Annuities and the Sequence of Returns Risk
As you approach retirement, one of the most important things to consider is how you will generate income in your golden years. While Social Security benefits can provide some support, they may not be enough to cover all of your expenses. That's where annuities come in. An annuity is a financial product that can provide you with a guaranteed stream of income for life or a set period of time. However, there is a risk associated with annuities that you need to be aware of: the sequence of returns risk.
Sequence of returns risk is the risk that you will experience negative investment returns early in your retirement, which can have a significant impact on your retirement income. Let's say you retire at age 65 and you have a $500,000 annuity that is designed to provide you with $25,000 per year for the rest of your life. If the market experiences a downturn in the first few years of your retirement, your annuity may not be able to keep up with inflation and you may be forced to withdraw more money than you had planned in order to cover your expenses. This can deplete your retirement savings much faster than you had anticipated.
While sequence of returns risk is a real concern, there are steps you can take to mitigate this risk when using annuities for retirement income.
One way to mitigate sequence of returns risk is to consider a fixed annuity. With a fixed annuity, the insurance company guarantees a fixed rate of return for a set period of time. This can provide you with a predictable stream of income that is not dependent on market performance. However, it's important to note that fixed annuities may not keep up with inflation, so you'll need to factor in the impact of inflation on your retirement income.
Another option to consider is a variable annuity with a guaranteed minimum income benefit (GMIB). With a GMIB, the insurance company guarantees a minimum level of income regardless of market performance. This can provide you with some peace of mind knowing that you will have a minimum level of income in retirement. However, it's important to note that variable annuities may come with higher fees and expenses than other types of annuities.
A deferred annuity is an annuity that you purchase now, but the payments don't start until a later date. This can be a good option if you're still a few years away from retirement and you're concerned about sequence of returns risk. By purchasing a deferred annuity, you can lock in a guaranteed stream of income for the future, which can help to mitigate the risk of market downturns in the early years of your retirement.
It's important to note that annuities are not a one-size-fits-all solution. The type of annuity that is right for you will depend on your individual financial situation and retirement goals. Before purchasing an annuity, it's important to do your research and consult with a financial advisor to determine which type of annuity is right for you.
In addition to considering the type of annuity, there are other steps you can take to mitigate sequence of returns risk. One strategy is to have a diversified portfolio that includes a mix of stocks, bonds, and other investments. By diversifying your portfolio, you can help to reduce the impact of market downturns on your retirement income.
Another strategy is to have a cash reserve that you can draw on in the event of a market downturn. This can help to mitigate the need to withdraw more money from your annuity than you had planned in order to cover your expenses.
It's also important to remember that annuities are just one piece of the retirement income puzzle. You may also want to consider other sources of retirement income, such as Social Security benefits, pensions, and other investments.
In conclusion, annuities can be a valuable tool for retirement income planning, but it's important to be aware of the risks associated with them. Sequence of returns risk is a real concern, but there are steps you can take to mitigate this risk. By considering a fixed annuity, a variable annuity with a GMIB, or a deferred annuity, you can help to ensure that you have a guaranteed stream of income in retirement, regardless of market performance. As with any financial product, it's important to do your research and consult with a financial advisor before making any decisions.