Annuities Revisited: Downsides, Deal Killers, and Alternatives

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In my first annuity post here years ago, I wrote, “In my view, annuities can be applied incrementally and strategically as part of your overall retirement income plan. And I’ll be focusing on the associated details and mechanisms for that in posts to come….”

Footbridge crossing gorge.

Well, it’s been a while, but here is my current and possibly final take on using annuities in my retirement plan.

For reasons discussed below, my view on annuities for retirement income has grown steadily more negative over the years. If you’d asked me recently when I was going to buy one, I’d have answered “probably never.”

Our net worth has been on a long-term growth trajectory. We don’t seem to need the guarantees of an annuity to meet our retirement spending needs.

Though the simplicity of a regular monthly paycheck in our later years has some appeal, we are only seven years away from starting my Social Security, essentially an inflation-adjusted annuity, at age 70.

So it may come as a surprise to you that I now own an annuity! Read on below for more details on my newly acquired annuity and how it does, or doesn’t, fit into our retirement plan.

A Floor With an Upside

In 2012 I posted an article here titled A Floor with an Upside: The Best Strategy for Lifetime Income? It was a non-technical overview of how to create a guaranteed retirement income floor using annuities, while keeping an upside for your wealth by using investments in the stock market.

I believed that most retirees, once they took all the income factors into account, would choose this path. And the article was popular. It presented a safe approach to locking in essential retirement income while keeping your hook cast for possibly better market returns. Though I didn’t invent the idea, I was an early proponent, and the concept has endured, for good reason.

But I’m no longer so certain that this will be our path. Based on my experience, I’ve grown more confident in the ability of a balanced, diversified portfolio to provide lifetime income from growing financial markets, and less confident in the ability of an insurance company or the government to do so. Through the end of 2022, the geometric mean of my investment returns going back for the 18 years I’ve closely tracked them was at 6.1%. That’s a comforting average for a conservative portfolio in these times, including the 2008-2009 Great Recession.

One clear benefit delivered by an annuity is its “mortality credits” — the extra return you get from putting your money into a pool with others, where those who live longer rely on the assets of those who die sooner. It’s a sound actuarial concept, but it’s tough to see and quantify those benefits in an annuity quote. Yes, annuities can pay higher interest rates than bonds or savings accounts, but that’s also because they are cannibalizing your principle to generate income payments.

Another benefit, from variable annuities—one of the most complicated kinds, is tax-deferred growth, like an IRA. That sounds like a good thing. But at what cost?

Chris has written here, “Years ago, my wife and I were sold a variable annuity inappropriate for our needs. That experience inspired me to start writing about personal finance and become a consumer advocate.” Like so many consumers, he discovered that variable annuities have hidden downsides.

Annuity Downsides

The most obvious problem with annuities in my view is their high and often hidden expenses. The fees on a typical variable annuity will total in the 2-3% range once you add the mortality and expense charge, administration charge, various endorsements and riders, and underlying mutual fund fees. It doesn’t sound like much, but most readers of this blog understand that could constitute half or more of all the available retirement income from an investment portfolio!

Should you want to exit your annuity contract early, there are punishing surrender charges, often starting at 10% of your initial investment.

As for those tax benefits mentioned above, Scott Burns wrote in Variable Annuities: A Product That Doesn’t Add Up that “The problem with variable annuities is that their most important benefit, tax deferral, costs more than any taxes deferred.” Consumers are always eager to save on taxes. But what really matters is your bottom line, after all taxes and expenses.

Another caveat to the alleged tax benefits of variable annuities is that when you take distributions, earnings are taxed at higher ordinary income tax rates instead of favorable long-term capital gains rates. Finally, there is no step-up in cost basis for your heirs when you die as there would be for most investments.

Yet another serious mark against annuities is that contracts are so complex that only experts, most of whom work for the insurance companies, can assess whether they’re a good deal. The prospectus for my annuity is 164 pages long, and that doesn’t even cover the underlying investments! I doubt that there is any reliable formula to reduce the value of a variable annuity to a single number for comparison to other investments. There are too many moving parts.

