The word annuity is oddly polarizing. Last August, I shared an article highlighting esteemed retirement researcher Wade Pfau’s assertion that annuities are better than bonds for guaranteed income. A reader, Phillip, commented:
“I believe that annuities are an investment product that is sold to people and not bought by people. Unsophisticated people buy these…”
In response to a more recent post, another reader, Wade, commented:
“Annuities! What a sham! My wife (H.S. Teacher) got sucked into this ridiculous investment because the commission driven investment advisers prey on teachers…”
I understand these readers’ sentiments. 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.
Annuities are insurance products, often layered with complexity and fees. Some annuity products are oversold to people by those incentivized by high commissions.
On the other side, I’ve read and listened to top researchers explain why buying the right type of annuity can benefit many retirees. Annuity advocates say that advisors working in an assets under management (AUM) fee structure with different conflicts of interests actually undersell annuities.
So what is the truth about annuities? Darrow has written several balanced articles about annuities, but it’s been over five years since we’ve covered this topic. One of the changes in the recently passed SECURE act eases the burden of getting annuities into 401(k) plans, so they’re likely going to become more prevalent.
Whether you’re saving for retirement or looking to increase retirement income, it’s important to be able to understand what an annuity is, the different types of annuity products, when to consider purchasing one, and when to beware.
The Oxford dictionary defines an annuity as “a fixed sum of money paid to someone each year, typically for the rest of their life.” By this definition, Social Security and pensions are annuities.
The second definition of annuity in the Oxford dictionary is “a form of insurance or investment entitling the investor to a series of annual sums.” In their simplest form, annuities you can purchase are insurance.
Annuities protect those who purchase them against longevity risk. Longevity risk is the chance that your life may last longer than your money.
An annuity can provide a lifetime income stream for those at risk of running out of money before running out of life. This provides a simple framework to answer our next question.
Why Buy an Annuity?
You can buy an annuity to transfer longevity risk from yourself to an insurance company. The company guarantees a regular payment for as long as you live, ensuring that you will never run out of money.
An insurance company can pool risk across a population, enabling them to pay a higher rate of return than an individual can get investing in relatively safe assets like high quality bonds or CDs.
Annuities eliminate the mental burden of determining how much money you can spend from a portfolio each year. This can be particularly valuable for a retiree whose combined income from social security, pension, and other passive income sources does not cover their essential needs.
Darrow outlined a strategy of using a portion of your portfolio to purchase an annuity to provide lifetime income to fill that void, creating an income floor. You can invest the remainder of the portfolio for upside growth.
It is important to note that you can never completely eliminate risk. You can only transfer risk.
One risk of annuitizing is dying young. Some people live longer than expected. It is to their benefit to have bought the annuity.
Others die sooner than expected. Their money is forfeited to the insurance company. That money is no longer available to leave to heirs or charities.
Another risk of annuitizing is relying on the financial stability of the insurance company issuing the annuity. You can mitigate this risk by researching the insurance company’s financial strength. You can diversify by using more than one insurance company.
Annuities are insured at the state level. Each state caps the amount they insure at different amounts for an individual policy. This may be another reason to diversify by buying several smaller annuities rather than one large one.
Even Social Security and pensions are only as good as their ability to meet their obligations. Each is underfunded and subject to risks ranging from the possible need to reduce benefits to outright failure of the most underfunded pensions.
A third risk is inflation. The income streams of most annuities are not adjusted for inflation. Even if you have a stream of income for life, annuity income may not meet your needs when you most need it years to decades down the road.
Who Is Likely to Benefit?
Now that we understand what an annuity is and the risks it eliminates and creates, we can better assess if we should consider an annuity. There are a few basic characteristics that make buying an annuity attractive.
The first is a long life expectancy. Being in good health and having a family history of long life expectancy increase the odds that you’ll live live longer. Women tend to live longer than men. These factors increase longevity risk for retirement planning and make an annuity more appealing.
