Annuities: The Good, The Bad & The Ugly
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.
Buying an annuity typically means you surrender any remaining benefits upon death. It is possible to purchase a joint annuity or a death benefit rider for an annuity, but these features add cost.
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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[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 has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. 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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Awesome and thorough rundown on annuities Chris. As with most things it’s not all bad or good, there’s some nuance and folks have to look at their circumstances and really evaluate annuities to see if it meets their needs.
This complex subject has been on my mind and I just did not know how to even begin untangling it. Your article provides a great base.
Thanks Connor. If you’re looking for more perspective on this topic, I recently listened to Jeffrey Brown on the Long View podcast. It’s definitely worth a listen. https://www.morningstar.com/podcasts/the-long-view/31
Hi Chris, early in my career I was strictly opposed to annuity products within retirement plans (I managed our company’s retirement plan). I focused on the higher fees, commissions, loss of control over management and the impact on the estate from the risk of an early death. However, as I approached my own early retirement, my opinion changed. I now believe they have role for some folks. Since the mid-80’s plans have morphed from low participation to high participation in large part due to automation and default settings. Many employees today are not engaged in their retirement plans because the thinking has been done for them. Companies have auto-enrolled and auto-increased their contributions over their careers. Companies have defaulted employees into Target year investments for gradual reduction of market exposure because the employee wouldn’t take time to actually select their own investments. Now, when it’s time to retire, they have 6 or 7 figure balances that they have no idea how to manage. I’ve seen too many retirees blow through balances in a very short time and then have nothing but social security.
Annuities can play a role for these folks. As guard rails so to speak. They weren’t engaged in participating (by allowing the company to make all the decisions by default along they way) and the probability of engagement in retirement is nearly zero.
For your readers who certainly are engaged – thoughtful investigation as to how an annuity could play a useful part of a portfolio is worth the time. You’re pro’s and con’s are an excellent tool to get the analysis started. Great post.
Thanks for the thoughtful comment. Agree that for someone totally disengaged, an annuity can make more sense. Unfortunately, the odds of someone totally disengaged and disinterested actually getting into a “good” annuity and not being sold one of the “bad” or even “ugly” ones is probably highly unlikely. Being financially ignorant can be very expensive. I learned that lesson the hard way!
Crystal-clear and concise summary Chris – thank you! I don’t know of any writers other than you and Darrow who’ve been able to tackle this topic with such clarity.
I don’t know if you even know about John Greaney, one of the great pioneers of ER writing and blogging (at it for 20+ years) but I just checked in with his site the other day and read this excellent post on the “ideal” annuity. As usual with Greaney, it’s witty, irreverent and spot-on.
Thanks Kevin. I hadn’t heard of Greaney. Thanks for sharing. Now if only someone would offer such an annuity!
According to Dirk Cotton (in a December 2019 Blog) “Sadly, it appears that the last company to offer CPI-linked annuities, The Principal, has stopped offering the product.”
You mention a couple of times that inflation adjustments may might be valuable but are not free.
Who is correct – are they available or not?
I know that if there are still companies offering this option, there aren’t many. He may be correct that there aren’t any at the moment, as I didn’t actually try to buy one. I would assume that someone will bring them back in the future if there is enough market demand for them at a reasonable price.
I bought a Variable annuity back in the late 90’s because I was making good money at the time and wanted an additional way to generate tax deferred income. The IRA limits were only $2500 /yr back then and the annuity gave me a way to invest an unlimited amount tax defferred, albeit at a higher cost. I paid a 5% load over 5 years and couldn’t get out of the annuity until it was paid.
As soon as that 5 years was up I “fixed” my mistake and transferred the Annuity to Vanguard. Their annuities have lower fees just like their stock funds and I choose how the annuity funds are invested; it’s part of my portfolio. I felt better about this annuity as it has grown substantially over the years and a financial advisor told me as annuities go, I had a good one.
Your situation is one time I think a VA may make sense, especially if you only have an IRA and no option to defer money with a 401(k) or other work sponsored plan. As you note though, even then it is important that you are buying the best VA rather than being sold one with unnecessarily bloated fees.
I don’t know if you still own the VA with Vanguard. I helped my parents do something similar, but Vanguard is getting out of the annuity business. At the time we did the transfer, there was also a solid option with a company that I believe was called Jefferson National that sold what they called a “rescue annuity” for people that were sold bad VAs and needed a way out. They have been acquired. Apparently there just isn’t enough profit in selling “good” annuities to make it worth their while.
