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Annuity Shopping: Time to Buy a Deferred Income Annuity?

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I want to buy an annuity. As I’ve written before, they make sense to me, in theory. In practice, I’m having a hard time pulling the trigger….

We received a modest inheritance. It doesn’t change our financial picture substantially, but it does mean we have some free cash to put to work — money we weren’t necessarily banking on. So this is a good opportunity to experiment with a new asset class. Diversify a bit. And one of the most compelling asset classes for retirees is an annuity — guaranteed monthly income for life….

We’re not interested in an immediate annuity right now, because we don’t need the income yet. We have several years of cash on hand, and years beyond that in conservative investments. We have a bit of business income. We are still at an age where our lifestyle remains flexible, where returning to work would be an option, where we can manage our own investments. In short, there is no need to put our retirement income on “autopilot” just yet.

But, a while back, I read about a new type of annuity, a deferred income annuity or DIA, also sometimes called “longevity insurance” or a “longevity annuity.” At the time, it was said, you could hand over a relatively small amount of cash (a 5-digit sum) to an insurance company while in your 50’s or 60’s and that could guarantee much of the income you’d need farther on in life, say from your 80’s onward.

So, I could potentially spend a small portion of my investment portfolio, and guarantee that we would never run out of money should we be fortunate to survive into our 80’s, 90’s, or beyond. That sounded pretty good!

And now we have some free cash that we hadn’t been counting on, potentially available to spend on such an annuity. So it was time to get serious about shopping for one….

USAA

I started by calling USAA. They originated as an insurance company after all, so I figured they’d have some compelling annuity offerings.

I’ve long been a USAA fan. My Navy father joined me up before I left home, and I’ve been a member ever since. I’ve had my auto insurance with them for as long as I can remember. And then, about 10 years ago, we closed all our local bank accounts and moved our banking to USAA. All of our day-to-day transactions — checking, credit cards, savings — move through their capable systems now. A few years ago, I even opened a brokerage account at USAA, to hold a portion of our taxable investments (still invested in Vanguard funds).

USAA has won numerous awards for customer service and I generally find their representatives to be top-notch: courteous, efficient, and knowledgeable. Since the money I’d earmarked for a possible annuity purchase was already on deposit at USAA, it would certainly be convenient to purchase the annuity through them and keep all the paperwork under one roof going forward….

Unfortunately, my annuity-shopping experience was disappointing. It took quite a bit of awkward discussion to establish that USAA doesn’t actually offer longevity or deferred income annuities. Oh well, I figured I’d get a quote for an immediate annuity, just for comparison purposes. That quote wasn’t particularly competitive, and when I asked to add an inflation rider, I was told they were having technical issues with their software and they’d have to get back to me. A follow up message arrived the next day informing me that “…we don’t offer the inflation option for a person under the age of 59 1/2, or for anyone at any age in New Mexico.”

Vanguard

Next up was Vanguard. Vanguard is not an insurance company, and doesn’t actually offer its own immediate annuity products. But I knew that they had partnered with other companies to offer a suite of related products including variable annuities, guaranteed income (GLWB’s), and fixed annuities. For the latter, they offered a comparison and purchasing service, where Vanguard leverages its name in order to get institutional pricing for its existing customers.

The representative at Vanguard was a seasoned pro who answered all my questions and then quickly generated quotes for the options of interest.

The answer to one of my questions was a bit of a bombshell: When you buy a deferred income annuity with inflation protection, when exactly does that inflation adjustment start? Turns out that such annuities don’t adjust for inflation until their income stream begins in the future. There is no inflation adjustment in the deferral interim. The representative was not aware of any products that offer full inflation protection. In other words, in our case where we might be waiting 25 years for the income to begin, just what that first year’s paycheck would be worth in today’s dollars is a total gamble. The amount would adjust for inflation once the income began, but the starting point, and therefore the ultimate value of the annuity, would be an unknown.

The suggested solution: You must bring more money to table if you want inflation protection in the interim. For example, in our case, if inflation held at its approximate historical value of 3% for 25 years, we’d need to invest almost exactly twice the amount of money, to preserve purchasing in today’s dollars. But it would still be a gamble. That amount might be too much, or too little, to match today’s purchasing power.

I got a quote to receive $1,000/month income starting when I was 80, and ending only when both of us died. This included a “return of premium” feature: meaning if we both died prior to the income start date, our estate would get the original premium back. Once payments started there would be no refund or cash value after we died. The best quote, for an annuity that would adjust based on the CPI-U inflation index, was for about $53K, and without the inflation protection, about $43K. This was from an A-rated insurance company.

