Before 2001, most Americans could not fathom the idea that their portfolios would obtain less than double-digit returns. Much of that success was a result of a different economic landscape: one where higher income taxes and mortgage interest rates, coupled with the Internet as a new way of making money, created heavy gains in the stock market. However, after 2000, we’ve endured several major market crashes, job losses, and an unstable economy.
Since then, many retirees’ mind frames have dramatically changed from focusing on wealth accumulation and exorbitant returns to instead concentrating on rising health care expenses and not outliving their hard-earned savings.
The 4% Rule
For years, financial advisors have been touting a supposed safe withdrawal rate, dubbed the “4% rule,” first introduced in the Journal of Financial Planning in 1994. Simply put, if you could live off of 4% of your investments’ income, it would allow ample time for stable growth and endure downfalls. Recently, that rule has been called into question, and most experts are stating that today’s “safe” rate should actually be around 3.3%. Retirees are putting themselves in jeopardy when they are forced to withdraw more than the suggested rate just to the rising cost of living expenses alone.
So, what options can assure retirees a guaranteed income stream for the rest of their lives? Let’s explore the different options available so you can make the best possible choice.
Certificates of Deposit (CDs)
Known as a safe alternative for saving and backed by the Federal Deposit Insurance Corporation (FDIC), certificates of deposit (CDs) have encountered limitations over the past decade from trying to keep up with inflation and facing historically low-interest rates.
The average 6-month to 1-year CD rate had dropped from an average of 5 % in 2000 to less than 1% from 2009-2021. Only in the last 12 months have interest rates increased to well over 3%. On top of that, the United States Department of Labor shows that inflation has been anywhere from 1.5% to a median of 3.24%. According to the U.S. Bureau of Labor and Statistics, inflation in 2022 has been 8.2%, an increase from 7% in 2021 and significantly lower percentages in years past.
If you are relying on CDs to keep up with the pace of inflation (the “silent” retirement exterminator), make sure you are overfunding and withdrawing as little as possible. A reliance on CDs to fund your “glory days” can result in a massive shortfall that could force you to continue working into retirement.
Once known for superb management, diversification, and affordability, combined with good returns, mutual funds have been recently scrutinized for their excessive fees and underperformance.
Typically, financial advisors (or brokers operating under a suitability standard) are at the forefront of recommending a mutual fund to a retiree because of convenience. But, as recent complaints have shed clearer light, investors are learning that they are often sold for personal gain and generating new business for the advisor’s firm.
Even mutual funds with an excellent past history do not guarantee performance in the future. That’s why they all disclose, “Past returns do not guarantee future results.”
When you invest in a variable annuity, you’re spreading your money into mutual fund-like subaccounts across different investments. Backed by insurance companies to provide reassurance, variable annuities gain and lose depending on market performance.
Usually sold by financial advisors or brokers, most variable annuities are weighed down by excessive expenses. Typical fees can total anywhere from 2% to almost 3.5% or even higher in some cases. The most frustrating part of all of it is that, in order to find out what you’re going to pay in fees, you have to struggle through a sizeable prospectus that even some advisors can’t decipher.
Frequently sold for guaranteed retirement income, the majority never actually exercise these benefits. Variable annuities often sound more appealing than they really are.
Regulated as an insurance product and not an investment, the indexed annuity has been a common tool used in retirement planning. According to the Life Insurance and Market Research Association (LIMRA), today’s retirees are depositing more in indexed annuities than variable annuities.
How does an indexed annuity work, and why are retirees relying on them more than variable annuities?
Account values are linked to a market index (such as the S&P 500, Dow Jones, NASDAQ, EURO STOXX, or Hang Seng) but have no immediate exposure to market movements. Each insurance company utilizes a different approach to how interest is credited, which is why you should research which one might be a proper fit.
The majority of the premiums received are invested in the insurance company’s general account, versus subaccounts, as with variable annuities. This allows greater control and hedges on longevity risks that are predictable, versus market risk, which is unpredictable. As a result, these savings can lead to higher guarantees than those provided by variable annuities.
Retirees purchase indexed annuities because they want control over market volatility, protection from inflation, and a guaranteed or predictable stream of income that they cannot outlast. Most are satisfied with not being credited all of the index return in exchange for sustaining losses when there is a plunge in the market.
For retirees, even one year of subpar returns can drastically impact their plans. Remember that if you lose 50% in one year, it requires a 100% gain the following year just to break even. Losses can cost both existing and future growth, and often at your expense.
If you are a retiree, I urge you to think more carefully about including safeguards to prevent disasters in your retirement plan. With investments like mutual funds and variable annuities, there is always the potential to lose a substantial amount on any given day. On the other hand, CD interest rates have dropped by more than half in the past decade; it’s clear why indexed annuities have been consistently delivering desired results for today’s retirees.