Thanks, excellent blog! I have had an annuity that I started at work (non-profit hospital 403b) about 10 years ago. The annuity pays 4.5% (4.26% actual) per year interest. I take a payout of 4.3% per year divided monthly over the year (annualized). I pay fed tax on the withdrawal, my state does not tax retirement plans.The withdrawal goes into ~2% savings account and isn’t used to live on. It is also built with a survivor for life benefit. I am happy with this (well not the fed tax part) and glad that I have it. Sure, it could be making more, but the other 80% of my $ is doing fine. Retired +4 years, my golf game still stinks.
As long as you’re happy, that’s what counts. More time to work on your golf game. 😉
Just curious if you shopped around to see what the payout on your annuity in the 403(b) is vs. what you could purchase on your own given your age at the time you started taking payments?
I need to point out something that was not clear in the article, you can have lifetime income with an annuity without annuitizing. This allows the balance of the contract to be paid to your beneficiaries upon your death, many SPIA’s have a cash value option that pays a lifetime income and returns the remaining balance to the beneficiaries upon the death of the annuitant. As you stated in the article, annuities are not for everyone however they may be appropriate for a portion of some portfolios and their use may be the better decision in some situations.
I’m assuming you’re referring to a death-benefit rider that decreases the monthly payout (or said another way adds to the purchase price to receive the same monthly payout). I don’t think any insurance company is giving out a “free lunch” of as high a monthly payout as you would get from a plain vanilla SPIA and refund of premium at death.
Annuities are a bit like onions, every time you peel back a layer, there is another layer that might be rotten. SPIAs can be important if you need income. Careful with the “Deferred Annuity” because there are DIAs and then VAs and FIAs are also called Deferred Annuities. So, DIAs are good, and VAs are bad, and FIAs can possibly be used as bond-alternatives. But again, an onioin…
Definitely a complex topic. Thanks for the input.
Any thinking about taking a aging blood test that can tell you your biological age before you buy a SPIA. You may find out your are 10 years older or younger then your chronological age.
Longevity Insurance for a Biological Age by Dr. Moshe Arye Milevsky talks about this subject.
I don’t have any specific thoughts on that. In general healthier people tend to find annuities more appealing, so that may already be priced in anyway.
I recommend Wade Pfau’s book Safety-First Retirement Planning if you really want to understand annuities. Much of it was over my head but he makes the case for different kinds of annuities given the individual’s situation, and he explains how the various types of annuities work. It was enlightening to learn how annuities, including other than the simple SPIA and deferred annuity, might be a smart part of someone’s portfolio, including for those interested in leaving a legacy..
Thanks for the recommendation Mainer.
I would be interested in your take on the company called Blueprint Income. They specialize in annuities, and they have a very interesting choice called the Personal Pension, which you actually build yourself through an initial “down payment” and regular monthly contributions. I’m too old for that, but it does look enticing for my adult children in their 30s as an alternative to investing. You probably can’t make a call one way or the other without some due diligence, but it seems like they are trying to re-invent the annuity market.
I can’t evaluate every product, but hopefully this article gives the framework I use to evaluate decisions like this. My question to you would be why your children in their 30s need an “alternative to investing”? What is so enticing? Investing comes with risk. A big pitch with many annuities is stock like returns without stock market risk. Generally, trying to avoid risk that you can afford to take on yourself is very expensive. Especially for someone in their 30’s that will be paying those fees for decades when they generally need growth and can afford (and are likely to benefit) from volatility.
Hope that helps,
Great information. An annuity is an insurance product, not an investment product (even though much of the time, they are pitched as an investment). Ability to deliver on the promises depends on the financial stability of the company providing the “insurance”, not the state of the market. Insurance per se is not a bad thing, and having a big stable company provide a backstop when the market goes south can be a good thing. There are absolutely places where insurance makes sense, but you need to know what event you are insuring against, and how much this is costing you (including opportunity cost).
Thanks Jeff and I agree with your comment completely.
In the section that starts out with the title “Who Is Likely to Benefit?”, the obvious answer is the insurance company. Personally, I strive to self-insure everything I can. In some cases it’s only prudent if you have very high net worth as well as a certain level of risk tolerance but for me, I generally hate insurance of any sort (and annuities is a form of insurance in my book) as it’s a losing bet statistically.
