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If you’re like many independent-minded boomers who cut their teeth on the market conditions of the 1990’s, you may harbor serious suspicions about annuity products. Who needs an annuity? With the stock market averaging near double-digit returns in the past, you could easily live off 4%, 5%, even 6% of your portfolio every year, without fear of drawing it down, and even expect that your holdings would grow in the process!

The independent financial press — writers such as Scott Burns, Richard C. Young, and Todd Tresidder — have done much to debunk the complex annuity products offered by the insurance industry. Many variable annuities, and more recently equity-indexed annuities, have been exposed as frightfully complicated contracts, larded with administrative expenses, underlying fund charges, costly riders, and poisonous surrender fees.

Even if one of these opaque products happened to be a fair bargain, it would be extremely difficult to know which one, because they are almost impossible to compare to one another!

Small wonder that many careful, frugal investors have long ruled out any sort of annuity as a retirement solution. Count me in that camp. For years, I loathed annuities because of what I read about the expenses and complexity. Why would I need an annuity, when I was enjoying great success at growing my own diversified portfolio well in excess of our retirement income needs?

But then three events transpired:

  1. The market crashed in 2009. Though our portfolio did better than most, and we had no need to produce income at that time, the huge stock market swoon allowed me to see a less-than-rosy picture through the eyes of others who had the ill-fortune to retire at the wrong time. And I knew that those who had purchased annuities, even the overpriced and complicated ones, were mighty happy with the steady paychecks they received during the crisis. I realized that annuities, of some sort, might have a place, at least for those without the investing skills and fortitude to endure a great recession. And that’s a lot of people.
  2. I retired. The decades looming ahead of me without a regular paycheck suddenly became very real, in a way they never could until I began the actual experience. It didn’t matter that I had many years of investing under my belt, and was highly confident in my ability to manage our portfolio at least as well as the pros at the large insurance firms. It didn’t matter that I knew our budget cold, and was confident that we could make significant reductions if needed. Because there was one thing I realized I couldn’t control: how long I would live. But, ironically, those large insurance firms could control for that factor. Simply put, by pooling my lifetime with thousands of others in annuities, they could economically insure us all against running out of money.
  3. I reviewed my estate plan. I realized that, even though I had done a decent job of saving and providing for my family, in terms of the amount of assets we had accumulated, I had overlooked one important factor: I had assumed that I would be around to manage those assets for the duration. But what if I weren’t in the picture? Was I confident that my loved ones could make those assets last as needed, regardless of whether they had any interest or skill in investing or money management? I could see they would need at least the option to put a portion of our assets on "autopilot," so they could count on a minimum of lifetime income without worries….

In light of these events, I began to see annuities differently, and more positively. Then along came new research demonstrating that adding an annuity to a diversified portfolio might increase the safe withdrawal rate by a percent or more. (In general, an immediate annuity lets you create a higher lifetime income stream than you can generate with the same amount in a conventional portfolio of stocks and bonds. This is because, with an annuity, you’re consuming both principal and earnings, and also pooling your lifetime risk with other buyers.)

Given my penchant for diversification, I began to realize that it could make sense to diversify my long-term portfolio management strategy by using an annuity for at least some of our assets. I wouldn’t do this right away, but as we grew older and had fewer options in life, I could see a more and more compelling case for locking in an income floor.

I’m talking here about using plain vanilla single premium immediate annuities (SPIA’s), not their complex and expensive cousins — the variable and equity-indexed annuities. With a SPIA you hand the insurance company a lump sum and they immediately begin paying you a monthly amount, no variability, no indexing, no extra fees. And I’m gradually coming around to viewing these "good" annuities, the SPIA’s, as functioning like another asset class in diversifying a post-retirement portfolio. They have the added bonus of removing longevity risk (the chance you’ll outlive your assets) from the equation.

Of course all kinds of annuities still have significant limitations, including:

  • They are only as secure as the underlying company and its state guarantee association
  • They reduce your flexibility for meeting large or unplanned expenses
  • They typically eliminate or reduce your ability to leave principle in a bequest to your heirs
  • They generally do not keep up with inflation, or require expensive and imprecise riders to do so
  • Their costs and value fluctuate with interest rates, which are not predictable over long retirement spans

So it’s important to realize that annuities of any flavor are not a silver-bullet solution for retirement income. They are simply one tool to be used in conjunction with your other retirement income assets. 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….

Meanwhile, have you priced or purchased an annuity? What has been your experience? If you chose one, would you do it again, or what would you change?

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