Retirement Planning, Part 3: Income Strategies: Annuities

A very common question I receive is “what’s your opinion of annuities?”  The person is always looking for either a “yes, they’re good” or “no, don’t use them” type of answer but in financial planning general advice is always bad advice.  My response is always “they’re a way to generate guaranteed income.”  Then the person gives me a perplexed look like I didn’t answer their question.  But asking what is my opinion of annuities is like asking what is my opinion of a screwdriver.  It’s an available tool.  When used for the proper job it can be very effective; when not, good luck finishing the job.  Translating our analogy to retirement planning, when annuities are used for the right reasons, they can greatly strengthen your probability of success.

The problem is that annuities are often misunderstood by the investor, misused in terms of planning and are greatly oversold by brokers because most pay very handsome commissions (a conflict of interest).  Hopefully this post will serve as an overview of annuities and provide some clarity on when they might make sense.

Overview of Annuities

In its original form, an annuity was a guaranteed source of income until you die (a pension).  These days, annuities are mainly used for their bells and whistles, called riders, and usually aren’t annuitized into income.  So what exactly is an annuity?  An annuity is a contract offered by an insurance company in which you can invest money and if you choose, you can hand over the balance to the insurance company in return for guaranteed income for life.  This is called annuitizing the contract and once this is chosen, the balance is gone forever but you’ll receive income every year as long as you live.  Many people are afraid of annuitizing money because if they die shortly thereafter, the money is gone.  To alleviate this fear, there are various income options that you can choose from, including income on just your life, income for you and a spouse (in case you pass away first) or income on your life with a guaranteed payout period to beneficiaries if you die early (10 years is very common).

Different Types of Annuities

You can choose to skip the investment part of the annuity and simply annuitize a chunk of money.  This is called an immediate annuity because you will immediately begin to receive the annuity income.

All annuities with an investment component (before annuitization) fall under one of two categories: they’re either fixed or variable, and this refers to the investment options inside the contract and the potential returns each year.  A variable annuity is kind of like a 401(k) in that you’ll have a list of available fund options in which to invest.  After the bear markets in stocks from 2000-2002 and 2008-2009, it became very popular to also purchase a rider on your variable annuity as a failsafe in case the funds don’t perform well.  The rider acts as a second value that differs from the actual account value and the most popular ones will offer a minimum value from which you can either pull income, annuitize, or count as a death benefit if you were to pass away.

Fixed annuities are more like CD’s in that they typically don’t have investment funds but simply pay a fixed rate of interest each year.  Something called Indexed Annuities have also become popular where the rate of interest paid each year will vary based upon the performance of some underlying index (like the S&P 500) with a floor of 0% and a cap usually around 5%.

Pros of Annuities

The biggest advantage is the guarantees that annuities provide, like guaranteed income for life.  Eliminating an unknown factor, like future investment returns, can definitely strengthen the probability of success in retirement.  Annuities also offer tax-deferred growth within the contract, which can be a benefit but usually takes some advanced tax planning to know for sure.  It can actually come back to bite you if you’ll be in a high income tax bracket in retirement since withdrawals are taxed as ordinary income.

Annuities can also make sense if you don’t have a pension from work – by using annuity income to create your own personal pension.  And lastly, they should be considered if you’re healthy and have a family history of living a long, happy life.

Cons of Annuities

The two biggest cons are that annuities are VERY expensive and pretty inflexible.  In terms of expenses, you have to keep in mind that an insurance company is giving you guarantees, and the more guarantees you want to include (in the form of riders), the more you’re going to pay in annual expenses/charges.  The riders on variable annuities are also structured against the investor in the way the fees are calculated and charged.  Because of this, one or two bad years in the investment funds makes it extremely difficult for your actual account value to ever catch up to the “rider value” again.  Insurance companies structure these products this way because there is a very high probability of knowing exactly what their risk is – the rider value.

They’re also inflexible in both the investment options (a limited list and sometimes you’re even restricted as to how much you can invest in a single fund or type of fund) as well as being able to access your money.  Most annuities pay a hefty commission to the broker that sold it to you so the insurance company needs to be assured that you’ll leave the money in the annuity for many years so they can make it back in annual charges, or else you’re forced to pay a surrender charge to gain access to the money.

My View on Annuities

If a client is 100% risk averse, investing in an annuity with certain guarantees might make sense.  If they’re willing to accept a modest amount of risk, most annuities, in my opinion, are currently too expensive for the guarantees they provide.  The charges haven’t changed much but the benefits/guarantees have come down over the past few years.  You have to keep in mind that insurance companies are bound to the same investment markets and interest rates as everyone else.  Where I think they do make sense, right now, is for a person just entering retirement to actually annuitize some of their investment assets in order to create guaranteed income (like a pension) to meet their required expenses in retirement.  Including guaranteed income will typically strengthen the probability of success for a retirement plan.  However, there is a tipping point where you will actually decrease your probability of success if you annuitize too much of your investment assets.  It’s all about finding the right balance which depends upon numerous factors including your lifestyle (expenses), other sources of fixed income, amount of investable assets, and how long you might live based on family history, just to name a few.

Social Security, pensions and annuities are all sources of fixed income which should be used to match your required living expenses in retirement – things like utilities, food and healthcare costs.  Discretionary spending above this amount, your “income gap,” is often filled with other sources of investment income generated from your portfolio.  The next few posts will cover some common portfolio strategies to accomplish this with a focus on some of the better approaches in today’s investment environment.

Thanks for following!

-Nick

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