Vanguard’s representatives do not work on commission. There is a transaction fee equal to 2% of the deposit amount built in to annuity quotes.

Shortly after hanging up the phone, I had the detailed confirming quotes in my inbox. A positive experience.

ImmediateAnnuities.com

Finally I called ImmediateAnnuities.com for a quote. They are one of the more prominent web portals for learning about immediate annuities. Their site is widely referenced, and I have always found it quick and easy to use. Recently, I subscribed to their email newsletter series on immediate annuities, and I was impressed. It contained easy-to-understand, accurate information based on the real-world experience of founder Hersh Stern. There was no sales pressure. The company seemed to evoke integrity at every turn.

The representative at ImmediateAnnuities.com was as professional as the one at Vanguard. He quickly quoted me on a comparable annuity: starting in 25 years, joint life, indexed to the CPI-U, paying $1,000/month, with the return of premium option. It, too, offered no inflation adjustment in the interim. The quote came in at over $59K and was from the same underlying insurer as the Vanguard quote. From this I concluded that Vanguard’s institutional pricing may, in fact, give it an edge. (But I’d recommend confirming pricing carefully for your own situation by getting quotes from both sources, and possibly others.)

ImmediateAnnuities.com charges no additional fees. (Presumably they receive a percent of the annuity premium as their commission.) The application process sounds very easy. They do a 5-minute questionnaire with you on the phone, prefill an application, and overnight it to you with an envelope to the insurance company. You then mail in the application with your check.

I had a detailed follow-up email in my inbox within moments. It contained lots of helpful information including a definition of terms, insurance company ratings, even a life expectancy table. Altogether, ImmediateAnnuities.com comes off as a highly professional and transparent company. Even if their pricing seemed at a disadvantage to Vanguard in this case, I would probably get a quote from them before making any final annuity decisions.

Analysis

Given my different options, buying an annuity versus investing in something else — stocks, bonds, real estate — how do I analyze the best use of my money? Valuing annuities is notoriously difficult, and even professionals can disagree on the details. Deferred income annuities seem doubly hard to assess because they are composed of a two-stage investment: the first of which — the interim before payments start — is not inflation adjusted, and the second of which may or may not be.

I analyzed the annuity quotes from several different angles, including comparing them to a balanced portfolio of stocks/bonds over the same period, and to a portfolio of dividend stocks. Unfortunately, none of these analyses filled me with confidence. The time span involved — 45 years in my case, up to age 100 — is immense, given financial variables that most experts can’t get right a year in advance. Ultimately, the fact that inflation-adjusted deferred income annuities are not quoted with inflation adjustment until payments start, years in the future, makes their true value for comparison purposes virtually unknowable.

So, the most fruitful analysis seemed to be comparing the non-inflation-adjusted deferred income annuity to the balanced stock/bond portfolio. And, according to my calculations, to match the income stream that a deferred income annuity promised me from age 80 to 100, a balanced portfolio would need to return a little over 5% annually over the same 45 year period (25 years until the annuity starts, plus 20 years of payments thereafter). If the investment portfolio returned less than that, the annuity would be a better deal. If our investments returned more than that, or if neither of us lived to age 100, then the portfolio would have been the better deal.

Will we do better than 5% with a balanced investment portfolio over the next half century? It’s anybody’s guess but, frankly, the odds are good. We’ve done close to 7% over the last tumultuous decade. For other data points, consider Vanguard’s flagship balanced funds: The conservative Wellesley Income Fund has returned 10.14% since inception in 1970 (44 years), and the Wellington Fund has returned 8.33% since inception in 1929 (85 years). Even if you knock a couple of percentage points off future returns, based on today’s low interest rates and high market valuations, a balanced portfolio is likely to outperform an annuity. And yet, the balanced portfolio is not “guaranteed,” while the annuity appears to be….

The Problem with Annuities

Buying a deferred income annuity is a paradox. On the one hand, it’s an extremely conservative thing to do with your money: You are accepting a return that will almost certainly be below the market, in exchange for the assurance of receiving some income for life. On the other hand, it’s an extremely risky thing to do with your money. You are “buying” a product that you won’t unwrap and use for decades hence. What kind of world will you be living in then?

People are attracted to annuities because they provide “guaranteed” income. But, looking at my deferred income annuity quotes, how “guaranteed” is anything 25 years from now? That’s almost half my lifetime. Twenty-five years ago, personal computers had just appeared on the landscape. Cell phones and the Internet didn’t exist. Do I really think, if I buy something now that I won’t use for 25 years, that I have any real “guarantee” of what I’ll be getting? Among the many wildcards — market performance, geopolitical risk, insurance company solvency — the biggest one might be inflation. What will our public and private debt have done to the value of the dollar by then? If I buy a product now in nominal dollars, without inflation guarantees, its value in 25 years is almost a complete crapshoot. Without inflation adjustment over multi-decade time spans, you really have no idea what you’re getting!

