Financial planners agree that pre-retirees and retirees need investment growth to beat inflation.
But while equities have outperformed fixed options in the long run, markets can plummet and take many years to recover. Retirees who have too much money tied up in the stock market take a big risk. If you need income and have to take withdrawals when the market is down, you may deplete your savings prematurely.
At the other extreme, putting all your money in safe Treasuries and CDs presents a different risk. With their low yields, they may not offer a sufficient bulwark against inflation.
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So how can you structure your savings to grow faster than the rate of inflation? How can you obtain safety, yield and growth potential?
Divide your retirement portfolio into three buckets: Safety, Safety Plus Growth Potential and Growth. By splitting up your savings wisely among these three slices, you’ll have the best shot at beating inflation without taking excessive risk.
Your Safety Bucket
Safe vehicles include certificates of deposit, bank accounts, Treasuries, municipal bonds and fixed-rate annuities. Safe investments, except municipal bonds (which are tax free) and deferred annuities, increase your current taxable income unless they’re in a qualified retirement account.
Among safe-bucket choices, only fixed-rate deferred annuities are tax-deferred. Without the drag of annual taxes on your interest earnings, your savings will grow faster until you need the money.
Tax deferral is a key tool to beat inflation. Max out your contributions to your IRA or 401(k) or similar plan, and then shelter from taxation even more of your retirement savings in annuities.
Like CDs, fixed annuities pay a fixed rate of interest for a set period of time that you choose. But they usually pay considerably more than CDs with the same term. For instance, the highest-paying five-year CD as of mid-June 2021 yielded a mere 1.15%, versus 3.00% for a five-year annuity. (For a list of fixed-annuity rates, see this rate table.)
Combining a markedly higher yield with tax deferral makes for a big long-term advantage.
Your Safety Plus Growth Potential Bucket
The fixed index annuity is the only vehicle in this category.
This is the only asset I know of that both guarantees your principal and gives you market-based upside potential. It can hedge against inflation without adding downside risk. Your principal is guaranteed, but the interest rate varies according to the performance of an underlying market index. The product is suited for people who want principal protection but are willing to withstand some interest-rate uncertainty.
You get an opportunity to earn more interest than with other safe investments. You can shelter some of your money from market risk without locking in a lower fixed interest rate.
The fixed index annuity credits interest based on the changes to a market index, such as the Dow Jones Industrial Average or S&P 500. Interest is credited when the index value rises, but when it falls, you lose nothing. Since the minimum interest rate is usually zero, there may be years when you earn no interest.
In exchange for downside market protection, you’ll usually receive less than 100% of the index’s gains. How much you’ll get depends on the limiting factor(s) used:
- A cap rate sets the maximum rate of interest an investor can earn. If the cap is 10% and the S&P rises 40%, the investor’s gain is limited to 10%.
- A participation rate determines what percentage of the increase in the underlying market index will be used to calculate the index-linked interest credits during the index term. So, if the annuity has a 50% participation rate and the S&P rises 20%, the investor is credited with a 10% gain.
- A spread rate or margin is a percentage that’s deducted from the change in the underlying index value to determine the net amount of index-linked interest credited to the annuity. In this case, if the S&P 500 rises 6% and the annuity has a 2% spread, the investor would be credited with a 4% gain.
Fixed index annuities are suited for investors with a longer time horizon of seven or more years. So, people who can meet their liquidity needs from other accounts are good candidates.
Your Growth Bucket
Growth investments, primarily U.S. and foreign stocks, are generally considered the best long-term inflation hedge, but they have unpredictable returns over the short and medium term. Retirement savers should decide how much risk they can withstand today while gradually reducing their equity portion as they age.
How much should you allocate to these three buckets? One question to ask is: How much of my funds am I willing to wait to regrow in case of a market decline before I want or need to access them?
Also, consider your need for cash and/or income. If you need to withdraw interest earnings annually, I’d recommend plain fixed-rate investments for that portion of your assets. Beyond that, the right mix of growth, safety and safety-plus-growth-potential investments is determined by your risk tolerance.