Too Heavy in Stocks? Annuities Could Be a Rebalancing Option

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When Fidelity Investments recently crunched the data on its retirement accounts customers, it found that 37% of those born between 1946 and 1964 (so-called Baby Boomers) have more equity holdings than they should.

Depending on age, people in this age bracket should have 47% to 67% in equities, Fidelity said. But well more than a third were above that.

While there’s no one-size-fits-all when it comes to asset allocation, experts agree that having too much in stocks beyond a certain age is risky. When you’re older, you don’t have as much time on your side to recover from market downturns.

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Fixed-income choices include annuities, bonds and CDs

Annuities, bonds and bank certificates of deposit (CDs) produce an income stream and thus are part of the fixed-income asset class you need to cut back your holdings in equities (stocks and stock funds). When choosing among them, consider yield, guarantees, the safety of your principal, liquidity and taxes.

Treasury bonds and notes, for instance, are popular because they’re guaranteed by the U.S. government. You’re guaranteed to get your principal back if you hold one to maturity, but you can lose money if you sell a bond before it matures. With Treasury bond funds, the price varies, and you may have a loss or gain when you sell. While interest is subject to federal income tax (unless held in an IRA or qualified account), it’s exempt from state tax.

Corporate bonds generally pay more than Treasuries but are subject to more credit risk. Municipal bonds are free of federal income tax, and in-state bonds are free of state income tax. Because they typically pay lower rates, they’re most appropriate for people in higher tax brackets.

Fixed-rate annuities often beat CDs

Bank CDs are popular because they’re easy to buy and guaranteed up to $250,000 by federal deposit insurance (FDIC for banks, NCUA for credit unions), which insures both interest and principal. And while you can cash a CD in before maturity, you’ll usually pay a substantial penalty. Non-qualified CD interest is subject to federal and state income tax in the year it was earned.

A fixed-rate annuity can be a better choice for part of your money. The most popular type is the multiyear guarantee annuity (MYGA), which guarantees a set interest rate for multiple years. Sometimes it’s called a CD-type annuity because it acts much like one, but there are some key differences:

Tax deferral and thus greater compounding. The biggest advantage over CDs is that annuities in non-qualified accounts are tax-deferred. You won’t pay any federal or state taxes on interest you’ve earned as long as you keep it in the annuity. Without the drag of taxes, interest in your annuity compounds and grows faster. When your current annuity matures, you can transfer the proceeds, via a 1035 exchange, to a new annuity and continue to receive tax deferral.

This doesn’t make any difference in qualified retirement accounts (IRAs, Roth IRAs, 401(k)s and similar accounts), since interest in these accounts is already tax-deferred, or tax-free with the Roth IRA. Even so, a MYGA can be a great choice for an IRA or a Roth IRA.

Often higher rates. MYGAs often pay higher rates than bank CDs with a comparable term. While you can today find short-term CDs (six months to a year) that pay more than 5%, annuities usually pay more if you’re looking for a longer guarantee. For instance, it appears that 4.75% is the top rate nationally on a three-year CD as of late September 2023, but you can find a three-year MYGA paying 5.60%. If you want to get a 10-year guarantee, you can earn 6% on an annuity.

While there are bonds and bond funds that do pay more currently, they typically fall into the high-risk or junk-bond category and thus entail more risk, and the goal of asset allocation is to reduce risk.

Typically, more penalty-free liquidity. With CDs, you can usually withdraw interest without paying a penalty, but if you want to tap any of the principal before maturity, you’ll typically pay a stiff penalty. Early-withdrawal penalties vary from bank to bank.

Many MYGAs offer more flexibility and let you withdraw up to 10% of the account value annually without penalty. (All interest withdrawn is taxable.) This can come in handy if rates go up and you’d like to transfer that 10% tax-free via a 1035 exchange to a higher-paying annuity.

Some annuities, however, have less generous withdrawal provisions in exchange for a higher rate. Nearly all MYGAs have surrender charges for withdrawals beyond the amount allowed by the contract. Some insurers may waive all surrender charges if the annuity owner has a terminal illness or is in a care facility for an extended period.

Withdrawal of annuity earnings before you reach age 59½ is subject to a 10% IRS penalty unless you’re totally disabled. While this is an important consideration for non-qualified funds, it’s not as significant an issue for IRA annuities because you’ll normally keep funds in an IRA past that age.

No federal deposit insurance. This is one area where CDs have an edge. But if you choose carefully, it isn’t a major drawback for annuities, I believe.

While annuities aren’t covered by federal deposit insurance, state annuity guaranty associations are required by law to protect annuity buyers, up to certain limits. Coverage limits and conditions vary by state. They apply to the state where you live.

Furthermore, life insurers, strictly regulated by the states, have an excellent track record of financial stability. AM Best rates most annuity issuers with a letter grade. While some people feel comfortable using only A-rated insurers, many companies rated B++ are worthy of consideration.

MYGAs aren’t the only type of annuities that can help you reduce an overdependence on equities. Fixed indexed annuities and lifetime income annuities are also worth considering — but that’s a story for a different article.

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. He’s a nationally recognized annuity expert and prolific writer on retirement income. A free rate comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling (800) 239-0356.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Retirement-income expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. Interest rates from dozens of insurers are constantly updated on its website. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information is available from the Medford, Ore., based company at www.annuityadvantage.com or (800) 239-0356.