For years, conventional investing wisdom has been that once you reach a certain age — generally when you’re within a decade or so of retiring — you should start to shift your investments away from stocks towards bonds, which are lower risk and better for preserving your wealth as your income starts to decrease. But a new study from David Blanchett (Prudential Financial) and Michael Finke (The American College of Financial Services) shows that there might be a better option for tapering your account away from equities as you get older: annuities.
For help planning your retirement income, including investing in annuities, consider working with a financial advisor. SmartAsset’s free financial advisor matching service can help you find a financial advisor in your area who fits your needs.
Why Annuities Beat Bonds
First, it’s important to understand how annuities and bonds both work. An annuity is a financial contract with an insurance company. You pay a premium now in exchange for a guaranteed payment at a later date. Bonds, meanwhile, are essentially a loan you give to another entity. You pay a certain amount for a bond and get paid back later with interest. This financial investment can be bought from companies (these are known as corporate bonds) or from the government (municipal bonds for local government and treasury bonds for the federal government).
Most financial planners suggest investing in equities like stocks early in your life, when you can take risk to build wealth. Later on, you taper your portfolio towards bonds, which are safer. But Blanchett and Finke suggest in their paper that annuities, not bonds, may be the better choice for retirees looking to maintain their lifestyle.
“We find strong evidence that households holding more of their wealth in guaranteed income spend significantly more each year than retirees who hold a greater share of their wealth in investments,” the paper says. “A household with a generous pension and no savings will spend more than a retiree with enough savings to buy an annuity that provides the same income as the pension.”
Essentially, when you have income, as you do with a pension or an annuity, you are more likely to spend the money you have than if it is all held in investments like bonds. Even if the amount of wealth you have is the same, the income causes retirees to spend more freely, allowing for a more comfortable retirement life. Retirees who use income-based vehicles have “the psychological benefit of being given a ‘license to spend’ accumulated savings,” the paper explains.
How to Invest in Annuities
There are a variety of annuity types, but generally you’ll be looking at two categories: fixed and variable. Fixed annuities offer a guaranteed return of principal plus a relatively small amount of interest. Fixed annuities are relatively free of surprises, and you’ll have the same payments for the entire length of the contract.
A variable annuity, on the other hand, allows you to choose the investments you use. You will always get your principal back, but interest varies. These annuities could give you a big payout, but have more risk.
To buy annuities, you can go directly to an insurance agent who will sell one to you. Unless you are a very experienced investor, though, it likely makes more sense to get help. A financial advisor can help you pick the right annuity for you and carry out the sale. Some financial advisors are also insurance agents and will be able to sell you an annuity directly, but be careful: they likely work on commission and, as such, would have a conflict of interest.
Bottom Line
The psychological feeling of earning an income that comes with an annuity makes retirees feel safer spending the money they’ve saved through the years. Investing in annuities may leave older people feeling freer to enjoy their retirement when compared with bond investors who may feel less comfortable using the money they have saved.
Retirement Investment Tips
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Want help with annuities or any other retirement planning issues? Consider working with a financial advisor. SmartAsset’s free tool connects you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors, get started now.
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The first battle of retirement savings is figuring out how much you need. SmartAsset’s free retirement calculator can help you get a sense of how much money you’ll need in retirement and how close you are to being on track.
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