How an Annuity Can Protect Against Stock Market Losses
With the stock market volatility we’ve seen this year, annuities have become a popular way to mitigate risk for a portion of a portfolio. Annuities are a contract between you and an insurance company and should be viewed as an asset class. As with all asset classes such as stocks, bonds and real estate, annuities can be used as an additional option to diversify your entire portfolio. Let’s look at how an annuity can help you.
Fixed Index Annuity
These annuities base your return on an outside stock market index. Since you don’t own the index, you do not bear any of the risk the index may endure. In around 2006, I was at a conference and was having a conversation with one of the leading designers of fixed index annuities. He was describing to me an annuity they were just about to release that generated unlimited upside potential with no stock market risk. At the time nothing like that existed. Historically, you could purchase an annuity that used a stock market index but had to apply modifiers such as caps, fees or averaging, all of which limited the upward potential of the index. As a skeptic I looked at him in denial and asked him, “Really?” I’ll never forget his answer to me. He said, “The technology around hedging against risk has progressed so incredibly fast that in the near future, people will think it was barbaric to take risk with their money.”
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All these years later, I would say he was correct except he missed an important part in that the true cost for unlimited upside potential with no risk is liquidity. Annuities have surrender charges if a withdrawal of more than 10% is made. This is why I only believe in using a portion of your portfolio for the annuity. It’s of vital importance to maintain sufficient liquid assets.
When we build an income plan we use the annuity as our base foundation of safety with no stock market risk, we then allocate funds with a liquid portfolio that strives to limit losses to be no greater than 10%. After that we will further diversify to another liquid portfolio manager who will mitigate losses in their own way.
We are seeing many people rolling their 401(k) into an IRA as an in-service withdrawal and then moving a portion into the annuity. This is a tax-free transaction that will not end the 401(k). We simply are swiping the balance to zero, but your contributions and any matching will build your balance back up again.
Lastly, annuities get the same tax advantages as an IRA and grow tax deferred. This is ideal for people with a large amount sitting in a savings account but are too nervous to get back into the market. Using an annuity can save capital gains taxes and taxable dividends.
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Written by Marc Montini, licensed fiduciary and IAR
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