One thing we can say with some certainty is that the insurance company, with a staff of attorneys, CPAs, and actuaries, has ensured that the annuity is a good deal for them. Otherwise they couldn’t stay in business. It seems foolish to assume that consumers would win against that army of professionals.

It would be nice to believe that those profitable insurance companies could afford to offer reliable, responsive service to their customers. And that is the case when you’re buying an annuity, But the opposite is true when it comes time to collect. Insurance companies are in the business of taking in more money in premiums than they pay back out in claims. So, just how motivated are they to process those claims? Not very in my experience.

In the past few years, we’ve had to deal with a number of insurance companies for a serious auto accident, multiple long term care policies, and now an annuity. Frankly, the customer service at these different companies has varied from aloof to atrocious. In particular, don’t expect a high-tech, user-friendly website for streamlining the processing of your claim. You’re likely to be stuck, as we have been, back in the 1970s era of paper forms, notarized signatures, fax numbers, and tiresome days of playing phone tag.

Annuity Deal Killer: Inflation

Years ago I investigated and wrote about deferred income annuities. This is a type of annuity that provides income starting at some point in the distant future. They are relatively inexpensive and can offer longevity insurance, covering your expenses if you live much longer than expected. Of course, looking so far into the future, you’d be very interested in protection against inflation too, which could seriously erode your purchasing power in the decades before the annuity starts.

For that reason, I was shocked when I read the fine print for deferred income annuities with inflation protection. It turned out that such annuities didn’t adjust for inflation until their income stream began in the future. What good is that? Not having inflation adjustment until payments start years from now makes their true value virtually unknowable.

Today’s single premium immediate lifetime annuities—essentially pensions purchased from insurance companies—have the same problem. Although companies offering annuities are quick to point out that increased interest rates mean annuity payments are at their highest levels in a decade, there’s a catch: They aren’t inflation adjusted.

In the latest edition of his succinct and useful book, Can I Retire?, Mike Piper notes that previous editions included a  chapter devoted to immediate annuities because at the time you could purchase such annuities with cost-of-living adjustments. But in 2019 he says the last insurance company offering such annuities stopped selling them. The remaining annuity products carry significant inflation risk, and he is “hesitant to recommend them to anybody.”

I checked ImmediateAnnuities.com and found them only offering annuities with fixed Cost of Living Adjustments. In other words, you have to guess at some constant inflation rate (between 0% and 5%) ahead of time, and that increase will then be built into your annuity quote. That’s essentially just buying a bigger annuity with no guarantee it will be the right size. You can’t buy an annuity linked to any of the government’s inflation measures, which would be far more accurate over the long haul.

A modern retirement can last 30 years. Just how certain can we be about our cost of living that far into the future? Inflation and the economy are wildcards over such periods. Thirty years ago, personal computers had just appeared on the landscape. Cell phones and the Internet as we know it didn’t exist. If I buy an income stream now in nominal dollars, without inflation guarantees, its worth in 30 years is a crapshoot. What will our public and private debt have done to the value of the dollar by then? Over multi-decade time spans, without adjustments for inflation, we have no idea what we’re getting!

Anyway, I already own the best inflation-adjusted annuity currently available. It’s called Social Security. And by waiting  until age 70 to claim it, I’m getting the best possible deal.

My New Variable Annuity

My mother was a frugal schoolteacher with a master’s degree. She always managed her personal finances wisely. But, like so many people, she was intimidated by investing, assuming it required some special knowledge she couldn’t acquire. She sought out a string of financial advisors. Eventually, after expressing her wish to be insulated from stock market shocks, she was sold a variable annuity from Brighthouse.

More than a decade later, I inherited that annuity.

