Potential Portfolio Insurance With a Contingent Deferred Annuity

Running out of money in retirement and generating a steady paycheck from a portfolio is arguably the hardest piece of investing. Given the uncertainties in the bond market, social security, and overall volatility, annuities are being touted by pundits and policymakers as great tools to get the income retirees need.

To that end, immediate annuities have gained in popularity. Here, investors hand over a lump sum of cash to an insurance company in exchange for a steady, monthly paycheck.

However, there are some issues with an immediate annuity. For one thing, you ‘lose’ that money when you hand over your check to the insurance company. That can be psychologically hard for some investors to do, especially when you consider the insurance company is betting on you passing on before they hand back all your investment as monthly paychecks. Dying earlier than expected is a real risk and, depending on the kind of annuity purchased and riders, you and your spouse/heirs could lose that initial investment

Secondly, immediate annuities are relatively cost prohibitive for many investors. It takes a lot of initial money to buy one and generate enough income. An investor may need to use their whole portfolio value to buy one to generate enough monthly income. Here again, that can be a hard pill for some investors to swallow.

As a result, immediate annuity adoption continues to get mixed responses despite the potential benefits.

So, an immediate annuity may not work for everyone. However, there is still a problem with generating enough income and not running out of money in retirement. And that is where a Contingent Deferred Annuity (CDA) could come in.

In a nutshell, a CDA starts paying out income to an investor when they run out of money.

Here, a CDA is purchased on a basket of assets, such as mutual funds, ETFs, individual stocks, bonds, etc. The annuity contract begins paying out a monthly check for life when those assets are depleted below a certain threshold. Investors are able to stay fully invested throughout full market cycles and withdraw money according to the annuity agreement as they see fit. So, if the market performs well and the value of the portfolio stays above thresholds, the CDA never kicks in.

However, if market volatility increases or we enter a bear/downward trending market, investors can continue to withdraw money from their portfolios like usual knowing the CDA will start paying out if the value drops below a certain level.

Additionally, if an investor lives longer than they expect and they deplete the pool of assets through normal spending and market conditions, the CDA kicks in, providing payments until the end of their days.

With a CDA, investors can tackle the three biggest risks to a portfolio at the same time: sequence of returns risk, market risk, and longevity risk.

There are some other benefits to using a CDA. For one thing, you can ‘bundle assets.’ Unlike a QLAC or buying an immediate annuity, investors can use assets in different accounts to buy a CDA, i.e., it acts like a wrapper product. You can take an ETF from your IRA, a mutual fund from your taxable account, and put them together under the CDA umbrella. This is huge because it eliminates rebalancing headaches, taxes, and other issues and keeps a portfolio as is.

Secondly, costs for a CDA are much lower than other varieties of annuity products. Because it is a separate investment account, unlike a variable annuity, fees and expenses are much lower for a CDA. It takes much less initial capital to purchase a CDA than an immediate annuity to generate the same amount of income later on.

However, there are some cons to the product. For one thing, your spending is limited to a set amount. With a CDA, the insurance company limits the withdrawal rate per year on the basket of assets. So, you can’t go out and blow all your money on a Ferrari and then expect the insurance to kick in. Some CDAs come with inflationary increase clauses, but you are limited on withdrawal rates. That could be an issue if there’s an emergency or unplanned use during retirement.

Additionally, despite being created in 2009, there are not many choices for CDA issuers. The bull market of the last decade has prevented their adoption. However, this is beginning to change as income needs grow.

Don’t forget to check out this article to learn how the SECURE Act can impact annuities.

For investors, securing lifetime income is a big issue when approaching retirement. A CDA could be the answer to removing some of the risks and gaining a steady paycheck after an investor’s portfolio is depleted.

Don’t forget to explore our recently launched model portfolios here.