The term “diversified portfolio” refers to the strategy of acquiring a wide range of asset types so that you aren’t putting the bulk of your money toward just a few investments. The opposite of diversification is concentration, in which the investor owns just a few classes of assets. In idiomatic terms, a concentrated portfolio is an example of putting all of your eggs in one basket, whereas diversification spreads your eggs into smaller groups across multiple baskets. Even if you drop a basket or two, you still have eggs.
Why Diversify Your Portfolio?
You should diversify your portfolio because it minimizes investment risk while ensuring returns. To understand, consider a concentrated portfolio that consists entirely of stock purchases. The risk would be high because a market downturn could result in tremendous losses. Compare that with a portfolio that counters higher-risk investments with stable assets like commodities and cash. Even with a major market downturn, stable assets can minimize the investor’s losses.
How Do Fixed Annuities Fit into a Diversification Strategy?
To appreciate how fixed annuities fit in a diversification strategy, we should first explain what they are. A fixed annuity, also known as a multiyear guaranteed annuity, is a long-term contract and retirement vehicle that you purchase from an insurance company. The term “fixed” refers to the rate of return, as the insurer sets it at the time of purchase and guarantees that your account will grow at that rate every year in the life of the contract.
In general, when you buy a fixed annuity, you contribute to it in either a lump sum or a series of regular payments. During what’s known as the accumulation phase, the insurance company invests your contributions in a portfolio of investments, which allows your account to grow at the agreed-upon rate. Again, because the rate is fixed, the market’s impact on the insurer’s portfolio has no bearing on the rate of return.
At the end of the contract term, you can choose to annuitize your contract, which means converting it into a series of cash payments. The payments, called distributions, can last for a specified length of time or the rest of your life, depending on how you’ve decided to arrange the annuity.
With the above in mind, you may begin to see how fixed annuities function in a diversified portfolio. Because the return rate and the distributions are guaranteed, you will receive a steady flow of income in retirement. The annuity, therefore, is a low-risk asset that helps to stabilize your overall portfolio. Even if your stocks and real estate don’t pan out as you’d hoped, you can still depend on annuity distributions to supplement your modest market returns as well as other income sources like Social Security.
Sample Diversified Portfolio with a Fixed Annuity
Consider this example of a diversified portfolio that includes a fixed annuity:
Ann Davis is a 57-year-old pre-retiree who plans to retire at 67. She expects to live 15 years past retirement age and to spend $60,000 per year in retirement.
The higher-risk assets in her portfolio are 30% domestic stocks and 20% international stocks. She also has $200,000 in savings, owns 15 United States Treasury securities that will mature in successive years, starting at her expected age of retirement, and has been contributing $5,000 a year into a traditional IRA since 35. She calculates that the bonds will each net her around $3,000 per year, while the IRA will have grown in value to around $480,000 by the time she retires. In addition, she estimates she’ll receive $1,900 per month in Social Security.
Wary of market volatility, Ms. Davis purchases a 10-year fixed annuity to ensure she has enough money to fund her retirement goal. She contributes $100,000 and gets a fixed rate of 5%. She calculates that the annuity will grow in value to almost $163,000 by the time her contract ends. In addition to the expected returns from her stable assets, that amounts to around $916,500 in guaranteed returns in retirement, or approximately $61,000 per year. With any returns from her stocks, she should have no trouble finding her standard of living.
Fixed annuities may be long-term retirement vehicles, but that doesn’t mean there’s a limit to when you can incorporate one into your portfolio. After all, any time is the right time to start planning a secure future. Speak with a financial adviser to learn more about the advantages that a fixed annuity has to offer and to design a retirement portfolio tailored to your exact financial goals.
Jason is the Marketing Manager at a local advertising company in Australia. He moved to Australia 10 years back for his passion for advertising. Jason recently joined BFA as a volunteer writer and contributes by sharing his valuable experience and knowledge.