Final answer:
Annuities are designed to mitigate market risk and superannuation risk by providing a stable income stream that is unaffected by market volatility and ensures income for life. However, they may not effectively protect against purchasing power risk, as fixed annuity payments might not keep up with inflation.
Step-by-step explanation:
When planning for retirement and ensuring a stable income in old age, many individuals turn to annuities to mitigate various financial risks. Annuities are essentially contracts with insurance companies that, in exchange for a lump sum payment or a series of payments, provide a guarantee of regular disbursements over a given time period or for the remainder of one's life.
Annuities are effective at mitigating market risk, which refers to the volatility in investment returns that one experiences when directly investing in stocks or bonds. While stocks and bonds may offer the potential for higher returns over an extended period, they also expose the investor to the risk of significant fluctuations in the short term. This can be especially problematic for individuals nearing retirement who cannot afford to wait out the volatility. Annuities provide a steady income, regardless of market conditions, and are particularly attractive to those seeking to stabilize their retirement income.
Another risk that annuities can help alleviate is superannuation risk, or the risk of outliving one's savings. Unlike other retirement savings options, annuities can offer a lifetime income stream, which addresses the concern of depleting one's retirement funds.
However, purchasing power risk, posed by inflation over time, can be one disadvantage of annuities. Since annuities provide a fixed income, they may not keep pace with inflation, resulting in a decline in the real value of the income received over time. This is a critical consideration for retirees who need their income to maintain purchasing power throughout their retirement.
Ultimately, the choice to use an annuity as part of one's retirement plan depends on individual circumstances and preferences for risk and stability. Annuities can be a part of a comprehensive retirement plan that might also include stocks, bonds, and other investment vehicles, each balancing the others in terms of risk and potential returns. The decision should be based on a thorough analysis of one's financial situation and retirement goals.