My options for dealing with it were limited:

  • I could transfer the annuity to another insurance company (known as a section 1035 transfer, after the associated IRS regulation).
  • I could keep the annuity but defer any distributions for up to 5 years.
  • I could receive a 6-digit lump sum, much of it taxable income.
  • I could convert the annuity into a stream of periodic payments over my lifetime, possibly with a cash refund on death or a guarantee period.
  • I could convert the annuity into a stream of periodic payments for a guaranteed period of from 5-10 years.

What to do? When I had to make this decision several months ago, I was dealing with two emotions: overwhelm at settling my mother’s estate, and exasperation and distrust of insurance companies.

I wanted out of this annuity in the quickest and most tax advantaged way possible. I didn’t want to keep the annuity at Brighthouse, or endure a lengthy transfer process just to have it in my life at another insurance company. I also didn’t want to take a lump sum, which would have resulted in a punishing tax bill in the first year.

So I decided to convert the annuity into monthly payments for the next five years. The quoted amount was a good fit for our current level of expenses and should not push us into a higher tax bracket. The payments will allow us to leave the rest of our portfolio relatively untouched during that time. Problem solved. Was this the most financially advantageous solution? I think so, but I really don’t know. Hardly any consumer ever does when dealing with annuities.

End result: for the next five years, like it or not, I will own a variable annuity, and be making space for its 100+-page contract in my file cabinet. We’ve already received the first couple of monthly payments on schedule, so kudos to Brighthouse for accomplishing that.

First Annuity Alternative: Balanced Portfolio

If, like me, you are hesitant to buy an annuity, what are your alternatives for producing retirement income?

Above we considered how inflation protection is an Achilles heel of the current generation of annuity products. So why not hold assets like real estate, commodities, and businesses—in other words, stocks—instead? As hard assets denominated in dollars, those will keep pace with inflation in most circumstances. Apply a safe withdrawal rate, and you’re done.

An annuity is a financial vehicle constructed on top of other financial vehicles, mostly bonds. The insurance companies issuing annuities are investing in the same markets available to the rest of us, then taking their cut.

If a do-it-yourselfer invests in those markets over sufficient time spans, and can ride out volatility, then they are statistically likely to come out ahead of buying insurance. In the worst case, in a world where a balanced investment portfolio subject to a reasonable withdrawal rate implodes, do I really think that all insurance companies will be able to honor their contracts? Not likely.

 Second Annuity Alternative: TIPS Ladder

In today’s interest rate environment, there happens to be another alternative to inflation-adjusted annuities.

A spate of recent articles show that TIPS (Treasury Inflation-Protected Securities—a type of bond that builds in inflation protection) with yields above 2% now can allow for a safe withdrawal rate above 4% in the years ahead. So, you can buy a ladder—a series of bonds maturing in succeeding years—of these readily available government securities and give yourself a retirement income “floor” similar to an inflation-adjusted annuity.

Just understand that the TIPS themselves will be consumed as part of this strategy. Unlike with a balanced portfolio, there is no chance of them outperforming and surviving. However, if you add stocks to the equation, you can improve your odds that some of the portfolio survives.

Allan Roth writes “Buying individual TIPS and holding to maturity guarantees a positive real return that is known when purchased …. combining an individual TIPS with stock index funds now provides guaranteed attractive real returns with the potential of much higher real returns.”

Just be warned, the implementation of this strategy is not trivial. Buying individual TIPS is not easy for the beginner. And, though a Defined-Maturity TIPS ETF has just been introduced by BlackRock, limited years are available and there may still be some bugs to shake out.

Lastly, I would not be a fan of staking all your retirement income on a single type of security. No matter how reliable the United States Treasury ought to be, there have been real threats to its creditworthiness in recent times.

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[The founder of CanIRetireYet.com, Darrow Kirkpatrick relied on a modest lifestyle, high savings rate, and simple passive index investing to retire at age 50 from a career as a civil and software engineer. He has been quoted or published in The Wall Street Journal, MarketWatch, Kiplinger, The Huffington Post, Consumer Reports, and Money Magazine among others. His books include Retiring Sooner: How to Accelerate Your Financial Independence and Can I Retire Yet? How to Make the Biggest Financial Decision of the Rest of Your Life.]

