This includes maximizing the value of your retirement portfolio – and creating dependable income streams that last as long as you need them to.
For retirement investors, one way to solve for this concern is drawing on a lifetime income stream from an annuity. But how appealing are annuities in the face of historically low interest rates? Especially ones such as those we have experienced for the last several years?
Since 2009, in the aftermath of the Great Recession, most developed countries have experienced a low-interest rate environment. Monetary authorities have sought to use low-interest rate schemas in order to spur economic growth and prevent deflation.
The U.S. saw rates cut to effectively 0% until 2016, when they began to inch higher. Still, today, the federal funds rate is only 2.5%, up just half-a-point from this time last year when it measured 2%.
How Have Interest Rates Played Out?
Before the Great Recession, the federal funds rate had been set as low as 1% in the early-to-mid 2000s. Historically, the rate agenda had seen higher benchmarks than this low point.
So, if low interest rates seem to be in a holding or slow-incline pattern, are annuities still an attractive option? How effective can they be when their payouts are tied to our current less-than-stellar interest earning rates?
Several experts who have considered this question see the potential role that deferred fixed annuities could play in the fixed-income portion of a portfolio.
According to them, this can be when investors seek to combine growth with the preservation of assets. And that is even with an expectation that interest rates might rise in the future.
Wade D. Pfau, Ph.D., CFA, is Professor of Retirement Income at The American College and holds a doctorate in economics from Princeton University. He is widely published in academic and research journals on retirement income topics.
In a recent whitepaper on this subject, Dr. Pfau concluded: “Purchasing a deferred fixed annuity at present has the potential to outperform other fixed-income strategies, even in a rising-rate environment.”
What Does This Mean for Bonds?
Fixed income assets include individual bonds, bond funds, deferred fixed annuities, and deferred fixed index annuities.
Understanding how bond prices are determined, and how bond values fluctuate with changing interest rates, can be beneficial. It can help people compare and contrast their options when choosing a fixed-income asset.
A key factor for bonds is the relationship it holds with interest rates. This seesaw image shows an inverse relationship between market interest rates and bond prices.
This bond will still offer a 2.25% coupon rate, but with the market-interest rate drop, it offers a higher payout than newly-issued bonds with the 1.75% coupon rate. If the 2.25% bond were sold before it reached maturity, the bond seller would likely benefit from a higher bond price than what they had paid a year prior.
This is because of the inverse relationship between market interest rates and bond prices. When market interest rates increase, bond values decline. Alternatively, when market interest rates go down, bond values rise.
In his whitepaper, Pfau states: “A low-interest rate environment is risky for investors, especially those approaching retirement. First, it is important to understand that bond prices will decrease if interest rates rise. Bond funds can be volatile and experience losses, and individual bonds may also experience loss when sold before maturity. Bond duration is a measure of just how sensitive bond prices are to interest rate changes.”
What Problems Can Annuities Solve?
In considering deferred fixed annuities and the benefits they might provide relative to other fixed choices, Pfau points out four advantages:
1. Protection of the annuity’s value from investment volatility.
“Deferred fixed annuities support growth at a specific interest rate without exposure to price fluctuations and potential losses as interest rates change,” Pfau observes. “Principal is protected and secured. This provides a way to take risk off the table in the pivotal years before the retirement date.”
2. The ability to earn higher yields than Treasury bonds.
Insurance company general accounts may invest in higher-yielding corporate issues to provide diversification(similar to a bond fund), while protecting the annuity contract holder from interest rate risk. And they provide the principal protection similar to an individual bond held to maturity.
3. Reduction in credit risk.
Because insurance companies can diversify their holdings across a wide range of fixed-income securities, deferred fixed annuities may offer lower credit risk.
4. Tax deferral.
Assets grow faster when investors are able to defer taxes on the interest earned until they actually withdraw it, or it is distributed to them. Because an annuity is tax-deferred for individuals, deferred fixed annuities postpone the taxes on growth until the annuity’s maturity date, allowing interest to compound, untaxed.
Getting the Timing Right
The bottom line is, if an annuity fits into your strategy, there are reasons to continue with this game-plan, despite low interest rates. Pfau cautions that if you waited for interest rates to go up, which could or could not happen, you could spend down more of your principal.
He points out that this would be especially true if your living expenses exceed the interest, dividends, and capital gains you were earning.
And if rates do eventually rise, you might not be able to purchase more income-generating products, such as annuities. Why? Because while you might be getting a higher interest rate, it would be applied to a now-smaller investment. Waiting, he concludes, adds a new form of risk.
Wait Until Closer to Retirement?
If you think you won’t face this risk anytime soon because you have several years until retirement, Pfau has a finding on that, too.
Laddering annuities could be a good strategy if your retirement isn't eminent, according to Pfau. This approach lets you put money into annuities over time instead of all at once. That can help you manage inflation risk, along with maximizing your guaranteed lifetime income.
With this said, an annuity -- or any financial or insurance solution for that matter -- must make sense for you and your financial circumstances.
The strategies and solutions that can help you reach your retirement goals must be customized to your unique situation. Working with a financial professional can assist greatly in achieving the peace of mind you gain from making informed choices.
Planning for Your Future Income Security
If you are considering an annuity for your financial future -- or if your existing income plan could be enhanced with guaranteed income streams -- you can request personal financial guidance to explore your options.
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