Wouldn’t it be wiser to hold assets like real estate, commodities, and businesses — in other words, stocks — that, pretty much by definition, will keep pace with inflation? The insurance companies that issue 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 same markets over sufficient time spans, and can ride out volatility, then they are statistically certain to come out ahead. Or, in the worst case, in a world where a balanced investment portfolio, subject to a reasonable withdrawal rate, somehow evaporates, do I really think that insurance companies will somehow be able to honor their contracts?

The 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. But, given the rather parsimonious deferred income annuity quotes I’m getting, it’s been tough to see the benefit of those credits on the bottom line….

We all crave security and certainty. The marketing departments at the insurance companies know this very well. But annuities may only deliver the kind of certainty you get from dining at a fast food chain: guaranteed mediocrity. After going through this annuity shopping exercise a couple of times now, I’m starting to think that the main benefit of an annuity may be simply that it forces people to budget, keeping them from spending their money all at once. In other words, they’re simply paying the insurance company to act as ‘Dad,’ handing out their own allowance money on a regular schedule!

Our Decision: Still Window Shopping

So, will we buy a deferred income annuity this year? No. Will we ever buy one? Doubtful.

Are we still in the market for an immediate annuity, at some point, so that we can lock in lifetime income and offload the need to manage investments in our later years? Probably.

But, for now, with interest rates low, with a flexible lifestyle, with plenty of cash on hand, and with a good investment track record on our own, there is simply no need to make the annuity decision. Rather, we will keep our assets diversified in the market. And we’ll revisit our options further down the road….

Comments

  1. Kirk Taylor says:

    I am a loyal reader of yours and I read and enjoyed your retirement book. I am also an insurance agent licensed (with a conscience) to sell annuities and various other products. Take my advice, skip the annuity and place that inheritance in the Vanguard Wellesley Income fund. Annuities are NOT liquid and in the current investment environment liquidity is paramount. I was delighted you mentioned the performance of this fund in the above article as I have been a big fan of this fund for many years.
    You heard this advice straight from “the horse’s mouse,” the only one who benefits from annuities is the underlying insurance company.
    Yours,
    K.T.
    Texas

  2. Thanks for the real-world report, Darrow. Too many times we read “Just go get a quote” without seeing what really happens!

    I share your skepticism on deferred annuities, and I think that the only credible one so far is Social Security.

    On the other hand an immediate annuity could bring a measure of stability to almost any portfolio, and is probably a good idea for a portion of an asset allocation. But you’re right– it also forces investors to impose a measure of discipline on their portfolio, or to find an insurance company that will do it for them.

    FinCon14 was less fun without you and your spouse! Alarmingly (or amusingly), Todd Tresidder and I are now considered to be “mentors”…

  3. Toon de Groot says:

    Annuity shopping: Fantastic article. It confirms all the doubts I had about annuities (and then some)! Thank you!

  4. Mark Pozner says:

    Thank you for an excellent analysis. I too have looked into buying a deferred or longevity annuity. All of your points are valid. Also, because we are in a very low interest rate environment now, it is a particularly bad time to buy that kind of annuity.

    I would also like to share that I have bought 4 immediate annuities (SPIA’s) over the last 31/2 years. The first at age 61 paid 7% and the others at ages 63-64 also paid 7%. Supposedly as you get older, the payout rate should increase. However that has not happened, so far. At age 65 you can get a Variable Annuity with Guaranteed Lifetime Withdrawal Benefit (GLWB) that pays 5% from Vanguard. As you have mentioned, it provides downside protection, at a cost of course. If you buy this, I recommend splitting your money to buy at different times of the year. I have bought two of these. Then you have two opportunities for a bump up in value which permanently increases your payout. I intend to buy more at different dates again.

    Thank you for tackling topics that those of us at retirement age think about.

    Mark

    • Thanks for sharing your real-world experience Mark! Those insights are hard to come by, and much appreciated. A 7% payout (in my 60’s) certainly gets more interesting. Great tip about diversifying start dates as well. Thanks again for the valuable comment.

  5. Spideriffic says:

    Thanks for another excellent article, Darrow. Love your website. I’ve always thought that it’s wise to avoid putting all your eggs in one basket, but that’s what annuities seem like to me. You wouldn’t put $50,000 into the stock of one company, but when you purchase an annuity you’re counting on that one insurance company to stay in business for decades. I’d feel more confident having my money invested in the stock of thousands of companies through mutual funds.