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11 Comments

  1. Why mess around with scamnuities when CDs are paying 5% or more at Fidelity? It literally takes seconds to buy one after you are certain that your CD is non-callable.

  2. I agree that many annuities are complicated, and generally designed to be more beneficial to the insurance company than the annuitant. There are a couple of nice things about SPIAs that many either fail to mention or possibly don’t recognize.

    If you are young (before retirement age) buying an SPIA will allow you to tap your retirement (basically under the rule 72(t)) without having to worry about how much you should withdraw to avoid penalties.

    Secondly, An SPIA will protect you from yourself. It is a fact that many of us will lose significant control of our faculties prior to death. Having essentially given a fraction of your money to the insurance company (in payment for the annuity) you are a significantly less likely target for the less honorable among us.

  3. Agree with vast majority of the article on annuities, but have a different take on the TIPs ladder based on our personal experience. We have a 10-year rolling ladder and buy new TIPs at Vanguard. Because the ladder is rolling, while one gets consumed, a new one is purchased. Also we dont find it any more difficult than buying stocks, ETFs or mutual funds. (I recognize Allan Roth had challenges with the 30 years and I highly respect Allan but I wonder if it was something due to his relative inexperience and the platform.) I agree with the comment about not staking all income on one security-we dont, we have 25% TIPs ladder, 25% bond ETFs and about 50% stock ETFs. And while there are threats to creditworthiness, we dont believe there will be an issue with payment. I would surprised if you think otherwise.

  4. Darrow,
    There is a website for making TIPS ladders (tips ladder.com) that does a good job of creating TIPS ladders of up to 30 years for whatever income you want. It gives you the CUSIP #’s and how many to buy. On the Vanguard site, there is a way to input a TIPS ladder to build and purchase it. Rob Berger has a good video on how to go thru the process. It was much easier than I expected and I was able to do it all this morning in under an hour.

    Great information, by the way, long time reader/first time commenter.

    Dave

  5. Thanks for the great post Darrow, it’s appreciated! We are using a “date specific” Bond Ladder to “bridge” us with income until taking Social Security at age 70. We are using a combination of “date specific” Ishare/Invesco Corporate Bond ETF’s and Treasuries for each of the 10 years between now and age 70. The “date specific” Corporate Bond ETF’s are comprised of hundreds of different corporate bonds, that when held to “maturity” should pay out the anticipated rate of return (it’s understood that “if” one or a few of the companies fail/default that the return is impacted negatively, but not as negative as a standard Bond ETF that fluctuates with rate changes. Just curious, any thoughts on this method of “bridging”?

  6. I’ve always looked at annuities with a jaundiced eye. But with today’s higher interest rates they do look more enticing. Especially as a way to generate an income “floor”.

    Here are some quotes from immediateannuties.com: (these are all single male quotes, joint life rates are lower)

    A 55 year old male investing $100,000 in a SPIA today will get $584 per month for life (7.008%)
    that is return of your own money for 171 months = 14.25 years.
    A 60 year old male investing $100,000 in an SPIA today will get $620 per month for life. (7.44%)
    that is return of your own money for 161 months = 13.4 years.
    A 65 year old male investing $100,000 in an SPIA today will get $677 per month for life. (8.124%)
    that is return of your own money for 147.71 months = 12.31 years.

    Depending on individual needs, it may be a good choice.

  7. Thanks for this excellent post Darrow!

    I especially appreciated your first-hand experience dealing with the annuity you inherited and you wise reminders about the differenc between dealing with insurance companies after the sale vs. before!

    I just finished reading the revised edition of William Bernstein’s “Four Pillars” and of course he makes a strong case for TIPS and against annuities. But the other thing he offers that I found helpful and which I think is a worthwhile add-on to what you wrote are guidelines about allocations in light of what percentage of the portfolio a retiree anticipates needing to withdraw.

