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Annuities and target date funds are popular assets for households that are saving for retirement or already in their golden years. How useful these can be for you depends on your financial goals and where you are on your journey to retirement.
For example, John and Susan are both 67 and recently retired. They have $1.2 million in a pre-tax IRA, $750,000 in taxable investments and receive $45,000 in annual Social Security benefits. Should they move their assets into a target date fund or an annuity?
Here’s how to view each item in context. (And if you need help assessing which investments and strategies make the most sense for you, consider talking to a financial advisor.)
Annuities are an income-oriented financial product that you purchase from an insurance company. In exchange for an upfront investment on your part, the company promises a series of payments over time that return both your initial investment and an interest rate.
For retirees, the most popular variant of this is a lifelong annuity. These are contracts that guarantee a fixed monthly payment for the rest of your life. Also called private pension plans, they can be extremely useful for people looking for security. Once you purchase this annuity, the only risk to your income is the unlikely insolvency of the insurance company.
What if our hypothetical couple John and Susan put all their money into annuities? First, investing their $1.2 million IRA in an annuity could yield approximately $82,220 per year ($6,851 per month) in pre-tax income from a single premium with immediate effect, according to Schwab’s Income Annuity Estimator. As long as you invest in a qualified annuity, you can generally do so without triggering an immediate tax event.
But suppose John and Susan want even more guaranteed income and sell their $750,000 portfolio and invest the proceeds in an annuity. After paying capital gains taxes (we’ll assume they had a cost basis of $75,000), John and Susan are left with approximately $558,000. They could use that money to buy a separate annuity that pays out about $38,280 per year ($3,190 per month).
In total, John and Susan would have about $120,500 per year in annuity income, before taxes, if they used their $1.95 million to purchase annuities.
While the two annuities would provide the couple with a steady stream of income for the rest of their lives, John and Susan would have to manage inflation risk since these payments would be fixed. Unlike Social Security benefits, many annuities are not indexed for inflation (you can buy an inflation-protected annuity, but it will likely cost you more). Unless the couple has a plan to use other investments to offset the rising cost of living, the value of their annuity income could decline significantly over the course of a long retirement.
This risk is even greater for people who rent and/or live in cities, where prices can rise faster than core inflation. The value of all this depends on one’s preference for safety.
Financially, John and Susan may be better off if they stick with their investments and forego the annuities. They would presumably still have a strong income stream by following the 4% rule, but one that can more easily hedge against inflation. On the other hand, if they are most concerned about making sure their income is safe and guaranteed, annuities may be able to give them that peace of mind. (If you are considering an annuity, consider discussing it with a financial advisor to assess your options.)
A target date fund is essentially an automated portfolio that is managed according to a predetermined date. With this asset you set a goal and a date (for example, study savings or retirement). The fund then automatically moves its investments based on your flexibility for growth versus your need for security. The further away you are from the target date, the more aggressively the fund will invest. As you get closer to the target date (when you are likely to need the money), the fund will switch to increasingly safer assets to avoid potential losses.
These assets can be very useful for investors looking for a relatively hands-off approach to investing. With both a target date fund and a robo-advisor, you can set a goal and then keep investing without having to manage specific assets and investments.
They are also most useful for people who have time to invest. The whole idea behind target date funds is that they shift the assets of your portfolio over time, allowing you to strike a balance between early growth and safety later.
This is why a target date fund is probably not that useful in John and Susan’s situation. Since they are already retired, they have essentially already reached their target date. While they can still invest around retirement levels (e.g., target date for age 75, age 80, etc.), retirees may not get much value from that.
However, a robo-advisor could be useful for John and Susan. These automated platforms use algorithms to select and manage investments. For example, John and Susan could put their money in a robo-advisor portfolio and set their goal based on modest growth and strong risk protection.
Again, for investors who want to take a hands-off approach to financing, a robo-advisor can be an excellent option. Others, however, may prefer their financial advice to come from a person and not an algorithm. After all, human advisors can also offer services that go beyond simple investment management, including income planning, estate planning and tax strategy. (And if you’re interested in working with a financial advisor, you can use this free tool to contact fiduciaries in your area.)
For households saving and planning for retirement, annuities and target date funds are two common but diverse products to consider. Annuities are insurance contracts that provide streams of guaranteed income, while target date funds strategically select and manage investments based on when the money will be needed. While an annuity may be more useful for retirees seeking income protection, inflation can reduce the value of these payments over time.
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If the idea of a private pension appeals to you, it’s important to understand both the pros and cons of getting an annuity. On the one hand, annuities offer a guaranteed income stream, with a fixed or variable interest rate. On the other hand, annuities are typically not indexed for inflation and may not provide the same returns as other investments.
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A financial advisor can help you assess whether an annuity suits your financial situation. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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The post We have $1.2 million in an IRA, plus another $750,000 and Social Security. Should we shift assets to a target date fund or an annuity? first appeared on SmartReads by SmartAsset.