The next factor to consider is estate planning. If you don’t feel strongly about leaving a bequest, it may be more beneficial to annuitize to assure your needs are met. If leaving an inheritance is important, it may be less desirable to risk forfeiting a substantial portion of your assets.
Another consideration in favor of annuitizing is a desire for simplicity. As we age, our ability to make sound financial decisions could deteriorate. Annuitizing allows us to outsource these decisions to an insurance company that in turn will provide regular income.
Those who aren’t sure if they’ve saved enough for a long retirement are more likely to benefit from an annuity. If you are fairly certain you have saved enough for a long retirement, there is little need to insure against longevity risk.
The “Gold Standard”
Some retirement experts consider Social Security the “best annuity money can buy.” So before considering purchasing an annuity, you should first consider how to optimize your social security benefits.
Optimizing Social Security is a separate topic for another day. Staying on the topic of annuities, let’s look at some key features of Social Security that make it so attractive.
Social Security provides inflation adjusted income for the remainder of your life. It guarantees you will never completely be without income, and your purchasing power should remain fairly stable over your lifetime.
Getting similar inflation adjustments when purchasing an annuity come with additional costs. It is questionable whether this benefit is worth the cost.
Social Security also provides survivor benefits for spouses. Even children and surviving divorced spouses may receive benefits under certain circumstances.
Single Premium Immediate Annuity
The most simple annuity product is a fixed lifetime single premium immediate annuity (SPIA). It’s exactly what it sounds like.
You purchase an annuity contract from an insurance company paid in full up front. You receive an agreed upon monthly payment from the company. Payments start on a specified date shortly after purchasing the contract and continue as long as you live. When you die, the payments stop.
The size of the payments are dependent on prevailing interest rates and your age at the time you purchase the annuity. The older you are the lower your remaining life expectancy, thus the greater the payments.
You can use the online calculator at ImmediateAnnuities.com as a starting point. You simply enter an amount you would consider annuitizing and see how much monthly income this will produce.
Annuity income is taxable. You can read more about the taxation of annuity income here.
You can purchase joint and survivor annuities. This means the annuity will continue to pay out as long as one of you is alive. Since there is a better chance that at least one partner will have a long life, this will reduce your monthly benefit significantly.
You can also purchase cost of living adjustments or inflation protection on your annuities. While this may be valuable, it is not free. You will receive a lower initial payment for the same purchase amount in order for the insurance company to be able to provide larger payments later.
A deferred annuity is another option to protect against longevity risk. As its name implies, with a deferred annuity you purchase an insurance contract now, but defer any benefit until a date in the future.
Michale Kitces has described how a deferred annuity fits into a retirement income portfolio. He points out a key feature that makes a deferred annuity more attractive than an immediate annuity for many people. A deferred annuity requires much lower capital outlay, because it is a more traditional insurance product than a way to produce income throughout retirement.
You can purchase a policy for a later age, for example 85 years old. Many people will not reach this age. Those who do have a relatively short life expectancy from that point. Thus, the same premium will yield a much larger monthly benefit when the annuity income begins compared to an immediate annuity that has to pay out over more years.
Variable and Equity Indexed Annuities
Fixed immediate and deferred annuities are often considered “good” annuities. You still have to shop around to find the best combination of payout amount and strength of the insurance company. But these are relatively simple and straightforward insurance products that serve a specific purpose, providing lifetime income to protect against longevity risk.
Variable annuities and equity indexed annuities are considerably more complex. Benefits are dependent on returns of underlying investments and are often challenging to understand.
Variable and equity indexed annuities often come with layers of fees that are difficult to decipher. These annuity products can range from bad to downright ugly for many investors.
I have yet to find any compelling reason why an average investor would consider either of these products. If someone has recommended one of these products to you, I would advise you to read the following items before proceeding. If you decide that either of these products make sense for your particular situation, proceed with caution.