    • Thanks for the kind words Spideriffic, and good point about diversification. Though annuities are generally backed up (to some limit) by a state guarantee association, it does feel like a potential single point of failure. If I ever do put money into annuities, it will be with only a portion of my portfolio, and probably spread across multiple smaller annuities, possibly from multiple insurance companies….

  6. Hi Darrow
    I did the same research as you and came to the identical conclusion. Like you the appeal of guaranteed income is appealing so I looked into secondary market annuities which pay better rates and frequently come with a Cola adjustment. They do take some homework but can be very attractive. I just purchased one from immediateannuities.com that has a payout of 5.50% with a 3% cost of living adjustment every year for 28 years. Many of these start payment at a future date.

    • Thanks Steve. Very interesting on the secondary market annuities. I’ll have to do more homework too, but I can see the appeal. The rates and COLA’s are certainly attractive. On the other hand, these aren’t life annuities, and they aren’t backed by the state guarantee associations. So they fill a slightly different niche, perhaps more like a CD. But if someone is willing to put in the legwork, I can see how they would be a good way to fill gaps in your future income stream. Thanks again for the pointer!

  7. Great article Darrow! I’m getting closer…….

  8. My sister and I manage our aging mother’s portfolio. When Mom was in her mid-80’s we bought her an immediate annuity to help her manage her cash flow and preserve her remaining portfolio. At the time, interest rates were higher, so annuities paid better. A year later, after several dips into her portfolio, we bought another, though through a different insurance company. She has now “outlived” the annuities and the income is all gravy. We didn’t get any inflation protection, but figured that could be covered with her remaining portfolio. The main thing is that without the annuities, her portfolio would have been exhausted by now. We learned a lot through the experience that has helped in planning for our own retirements.

  9. Hi Darrow

    I am a new reader but– so far I really like your real-world perspective. I have ordered your book on Amazon and am looking forward to reading it soon.

    I am trying to set things up so that I can join you in the early retirement realm. Although I have been a saver my whole life and have garnered a respectable net worth I am struggling on when to pull the plug. Life without the paycheck is simply…. scary.

    I spend quite a bit of time trying to figure out how to “replace” my paycheck. It is a daunting task because ( I am 50) it may need to last 50 years- at least for planning purposes.

    Your article above on Longevity Annuities was great. I too have heard about them recently. They seem to be a bit trendy. I agree with your skepticism. However –I am a fan of the “asset dedication” theory (have you read the book?) which proposes a guaranteed floor of income that is not subject to the whims of the market ( annuities, bonds held to maturity, social security, and pensions) to cover essential expenses. And a balanced portfolio above that for discretionary items.

    Thanks for doing what you do. I will be reading along from now on.

  10. Edward Draiss says:

    Excellent article. I have looked at this several times and never felt comfortable about buying one just because I couldn’t quantify the pros/cons. My biggest concern has been that 25 years is a long time away and while you can pick companies with a good track record, there is no guarantee where they be in 25 years. Thanks for sharing the analysis. This will certainly help me in my analysis going forward.

  11. Excellent post Darrow. Especially liked the comparison to alternatives Wellesley and Wellington. Whether one chooses those two funds, a CD or Bond ladder, or some other alternative, I like your point that ‘comparing’ what the annuity provides versus other alternatives is one of the best ways to judge whether an annuity is a good investment for one’s situation. I also learned from your article that deferred annuities are not inflation adjusted during the deferral period which, I expect is a deal killer for most who’d consider one.

    One aspect of our plan is to use an ‘annuity hurdle’ concept as described in the article by Fullmer. In that approach, a balanced portfolio is used until and if it reduces to a value where it can purchase an immediate annuity which provides just the amount of income required. Such an ‘annuity hurdle’ is our backup plan to the balanced portfolio portion of our income streams. If it’s not necessary, and the hope is that it’s not, then we will continue with our pension, SS and balanced portfolio plan. If it is necessary, then income is pension, SS and immediate annuity.

    • Thanks Mark, glad the article was helpful. I like the annuity hurdle concept too. That’s certainly one of the tools I’d use to approach this decision. Though I suspect my initial response to a falling portfolio would be to cut expenses, with purchasing an annuity only a last resort. And the happier scenario would be to arrive in the later stages of retirement with enough resources to purchase an annuity to lock in our ‘floor’ income, while maintaining an investment portfolio for upside growth and discretionary spending.

