Stocks are on a tear, and it’s tempting to run full-speed-ahead with them, but that could get you in trouble. Markets can turn on a dime. That’s why you need an asset allocation plan — and possibly some fixed annuities.
An asset allocation plan means that you set the percentages you put in equities (stocks or stock funds) and fixed income, which includes savings accounts, money markets, CDs, bonds and fixed annuities. Your asset allocation should not change in the short term, but it will change over the years. As you approach retirement, you’ll normally decrease the percentage in stocks and boost your share in safe investments. Once you’re retired and begin withdrawing your savings, you’ll likely want to become even more conservative.
Sticking to your asset allocation decreases excessive stock market risk and prevents you from buying high and selling low. When the market falls, you’ll be less tempted to sell everything because you’ll also have a solid cushion of fixed assets. Many people without a plan panic and sell their stock funds at exactly the wrong time, when the market is at a low point.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
You’ll also be able to resist overinvesting in the market when it’s reaching new all-time highs, as it’s been doing. When there’s a bull market, it’s easy to get too excited and forget that what goes up will come down eventually.
The right asset allocation is individual. Besides your age and expected income in retirement, your psychology is important. Some people are very risk-averse. Others don’t mind the ups and downs of the stock market too much.
Choices for your accumulation phase
Most people’s financial lives fall into two distinct phases: accumulation and distribution, sometimes called decumulation. When you’re working, you’re in the accumulation phase. You’re saving for future needs, such as a first home, education for your kids and retirement.
It’s hard for many people to put aside much money in the early years of their working life. But once education and other needs are met and as you advance in your career, you can ramp up your savings, especially in your 50s and early 60s.
Stocks, savings accounts, money markets, CDs and bonds can all play a valuable role as part of your asset allocation during the accumulation phase. Their characteristics are well known. The advantages of fixed annuities, on the other hand, are less well known.
A deferred fixed annuity is suited for the accumulation phase because you don’t need current income. It defers payments, and thus taxes, until the distribution phase, when you do need income. Without the drag of taxes, all your earnings can be reinvested and grow faster.
One of the most popular products is the multi-year guaranteed annuity, also called a CD-type annuity. You make a single deposit. The annuity pays a set, guaranteed interest rate for a set period of time, usually three to 10 years. There’s no sales charge. Every dollar you deposit goes to work for you immediately. Unlike a CD, the annuity is not guaranteed by the FDIC. It is issued and guaranteed by an insurance company, not a bank. State regulators constantly monitor the financial strength of insurers.
State guaranty associations provide an additional layer of protection, which varies by state. Nevertheless, it’s wise to check out an insurer’s financial strength before buying an annuity.
Fixed-annuity advantages include:
Higher guaranteed rates
Multi-year guarantee annuities often pay substantially more than a comparable bank CD. For example, as of late December 2019 the highest-paying five-year CD was recently yielding 2.20% versus 3.71% for the top five-year annuity.
Tax-deferral
All of the interest CDs earn is subject to federal and state income tax annually, even when it’s reinvested in the CD. Similarly, interest from money markets and most bonds is also taxable unless held in a qualified plan, such as an IRA. Municipal bonds pay tax-free interest, but muni rates are lower than other types of bonds.
With a deferred annuity, you won’t receive a 1099 and you won’t owe tax on the interest until you withdraw it. At the end of the annuity’s initial guarantee period, you may renew it for another term or roll it over into another annuity.
You can continue to defer taxes as long as you like, until you need the money for retirement or another purpose.
Guaranteed principal
Your principal is guaranteed by the issuing life insurance company. Life insurers are strictly regulated by the states to ensure solvency. An additional layer of protection is provided by state guaranty associations up to certain limits that vary by your state of residence.
Bond mutual funds are also used in asset allocation to reduce risk. However, bond-fund share prices vary. You can lose money in a bond fund, especially in long-term funds.
There are some downsides to fixed annuities.
First, they have less unpenalized liquidity than most alternatives. You can always cash an annuity in, but you’ll pay a penalty for an early surrender if you do it before the contract term is over. Because they have less liquidity than bond funds or money markets, you probably wouldn’t want to put all of your fixed-income investments in annuities.
But there is some liquidity. Many fixed annuities let you withdraw up to 10% a year penalty-free. They’re thus more liquid than most CDs, which usually have penalties for early withdrawals of any amount.
Second, interest earnings are taxable when withdrawn, and prior to age 59½ are also subject to a 10% IRS penalty. If you’re under 59½, you should be able afford to tie up some of your money past that age. You can continue to defer taxes by rolling over funds into a new annuity when the current contract guarantee period ends. People who are already 59½ or older don’t face that drawback.
During the distribution phase
Once you’re retired, you’ll need income from your savings. This is the distribution phase of life. Annuities offer unique advantages here.
If you have an existing annuity, you may choose to annuitize it. That is, you’ll convert the cash into a stream of income guaranteed for whatever period of time you choose, such as 20 years or your lifetime — the most popular option.
Lifetime income helps assure you won’t run out of money even if you live past 100. It’s longevity insurance.
Another choice in this stage is to buy an immediate annuity. This will also provide a guaranteed stream of income for a set period or your lifetime.
-
Stock Market Today: Have We Seen the Bottom for Stocks?Solid first-quarter earnings suggest fundamentals remain solid, and recent price action is encouraging too.
-
Is the GOP Secretly Planning to Raise Taxes on the Rich?Tax Reform As high-stakes tax reform talks resume on Capitol Hill, questions are swirling about what Republicans and President Trump will do.
-
Social Security Is Taxable, But There Are WorkaroundsIf you're strategic about your retirement account withdrawals, you can potentially minimize the taxes you'll pay on your Social Security benefits.
-
Serious Medical Diagnosis? Four Financial Steps to TakeA serious medical diagnosis calls for updates of your financial, health care and estate plans as well as open conversations with those who'll fulfill your wishes.
-
To Stay on Track for Retirement, Consider Doing ThisWriting down your retirement and income plan in an investment policy statement can help you resist letting a bear market upend your retirement.
-
How to Make Changing Interest Rates Work for Your RetirementHigher (or lower) rates can be painful in some ways and helpful in others. The key is being prepared to take advantage of the situation.
-
Within Five Years of Retirement? Five Things to Do NowIf you're retiring in the next five years, your to-do list should contain some financial planning and, according to current retirees, a few life goals, too.
-
The Home Stretch: Seven Essential Steps for Pre-RetireesThe decade before retirement is the home stretch in the race to quit work — but there are crucial financial decisions to make before you reach the finish line.
-
Three Options for Retirees With Concentrated Stock PositionsIf a significant chunk of your portfolio is tied up in a single stock, you'll need to make sure it won't disrupt your retirement and legacy goals. Here's how.
-
Four Reasons It May Be Time to Shop for New InsuranceYou may be unhappy with your insurance for any number of reasons, so once you've decided to shop, what is appropriate (or inappropriate) timing?
