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Retirees Must Manage Risk


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After a lifetime focused on maximizing wealth or beating a benchmark, your goal becomes creating sustainable income over an indefinite length of time—the rest of your life. Lifetime risk can be framed simply as the possible shortfall in the amount you will need to spend, which can happen when market returns are bad or your life is unusually long.

Not very long ago in America, most people who had a long-term job could look forward to a pension based on their level of income while working and that was pretty much guaranteed by their employer. In other words, along with Social Security, they had a somewhat predictable retirement income that would last them the rest of their lives. Any risks associated with the investments that underlay their pensions were assumed by their employer.

Today that scenario has changed radically: Employees must rely on 401(k)s based mostly on the employee’s contributions and, if they can, any extra money that they put into personal IRAs. While the employer-run 401(k)s may offer a limited set of mutual funds chosen by the employer and the 401(k) custodian, presumably with the employee’s interests at heart, the individual employee must still choose which of those funds to place their retirement money into.

Retirees must manage risks like market performance along with their own longevity and the uncertainty about their spending requirements. There are some key differences to investing before retirement and investing after retirement. Before retirement, an investor has the opportunity to use automatic contributions to their retirement account to gain the benefits of dollar cost averaging.

The importance of avoiding risk is substantially increased in retirement because dollar cost averaging can start to work in reverse. If an investor is drawing down the value of their account during retirement, then they are effectively using dollar cost averaging in results and will sell the most shares at the worst times.

When people think of risk, they are usually thinking of volatility, or the daily fluctuations in the stock and bond markets. Many people understand they need to take some risk in their portfolios — it’s an inherent part of investing. They focus on getting the highest return possible on their funds, but may end up taking on too much risk as a result.

The U.S. retirement system has long been based around three main sources of income: Social Security, employer retirement benefits and personal savings, however, their results indicate that today’s worker are expecting to draw their retirement incomes from a significantly more diverse set of sources.  Exposure to more volatile higher-risk assets, such as equities, means that members run the very real risk of a sudden drop in the value of their investments before and at retirement.

And the personal IRAs must be managed by the employee. In both cases the employee assumes all of the risk that will influence how much money he or she will have at retirement and during retirement.  It makes sense to protect retirement savings by selling when the market is going down, but where’s the best place to put that money if a retiree investor does decide to sell?

Retirement plans are like containers. They hold your investments within them. When you sell, you sell one (or more) of the investments inside the container and you can buy a different investment inside.  With the aging population, and declining defined benefit plans, it stands to reason that demand for income replacement tools such as Fixed Indexed Annuiies (FIA)s will continue expanding.

These annuities offer a minimum guaranteed return like traditional fixed annuities or bonds, combined with an interest rate that’s linked to a market index such as the S&P 500.  One key reason retirees purchase FIAs—also called indexed annuities or equity-indexed annuities—is to protect their retirement income from market loss.  One of the core elements of the FIA value proposition is the opportunity to participate in market performance without putting principal at risk.

FIAs are not necessarily an equity replacement, but they are certainly a way for consumers to hedge themselves in equity markets. FIAs can offer a higher return than a traditional fixed annuity. Any gains earned are locked in and will never decline.  The primary pro is that they allow investors to partially participate in the upside of equities, and then lock in that upside.

As reliable sources of income, they resemble bonds more than stocks. They can serve the purpose that bonds traditionally have in an asset allocation model, though FIAs do not participate in any stock, bond or other investment directly.

A fixed-indexed annuity, or FIA for short, is an annuity that earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the Standard & Poor’s 500 Composite Stock Price Index (the S&P 500).

With concerns over inflation and making sure that investments will meet our future needs, many people have turned to the fixed market for higher returns. It makes sense when you consider how well the S&P 500 index has performed historically.

The first and possibly most attractive provision of a fixed-indexed annuity is the no-loss provision. This means that once a premium payment has been made or interest has been credited to the account, the account value will never decrease below that amount. This provides safety against the volatility of the S&P 500.

FIAs offer consumers what could be described as the best of both worlds: a market-driven investment with potentially attractive returns, plus a guaranteed minimum return. In short: You get less upside but much less downside.

While it’s a lot like investing directly in the stock market, you don’t get the full boost of a rising market. With fixed-indexed annuities, the money put down by you, as a purchaser, isn’t invested directly in the stock market. Instead, you are offered a percentage of how much the index gains over a period of time, and a guaranteed minimum return if the stock market declines.

Your fixed-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum.

A fixed-indexed annuity typically offers other benefits that are not generally included in traditional policies: a 100 percent money-back guarantee, no front-end sales charges, and no annual management fees or administrative fees.

Before you invest in a fixed-indexed annuity you will want to read the fine print. There are surrender charges for early withdrawal, although most companies now allow yearly withdrawals at set amounts. Notably, the surrender charges often decrease the longer you let the company keep your money.

 

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Wednesday, June 3rd, 2015 Wealth Management

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