According to the Center for Retirement Research at Boston College, as of 2009 more than 50 percent of seniors were at risk of being unable to maintain their standard of living in retirement. Understanding the fundamentals of various investment opportunities is key to successful retirement planning. Looking at the characteristics of two very different products – annuities and real estate – is a good place to start.
Early on in your adult life, investment risk is not such an important issue. As you near and enter retirement, however, it takes on an increasingly prominent role in your decision making. If you make a big investment mistake after you turn 60, you will find yourself with a lot less time to make up for it. Unfortunately, risk assessment is not usually always a straight-forward analysis.
In comparing the risk inherent in an annuity and in owning rental property, you will have to make some assumptions, especially about vacancy rates, appreciation and interest rates. And you will have to choose which type of annuity to use in the comparison. How much risk rental real estate entails depends upon some facts under your control – the location, condition, rent history, price of the building and amount and type of insurance you possess, for instance – and others outside your control, such as the local job market and unexpected natural disasters. If you invest in real estate rentals, minimize your risk by buying properties with solid rental histories and a strong positive cash flow.
The fundamental questions related to risk, once you have narrowed down the potential investments, are, "to what degree am I guaranteed my principal will be maintained, how long will I receive payments or income and what will the payments or income be?"
There are life annuities, fixed annuities and variable annuities. In a nutshell, the life annuity -- which guarantees you a minimum fixed payment for the rest of your life -- comes with very low to no risk but also with a low return on investment. A fixed term annuity specifies the duration of payments: here the risk is also very low and the minimum rate of return is also low, although higher than for a life annuity. The variable annuity depends entirely on how well the underlying investment does. Both risk levels and maximum possible returns vary with investment choices: savings accounts will be risk-free but engage only low returns; stock investments may tank or triple in exchange for a relatively high level of risk.
Return on Investment
The flip side of risk is reward. The return rate on a given annuity will differ based on factors such as how long before you draw off the annuity you begin contributions into it, whether and how much of a death benefit is included and which of the three basic types of annuities you have chosen. Ask your investment or insurance company what the annuity return rate will be if it is guaranteed or what the historical return of it has been if it is not guaranteed.
Historically, real estate produces about an 8.6 percent return on the price of the property averaged during a long period of time. However, this is the return on the full property value. Your investment is typically only 20 to 35 percent of a property’s cost through a down payment. Through leverage, then, your return on investment will be three to five times the appreciation on the property’s value. Additionally, if you buy a property that produces a positive cash flow every month and you claim depreciation of the building, you gain a stream of income with minimal and sometimes no taxation. When looking at rental property, compare the costs associated with carrying the building with rental income to arrive at an estimated monthly income stream. Then compare that with an annuity stream based on an investment equaling your down payment and closing costs.
No one will ever call you in the middle of the night to talk to you about your annuity. Expect a never-ending flow of issues drawing your attention when you own rental property. Even if you have a property manager, you will have to be materially involved with your rental property, at minimum, from time to time. Talk to friends who own rental real estate to estimate how much of your time attending to rental real estate will consume.
Annuities are for specific time-frames or a lifetime. With real estate, your income stream goes on as long as you want it to -- including beyond your own lifetime. Although some annuities pay out a death benefit equal to some percentage of your original principal investment, 100 percent of your equity will be passed on to your heirs if you own rental real estate. If leaving an estate is important to you, consider the estate value of rental real estate to the death benefit of an annuity.
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