Safety and Income: Guaranteed-Income Products
By Brian Perry
Some individuals who are interested in safety and income may find that guaranteed income products are appropriate for their needs. While these products have their benefits, they also come with some drawbacks. Therefore, very careful consideration must be given prior to deciding whether these are appropriate. In this section, we will examine some of the characteristics of guaranteed income products as well as some of their benefits and drawbacks.
What is a guaranteed-income product?
There are two main types of guaranteed income products. The first of these, often referred to as an annuity, is essentially a product where, for an initial investment, an individual receives a guaranteed income stream for the remainder of his or her life. Annuities can be further broken down into fixed-rate and variable-rate products. A fixed-rate annuity guarantees a certain level of income for the term of the annuity; there is no risk that the cash flow from the product will decrease, but it is possible that inflation will gradually eat away at the value of the income stream. A variable-rate annuity is linked to the performance of an investment portfolio; income levels can fluctuate and even decline, but also have a better chance of keeping pace with inflation.
The second main type of guaranteed income product is the reverse mortgage. In a reverse mortgage, homeowners receive monthly payments from the reverse mortgage lender for the remainder of their lives. At the time of their death, the money they have received must be repaid to the lender by the estate, or possession of the house is granted to the lender. The decision to take out a reverse mortgage can be a difficult one to make, and cases of predatory lending have been reported. The AARP, an American organization dedicated to protecting the elderly and retired, has extensive free resources designed to protect senior citizens from potentially unjust lending practices. Anyone considering a reverse mortgage should gather as much information as possible before carefully considering whether a reverse mortgage is appropriate. (See Is a Reverse Mortgage Right For You? to learn more.)
Benefits of Guaranteed-Income Products
Guaranteed-income products essentially function like a pension plan by providing consistent monthly income payments to retirees. The main benefit of these products is that they remove the possibility that individuals will outlive their assets. Guaranteed-income products also make budgeting simpler because monthly cash flow is known in advance and is not dependent on financial market conditions. Finally, these products protect retirees from a sharp market decline that could harm their portfolio and force them to reduce their standard of living.
Drawbacks of Guaranteed-Income Products
While stable income for life is an enticing proposition, guaranteed-income products do have several disadvantages. One of these disadvantages is that individuals are generally locked into a relatively low rate of return. In other words, if an investor buys a diversified stock and bond portfolio instead of purchasing an annuity, portfolio growth over time may ultimately provide a higher level of income than the annuity offers. This means that in exchange for the peace of mind that comes with guaranteed income an individual sacrifices the possibility of higher returns. Costs can also be high with guaranteed income products and are not always readily apparent. This makes comparison shopping absolutely vital when considering these products.
A second drawback of guaranteed-income products is that they often suffer from a lack of liquidity. In other words, once an individual has committed to an investment in a guaranteed-income product they may not be able to reverse their decision. As well, these products may not keep pace with the rate of inflation. In other words, the income the individual receives will gradually be worth less in real dollar terms as time goes by. Some newer guaranteed-income products offer protection against this in the form of cost-of-living adjustments; however, it is important to remember that the investor does not get something for nothing. Future cost-of-living adjustments are priced into the cost of the product.
Guaranteed-income products are also unattractive options if an individual dies at an early age. The longer the individual lives, the more annual income payments they receive, and the higher the "return" on their initial investment. An early death results in fewer income payments, and therefore a less attractive investment return. Therefore, general health and life expectancy are important considerations prior to purchasing a guaranteed income product. It is also important to determine whether a spouse is going to be included in the guaranteed income contract; if so, plans should be made for the annual income payments to continue as long as either spouse is alive.
Finally, guaranteed-income products may not be appropriate options for individuals interested in leaving a bequest to their heirs. Individuals interested in providing for future generations might be better off building a traditional investment portfolio, spending what is necessary during their lives, and then leaving the remainder to their heirs.
Guaranteed-income products are perhaps the most controversial of the asset classes discussed in this tutorial. The benefit of these products is quite clear - the individual no longer needs to fear outliving their assets, and receives a consistent income for the remainder of their lives. However, there are significant costs to these products, including: potentially below-market returns, potentially declining real income, the risk of an early death, a lack of liquidity and reduced options for estate planning. Furthermore, high price structures are sometimes built into these products, and stories of predatory lending practices are common.
As the investment community begins to focus more closely on the needs of the retiring and the elderly, guaranteed-income products will likely become more standardized and more transparent. In fact, this process is already occurring. Still, individuals interested in guaranteed-income products are strongly advised to thoroughly investigate their characteristics, consult the free resources that are available, and do business only with the most reputable of providers. If individuals take these precautions, they may find that guaranteed-income products provide them with consistent income and peace of mind. (More on annuities can be found in our article Annuities: How To Find The Right One For You.)
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