  12. I am leaning towards buying an Immediate annuity and not deferred because I would like to retire early and the guaranteed income is something which would make it easier to take the plunge v/s all the complicated Glide path analysis which i also read with academic interest 🙂

    One advantage of annuities which was not mentioned is that it saves us from ourselves. As we get older; our mental capacities are diminished and that is why old folks are prey to scams easier than younger ones (forgot the study). So in that sense it provides the monthly income without us panicking or falling prey to slimy salesman when we are most vulnerable.

    • Thanks John. I agree that simplifying money management in our later years is a genuine benefit of annuities. I value that, and it’s one reason why immediate annuities will remain on our shopping list for our 60’s or later.

  13. Darrow, thanks for this article. I’ve had my concerns about deferred annuities and haven’t been able to pull the trigger on them. Your comparisons are helpful. For now I think I’ll hold off and will revisit when we retire in 3-4 years.

  14. So If I understand you correctly if someone age 55 invests the 43K today in a portfolio of stocks and or Vanguard Funds. That when they turn 80 that portfolio will return 1K a month until 100 or at death? I got the gist of the article I am just questioning the calculations to see if it is apples to apples. Also many people question the uncertainty of the financial markets in the future aka Dividend stocks still paying dividends in the year 2050,(as they are depending on it for income) but if I’m not mistaken insurance companies also invest in the markets. So if financial markets go under, who’s to say that the insurance market will stay solvent?

    • According to my calculations, as long as you earned a little over 5% annually, a portfolio of $43K at age 55, would provide $1K/month income from ages 80-100, at which point the portfolio would be exhausted. And, odds are, a balanced portfolio would do much better than that (last longer or pay more), though there is no guarantee. Agree with your other points about the markets. Thanks EL!

  15. Darrow – thanks for the insights. What are your thoughts on a variable annuity? I have one with Vanguard, invested in their Moderate Allocation portfolio (60% equity/40% bond invested in Vanguard index funds). The expense ratio is .49%. I don’t have any riders to guarantee income, nor do I plan to annuitize it. I’m 53 and plan to just leave it invested and re-allocate as needed and tap into it during retirement as needed like an IRA. While the expense ratio is higher than I’d like (vs. my IRAs), at least I can avoid income taxes and re-balance as needed without tax concerns, like an IRA. Am I missing something?

    • Hi Bill. I don’t have much experience with variable annuities, but it’s hard to find a trusted expert who speaks kindly of them. You’ve already outlined the key issues. The best application for variable annuities, as I understand it, would be in tax deferral for high-net-worth/high-tax-bracket individuals. And perhaps that justifies the expense in your case. Certainly, if I was going to buy a variable annuity, I’d want to get it from Vanguard. FWIW, one of the best short books I’ve read on the subject is fellow blogger Todd Tresidder’s Variable Annuity Pros & Cons.

  16. Thoughtful and well researched overview. Thought I would pass along a note that as an advisor, I also work directly with the annuity folks with Vanguard on that side of their business and would recommend them for any consumer looking for this type of product for their portfolio. My experience with my contacts there has been very positive. If a consumer is looking to use either an Immediate Annuity or a Fixed or Variable Annuity, they should be able to get good, competent support from Vanguard in this area. And their products are very clean and low-cost, as you would expect.

    On the particular product in question, I am very dubious about how successful it will be for most consumers. I struggle to understand the appeal of it to most people.

  17. Invertron says:

    How’s this: Use your lump sum to buy TIPS that matures in 25 years. Then use the proceed to buy an immediate annuity with inflation rider.

    • Thanks for the suggestion Invertron. Certainly a strategy worth investigating, since it does supply the needed inflation protection. On the other hand, as I understand it, the yields on long TIPS are abysmal right now: In the latest Treasury auction results, it looks like 30-year TIPS are yielding just a little over 1%. So, although this strategy would provide inflation protection, it might be very hard to achieve our retirement objectives getting only 1% real growth over that long time span.

      • Great article. Two points I did not see mentioned:
        1. QLAC (Qualified Longevity Annuity Contracts) can now be purchased inside an IRA and reduce the amount used to calculate mandatory withdrawals.
        2. I bought an annuity for my mother several years ago. Getting that monthly check is something she very much looks forward to! So, from a purely psychological standpoint, it can be a positive.
        Last, do you think there will ever be noload annuities?

        • Thanks for the points well taken Catdr. I don’t know enough about the insurance industry to comment on noload annuities, except it’s a cinch that businesses must generate a profit. Fortunately there are a few ethical, consumer-oriented businesses willing to accept modest profits.

  18. If your inheritance is NQ the annuity would offer some unique tax advantages. Tax deferred during the 25 deferral years and then tax exclusion ratio treatment during the income years (until return of cost basis is reached).