The stock market remains the most attractive place for investors over the long term - beating out bonds and other low-risk investments. However, to earn those higher returns, investors face more volatility.
Many older investors simply don't have enough time before retirement to risk a big loss. That was illustrated painfully during the 2007-2008 market decline. Even investors who are confident they can earn superior returns from stocks may reach a point where they want to lock in some of their gains in case markets turn fickle.
Fidelity Investments recently laid out a compelling illustration of how uneven market performance would affect two investors. Fidelity presented a 25-year cycle of annual market gains and losses. At the end of 25 years, the market had achieved identical percent gains and losses each year. But in the case of one investor, annual losses were bunched in the early years, while market increases occurred later on. For the second investor, the pattern was reversed.
Beginning with $100,000, each investor took out $5,000 a year in retirement income. For the investor who experienced early market declines, the portfolio was exhausted by year 20. For the second investor, however, early investment gains bolstered the portfolio against later losses. Total holdings, even with $5,000 annual withdrawals, reached a peak of more than $335,000 in year 16. Even after absorbing three poor years, the portfolio still held more than $240,000 at the end of year 25.
To avoid the risk of an ill-timed market downturn, Fidelity suggested retirement investors consider using some of their nest egg to purchase an annuity. "By adding guaranteed lifetime income, investors can be protected from future market declines while securing income to cover essential retirement expenses," Brett Wollam, senior vice president of Fidelity Investments Life Insurance Company, said in an interview.
Still, annuities are an acquired taste. Many investment advisers do not like their high fees or the prospect of tying up client funds in a relatively illiquid investment.
The bulk of annuity sales are of variable annuities, which allow investors to place assets in mutual funds and therefore participate in stock market gains. Variable annuity assets hit $1.7 trillion at the end of March 2013.
A type of fixed annuity called a deferred income annuity has been growing in popularity. It offers predictable, guaranteed lifetime income beginning on a future date the investor selects. By purchasing a deferred income annuity several years before retirement, investors have the potential to generate higher guaranteed future lifetime income, while reducing some market risk from their overall portfolio during the years before they retire.
"As part of a diversified plan, deferred income annuities enable investors to take more control of their personal economy by creating a future stream of guaranteed income now," Wollam says. According to Fidelity, a $100,000 deferred income annuity today that is purchased by someone at age 60 would generate $671.81 a month ($8,061.72 a year) in income for a woman and $696.89 a month ($8,362.68 a year) in income for a man. Payments to women are lower because they have longer lifespans than men.
Deferred variable annuities provide a different set of choices. These annuities are usually sold with a feature called a guaranteed lifetime withdrawal benefit, which allows investors to participate in future market gains while being protected from market declines. They also enable investors to maintain some control over their assets while still guaranteeing lifetime income payments.
If you decide at age 60 to buy a guaranteed lifetime withdrawal benefit for $100,000, Fidelity offers a product from MetLife that will charge you a fee of $1,900 a year if the product covers only you, or $2,050 a year if you want the product to provide income for your lifetime and that of a surviving spouse.
In exchange for this money, you are guaranteed annual income payments of $5,000 a year beginning at age 65. The MetLife product puts your $100,000 into a Fidelity balanced mutual fund that has 50 percent of its assets in stocks, 40 percent in bonds and 10 percent in cash. The fund charges annual management fees of 0.8 percent. You'd also pay annual management fees - although they might be smaller - if you decided to forgo the annuity and keep your funds invested in the market.
On each anniversary date of your annuity, the following year's 5 percent payout guarantee is reset and will equal 5 percent of either your original $100,000 or of the actual account value as of the anniversary date, whichever is larger.
In the case of a $2,050 annual fee for a joint survivorship annuity, the net value of your annuity's balanced fund investments would have to rise by about 7.05 percent to maintain its $100,000 value. In other words, it would need to rise by enough for you to get your $5,000 guarantee and pay the $2,050 annual fee.
Now, if the market value of your account rises by more than this amount, the resulting total will become the new floor for your payments for the rest of your life (and the life of your spouse). Let's say it rises by 9.05 percent and totals $102,000 at the end of the year. You will then be promised annual payments of 5 percent of $102,000 every year.
If the market does poorly and your account value slips below $100,000, you'll still be promised $5,000 in annual payments (5 percent of the funds you first placed into the annuity).
While a guaranteed lifetime withdrawal benefit variable annuity would not usually pay as large of a monthly payment as a deferred income annuity, Wollam says "they may be appropriate for investors who wish to help support their desired lifestyle with guaranteed income and maintain access to the assets to meet unexpected needs."
Even if the cost and terms of an annuity contract seem attractive, there are some fundamental questions that need to be addressed before buying an annuity:
1. Annuities are illiquid. If you change your mind about an annuity contract, there may be steep fees for the early sale of the annuity. Can you afford to leave your annuity funds untouched for a long time?
2. Are you so far away from retirement that it would be better to leave your retirement funds in the market?
3. What are the financial and tax consequences of assembling the funds needed to buy an annuity? Annuity gains are free from taxes until the product "annuitizes," or begins generating retirement income. So, they are particularly attractive in taxable portfolios. That's because investment gains in tax-deferred retirement accounts are already tax-exempt. However, if you need to sell taxable investments to buy an annuity, make sure the annuity still makes sense.
4. Annuities are particularly helpful when it comes to paying fixed retirement expenses such as housing, utilities and other essentials. If you already have enough income from Social Security and pensions to pay your fixed expenses, do you really need another layer of guaranteed income, or would you be better off leaving your funds in the market?
More From US News & World Report