There is no disputing that insurance is a losing bet statistically. If as a whole insurance companies took in less money than they pay out (plus all the costs to run their business) those companies wouldn’t be around to pay out when we need them. That’s simple math.
That said, insurance plays a role in financial planning. Some risks you can’t afford or don’t feel comfortable accepting on your own. In those cases, it is wise to understand exactly what you want to insure and find the optimal way to do it.
Thanks Chris for covering this topic in a very clear and concise post. I wonder if you’d consider a reverse mortgage as a (sort of) annuity? You mentioned Wade Pfau in this article … I’m just finishing his book on reverse mortgages and he makes a compelling case for them. And not just as a last resort for cash strapped seniors, but as a serious consideration for anyone age 62+.
I’m not sure if I’d consider a reverse mortgage because I honestly haven’t given it much consideration since I’m only 43 and the decision is far off in the future for me.
I am aware of Pfau’s writings, covered the idea briefly here (https://www.caniretireyet.com/home-ownership-investment-portfolio-financial-plan/) and may do a deeper dive into the topic in the future.
I agree with Mr. P2F…….I prefer Target year Mutual Funds for investors who are not engaged or educated about their retirement funds investment allocations.
Chris….I’m curious of your thoughts on Target year funds, and would love to see a similar research article.
Thanks in advance!
Like all financial products there are better and worse versions. Assuming it is a low-fee version, I’m a big fan. We really haven’t written much about target date funds, though I frequently link to others who do in our monthly “Best of” posts. Maybe it’s something I do need to write about. Thanks for the suggestion Bill.
Excellent article, thanks Chris. My own situation has been helped by annuities. At retirement my wife and I moved to a new community and looked to purchase property. Mortgage companies, we learned, count only active income, not savings. Without the our four annuities’ guaranteed monthly income (life-time joint, survivor, heirs – each paying out roughly from 3.75% to 5%) we would not have qualified in expensive NYC to purchase the income-producing three family home we enjoy today. Thanks to my financial advisor who layered these fixed annuities over several years before our retirement!
Thanks for sharing that IAT. I hadn’t considered that angle, though Darrow has written about the challenge of getting a mortgage when you don’t have income. https://www.caniretireyet.com/getting-a-mortgage-when-you-have-assets-but-no-income/
Thanks for confirming everything I’ve thought about annuities.
My wife an I (age 65 and 64) each draw Social Security benefits and I have a small deferred annuity which will start paying out in 2 years. I’ve long considered getting more single payment fixed annuities to create an income floor to reduce longevity risk. But since I don’t need the income anytime soon, I’ve been waiting for interest rates to climb back up some to get a higher payout for the same premium (and it won’t hurt that being older will also increase my payout).
I realize that it’s generally foolish to hold off “investing” hoping to get a better “price”, and I don’t do this with my other investments. But with interest rates at or near recent historical lows, I think my strategy is good. Of course I still need to decide when is a good time to buy but I don’t think we’re there yet. I’d be interested in your thoughts.
I can’t give any specific advice, but in general it sounds like you’re approaching this with sound thinking. There are two parts of the equation.
The first is interest rates. While interest rates remain low, there is no telling when they’ll go back up. For the past decade, “experts” were sure they had to go up, but they’ve bounced around in a very small and historically low range. They still can’t go much lower, but they do have a lot of room to go up.
The second is age/life expectancy. We know that the longer you wait to annuitize, the shorter your remaining lifespan and thus the greater the annuity payout amount for the same policy purchase assuming interest rates are relatively stable (and again they have more room to go up than down).
Best wishes on your decisions and on a long happy retirement.
I love Darrow’s and your site as it always pushes me to think, sometimes too hard! Anyway, Social Security is one of the best annuities, but it doesn’t seem as painful by paying the upfront costs over a lifetime. For example, my SS statement says I’ve paid around $100K and my employers about $100K. We accept this annuity as a viable part (and legal requirement) of our retirement plan. We don’t seem to fret as much about paying that money upfront, but we go kicking and screaming when we thinking about carving a sum from our portfolios. I look at an annuity like my life insurance. I didn’t buy that for me, but to give peace of mind and financial stability to my family. A joint annuity will do the same for a surviving spouse. It may not make the best financial sense, but neither did retiring early, and it’s all about quality of life.
Great perspective Ed!
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