- U.S. Securities and Exchange Commission Updated Investor Bulletin: Variable Annuities
- FINRA Investor Alert. Variable Annuities: Beyond the Hard Sell
- Variable Annuities: What They Are and Why They’re a Bad Idea for Most Investors
- U.S. Securities and Exchange Commission Investor Bulletin: Indexed Annuities
- FINRA Investor Alert. Equity-Indexed Annuities: A Complex Choice
- Why Indexed Annuities May Promise More Than They Deliver
We have established that some annuity products can serve a specific role in your portfolio and retirement plan. Others are less likely to be useful.
Unfortunately, the least useful products for you are the most profitable for insurance companies. Salespeople incentivized by large commissions aggressively sell these products. You need to be aware of when and where you may be vulnerable to encounter these least desirable products.
Annuities are frequently sold in 403(b) plans as a retirement vehicle for school teachers. They have been troublesome.
Tony Isola has been a consumer advocate bringing this problem into the spotlight. His work garnered this feature article in Barron’s, The Annuity Trap That Teachers Need to Avoid.
Gerry Born is a teacher who writes the blog The Millionaire Educator. He’s another vocal critic of high fee annuities in teachers’ retirement plans, writing Why Your 403(b) Sucks Beyond Belief. I’ve witnessed this phenomenon with two teachers in my family who had me look into their investments.
While the particularly poor investment options in teachers’ 403(b) plans have gotten some attention, those 403(b) plans are not unique. My wife’s previous job at a not-for-profit hospital also had a 403(b) plan. Participating in the plan required using an annuity with high investing fees and surrender charges.
401(k) plans traditionally had more strict regulations on annuities than 403(b) plans. The recent passage of the SECURE act lessens those regulations, leading some to speculate that more people may soon have annuities in their 401(k) plans.
This may be a good thing for some people approaching retirement who actually want and would benefit from an annuity. My knowledge of annuities in 403(b) plans makes me skeptical.
I anticipate more fee laden and complex annuity products in 401(k) plans being pushed on those in the accumulation phase who are unlikely to benefit. Investors beware!
People entering retirement have accumulated a lifetime of savings. This puts a target on your back for financial advisors who are looking to “help” you manage those savings.
Many people seek financial assistance when determining whether to roll over a 401(k) or other work sponsored retirement account to an IRA when retiring or changing jobs. The latter was the position my wife was in when our advisor, who was paid by commissions on products he sold, recommended we purchase a variable annuity in her rollover IRA.
As outlined above, an annuity could be the right decision for many retirees. However, an advisor paid under an AUM arrangement has a strong incentive to not recommend an annuity. It’s not in their best interest to have you spend a substantial portion of your investment portfolio on an annuity purchase when that portfolio allows them to generate fees.
It’s important to not trust anyone blindly with your money and to understand that all methods of paying for financial advice present conflicts of interest.
Even worse is the plight of some older retirees who may no longer have the capacity to make informed decisions in their own best interest. They are particularly vulnerable to be preyed upon by those who don’t have their best interests at heart.
Annuities that are unnecessarily expensive and complex are aggressively sold to this segment of the population. AARP shined a light on this practice with their Report on Protecting Older Investors. Ron Leiber wrote about it in the New York Times.
This situation highlights why we need to consider decisions that will contribute to the quality of our later years now, when we have the ability to act in our own best interests.
An Annuity In Your Future?
Many of you are still saving toward retirement or already are early retirees. An annuity may have never crossed your mind.
Some of you may have read about overzealous sales people pushing inappropriate annuity products. Others may be suffering from buyer’s remorse because you bought an annuity inappropriate for your needs and have ruled out any future annuity product.
We all want to have long, happy, healthy retirements. Buying the right annuity at the right time can enhance the quality of your later years. Buying the wrong annuity can be a costly mistake that can derail your retirement plans.
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[Contributing Editor Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris' writing has been featured in MarketWatch, Doughroller, Business Insider and RockStar Finance. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at firstname.lastname@example.org.]
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