We Have $1.2M in an IRA, Plus Another $750k and Social Security. Should We Shift Assets to a Target Date Fund or an Annuity?

Annuities and target date funds are popular assets for households who are either saving for retirement or already in their golden years. How useful each may be for you depends on your financial goals and where you are on your path to retirement. 

For example, John and Susan are both 67 and recently retired. They have $1.2 million in a pre-tax IRA, $750,000 in taxable investments and collects $45,000 in annual Social Security benefits. Should they shift their assets to a target date fund or an annuity?

Annuities are an income-oriented financial product that you purchase from an insurance company. In exchange for an up-front investment on your part the company promises a set series of payments over time that return both your initial investment plus a rate of interest.

For retirees, the most popular version of this is a lifetime annuity. These are contracts that guarantee a fixed, monthly payment for the rest of your life. They are also known as private pension plans, and they can be extremely useful for people looking for security. Once you buy this annuity, the only risk to your income is the unlikely event of the insurance company’s insolvency. 

What if our hypothetical couple John and Susan shifted all of their money into annuities? First, investing their $1.2 million IRA in an annuity could yield approximately $82,220 per year ($6,851 per month) in pre-tax income from a single premium immediate annuity, according to Schwab’s Income Annuity Estimator. So long as you invest in a qualified annuity, you can typically do this without triggering an immediate tax event. 

But suppose John and Susan want even more guaranteed income and sell their $750,000 portfolio, investing the proceeds in an annuity. After paying capital gains taxes (we’ll assume they had a $75,000 cost basis), John and Susan are left with approximately $558,000. They could use that money to purchase a separate annuity that pays approximately $38,280 per year ($3,190 per month). 

In total, John and Susan would have around $120,500 per year in annuity income, before taxes, if they used their $1.95 million to purchase annuities.

While the two annuities would provide the couple with a constant stream of income for the rest of their lives, John and Susan would have to manage inflation risk since these payments would be fixed. Unlike Social Security benefits, many annuities are not indexed for inflation (you can purchase an inflation-protected annuity, but it’s likely going to cost you more). Unless the couple has a plan to use other investments to make up for the rising cost of living, the value of their annuity income could drop considerably over the course of a long retirement.

This risk is even greater for people who rent and/or live in cities, where prices can rise faster than core inflation. The value of all this depends on a person’s preference for security.

Financially, John and Susan might be better off sticking with their investments and forgoing the annuities. They would still presumably have a strong income stream by following the 4% rule, but one that is more easily hedged against inflation. Then again, if they’re most concerned with knowing their income is secure and guaranteed, annuities could potentially give them that peace of mind. (If you’re considering an annuity, consider talking it over with a financial advisor to assess your options.)

A target date fund is, effectively, an automated portfolio that’s managed according to a predetermined and date. With this asset, you set a goal and a date (for example, college savings or retirement). Then, the fund automatically shifts its investments based on your flexibility for growth vs. your need for security. The further you are from the target date, the more aggressively the fund will invest. As you get closer to the target date (when you’ll presumably need the money) the fund will shift to increasingly secure assets to prevent potential losses.

These assets can be very useful to investors looking for a relatively hands-off approach to investing. Both a target date fund and a robo-advisor let you set a target, then keep investing without needing to manage specific assets and investments. 

They are also most useful for people who have time to invest. The entire idea behind target date funds is that they shift your portfolio’s assets over time, letting you strike a balance between early growth and safety later on.

This is why a target date fund probably isn’t all that useful in John and Susan’s situation. Since they have already entered retirement, they’ve basically already hit their target date. While they can still invest around tiers of retirement (say, a target date for age 75, for age 80, etc.), retirees may not get a lot of value out of that.

A robo-advisor might be useful for John and Susan, though. These automated platforms use algorithms to select and manage investments. For example, John and Susan could put their money into a robo-advisor portfolio and set its goal based on modest growth and strong risk protection.

Again, for investors looking to take a hands-off approach to finance, a robo-advisor can be an excellent option. However, others may prefer their financial advice come from a person – not an algorithm. After all human advisors may also offer services that go beyond simple investment management, including income planning, estate planning and tax strategy. (And if you’re interested in working with a financial advisor, this free tool can match you with fiduciaries who serve your area.)

For households saving and planning for retirement, annuities and target date funds are two common yet divergent products to consider. Annuities are insurance contracts that produce streams of guaranteed income, while target date funds strategically select and manage investments based on when the money will be needed. While an annuity may be more useful for retirees seeking income protection, inflation can reduce the value of these payments over time.

• If the idea of a private pension appeals to you, it’s important to understand both the pros and cons of getting an annuity. On one hand, annuities provide a guaranteed stream of income, with either a fixed or variable interest rate. On the other hand, annuities typically aren’t indexed for inflation and may not produce the same return as other investments.
• A financial advisor can help you assess whether an annuity is appropriate for your financial situation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/PeopleImages, ©iStock.com/kate_sept2004, ©iStock.com/PIKSEL