitized amounts or conservative withdrawal rates or stock allocations can achieve sustainable income for life. All you need to do is replace a portion of your portfolio with a variable annuity with GMWB.
It can increase your lifetime income: Research by Wade Pfau has shown that a well-integrated portfolio that includes immediate or deferred annuities can lead to higher income levels. It can also result in a larger amount of inherited assets available to beneficiaries compared to the investing-only asset allocation approach. This is largely because a group of insured beneficiaries shares the risks, so the payments for those who do not live long are funded by the payments of those who live longer.
More sophisticated investing: Annuities allow for more sophisticated investing in other areas of your portfolio. Deferred or immediate annuities also help provide a better idea of your future income regardless of market performance. Calculators like the AARP annuity calculator let you assess the expected income from an annuity. You can invest in other funds more sophisticatedly, knowing that a portion of your income is guaranteed.
Important: An investor who buys a variable annuity with a guaranteed lifetime withdrawal will receive a guaranteed payment every year for the rest of their life. This holds true even if the value of the underlying assets of the annuity declines.
How to integrate annuities into your portfolio
Adding annuities to the mix starts with the traditional asset allocation by determining the percentage of funds you want to allocate to stocks versus bonds. Then follow these steps to adjust your asset allocation to accommodate annuities.
Determine
Type of Insurance
You can allocate a portion of your portfolio to one of the three common types of insurance:
- Variable Annuities: These insurance products change with market performance. They allow you to choose a mix of underlying assets. This makes them suitable for investors who want greater control over future investment gains. For example, you can achieve aggressive, moderate-risk, or conservative investment annuities, depending on the assets held within the annuity.
- Immediate Annuities: These types of insurance start paying income immediately, making them suitable if you are retiring now.
- Deferred Annuities: These insurance products provide specific payouts that begin later. They may be more suitable for younger investors with longer time horizons.
Allocating the Insurance Portion of Your Portfolio
Determine the percentage of your portfolio that you wish to allocate to insurance. Below are some asset allocation examples using a mix of traditional assets with insurance:
- Conservative Portfolio: Instead of having a portfolio made up of 20% stocks and 80% bonds, you could create a portfolio consisting of 20% stocks, 60% bonds, and 20% guaranteed income from insurance.
- Moderate Portfolio: Instead of having a portfolio made up of 40% stocks and 60% bonds, you could build a portfolio consisting of 40% stocks, 45% bonds, and 15% insurance. To create additional guaranteed income from moderately risky insurance portfolios, you could allocate 40% stocks, 25% bonds, and 35% insurance.
- Aggressive Portfolio: Instead of having a portfolio made up of 60% stocks and 40% bonds, you could assemble a portfolio consisting of 60% stocks, 30% bonds, and 10% insurance.
Allocating the Equity and Bond Portion of Your Portfolio
Once you know the type of insurance you want to invest in and how much you want to allocate, allocate the equity and bond portion of your portfolio according to the percentages you previously determined. Here are some allocation strategies, in terms of increasing risk:
- Use bonds with staggered maturities and buy dividend-paying stocks, or use a dividend income fund to allocate stocks. Invest in a retirement income fund that automatically allocates and rotates between stocks and bonds at the appropriate percentages for you. Add some high-yield investments to your traditional stock/bond portfolio to maximize current income.
Additional Guidelines for Asset Allocation
Asset allocation decisions are made only once. Asset allocation decisions should be made after crafting a comprehensive income plan either by yourself or with the help of a advisor, taking into account the following factors:
- Current Income: The shorter your life expectancy, the more you might prefer investments and strategies that maximize current income.
- Lifetime Income: The longer your life expectancy, the more you may want to choose strategies that maximize lifetime income. This may mean they generate less income now, but are expected to keep income in line with inflation.
- Lifestyle: You can adjust strategies to meet lifestyle needs. For example, you might want to maximize current income during the first decade of retirement when you are healthy. Then you may intend to withdraw less income later when the pace slows.
Conclusion
Insurance can be a valuable part of your retirement investment strategy. Instead of choosing insurance over stocks and bonds, you can integrate insurance alongside other asset classes in your portfolio. This can help you achieve long-term income for yourself and your beneficiaries without fear of future market volatility.
There are many types of insurance and distribution methods you can use to diversify your portfolio. You should consider your unique investment goals, risk tolerance, and retirement outlook. Then take the approach that best supports your vision for your retirement.
Source:
https://www.thebalancemoney.com/retirement-asset-allocation-2388544
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