    In a nutshell, you look at your residual [essential] living expenses (RLEs) after Social Security and any pensions kick in and if your anticipated withdrawals from the portfolio are 2% then almost any mixture of equities and bonds from 25-75% or vice versa should work over a 30 year retirement. Conversely, if you’ll need to take out 4% or more he strongly recommends creating a liability-matching portfolio with TIPs. Between 2% and 4%+ is a grey area.

    We’re in that grey area ourselves, and while sorely tempted by the certainty of a TIPS ladder have decided not to go there for reasons that you touch on in your post: there are decisions to be made every year when a bond matures that assume one (which could include a spouse with no interest in dealing with such things) will continue to have the cognitive abilities to deal with for decades to come; added complexity from needing to both keep the TIPS in an IRA and spend out of it when RMDs kick in; and the total lack of flexibility when large lumpy expenses occur, as they so often do later in life.

    James Shambo wrote a good rejoinder to the Allan Roth piece you provided the link to that addresses some of these issues:

    https://www.advisorperspectives.com/articles/2022/12/20/the-4-rule-did-not-become-a-whole-lot-easier

    At the end of the day I decided to hew to the approach recommended by Rick Ferri and Jonathan Clements: stick to short duration Treasury bonds half inflation-protected and half nominal (SCHO and VTIP in our case) with broad, dirt cheap stock index funds (VTI, VXUS) for the rest. I have to say though that it was easier to make that choice because of having already started taking SS. If that weren’t the case I’d be very tempted to buy a few years worth of the new iShares TIPS ETFs as a kind of roll-your-own inflation-indexed annuity to bridge to SS.

  8. Darrow, regarding your comment about the limited options with an inherited annuity, I was actually surprised there were so many. Since I think our investment philosophies are pretty similar, I took a stab at deducing which option you chose. Personally, my first thought would have been to take the money and run, despite the tax consequences, but logic would have prevailed and I would chosen the option you did. Had the firm’s financial strength ratings not been so high, it would have been back to my first choice and damn the tax consequences. Unfortunately (or, perhaps, fortunately) I still retain the healthy skepticism of insurance companies I picked up back in my banking days.

  9. Great article and comments!

    Glad to see you mention Mike Piper. He does an excellent job explaining how to calculate and incorporate annuities into a retirement income plan.

    Annuities are an insurance product. Life insurance protects against a short life. A lifetime income annuity protects against a long life.

    Not all variable annuities are expensive. Read the prospectuses. Ask questions.

    A mix of fixed and variable annuities can provide steady income and combat the devastating effects of inflation.

    Although annuities aren’t for everyone, they can be very useful as part of retirement income planning or to provide lifelong income to a spendthrift beneficiary.

    Wealth accumulation, wealth transfer, and charitable giving can be more strategically accomplished through investments outside of tax deferred retirement accounts, life insurance, etc. The goal of a retirement account is ultimately income.

  10. I have a variable annuity via Fidelity. It is the result of a 1035 conversion of a whole life insurance product, I wished I hadn’t bought in my late 30s. Feeling trapped later on in my 50s, I went with a Vanguard variable annuity, which eventually became a Fidelity variable annuity because Vanguard exited the annuity business.

    I pay .1% Fidelity VIP Index 500 plus .25% annual annuity charge for a total of .35%, which is one of many index funds available within the variable annuity fund offerings. (For comparison FXAIX (Fidelity S&P 500 Index charges .015%, or .335% less than the annuity version. Thus it is $335 more expensive per year per $100,00 invested.)

    The variable annuity is better than the whole life product! I’m glad I was able to turn lemons into lemonade.

    Would I buy it again on its own merits? Yes! I can be more aggressive with the asset allocation in this long term investment and not worry about capital gains taxes when I reallocate.

    I’m sure I’m missing something because everyone else is so negative on them.

    1. Bill,

      I agree this is all things considered a good solution given your starting position. Lemonade indeed!

      However, for someone not already in another life insurance or annuity product and starting with a blank slate, this is likely not a good first choice. The reasoning warrants an entire blog post, and I just added it to my list.

      Best,
      Chris

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