R101 #8 - Annuity Basics for Retirement
Despite what the financial advice industry may have you believe, annuities are neither the devil nor the answer to your prayers. So let’s dig into what annuities are, how they work, and how they might fit into your strategy for providing retirement income.
Before we start, though, let’s go back to the question of whether or not your retirement income is already funded. If you have plenty of retirement income, and/or sufficient assets to support your retirement income, you probably don’t need an annuity. Don’t be a hammer in search of a nail.
Let’s also revisit the risks you are concerned about. Are you concerned about outliving your assets and/or averse to taking risk in the markets? Maybe you are willing to commit to an annuity to compensate for some of these concerns and help you sleep better at night.
What is an annuity?
This is a bit like asking to describe what is ice cream - there are so many flavors of annuities that they’re a bit like Baskin Robbins. At it’s most basic, an annuity is a contract between the person who purchases it and the insurance company who sells it. Although the annuity industry tries to sell annuities as “investments”, they’re an insurance contract. The contract could contain some terms that act like investments, but at the end of the day, annuities are insurance.
The person who purchases the annuity is the person who owns the contract. The person (or people) on whose life expectancy the payout is based is the annuitant. The cost to purchase the annuity is the premium paid - either one-time or as a series of payments.
Quick rabbit hole - because annuities are contracts, it matters which company you contract with. Not all annuity contracts are created equal - just like ice cream isn’t the same at Baskin Robbins v. Ben & Jerry’s. It’s important to comparison shop. The other thing to know is that the company (and the person selling you the annuity), needs to make money. They aren’t doing this out of the goodness of their hearts. It can be very difficult to figure out how much you are being charged in fees for various types of contracts. Not that all fees are bad, just that you need to understand that they exist, even if you can’t see them.
Given that, I like to simply explain a basic annuity as a financial product you can buy that can help you manage certain types of risk to your retirement income picture. The idea is that they replace a portion of your assets (replacing bond holdings) to provide a way to reduce longevity risk and/or investment/sequence of returns risk. The vanilla annuity is not there to replace your stock holdings, but to instead make you comfortable enough to take risk with the rest of your portfolio.
Depending on your retirement income personality that we discussed previously, this may or may not seem attractive to you. Those who worrying about outliving their assets, and are willing to pay to reduce that risk, are usually willing to entertain annuity sales pitches. For those who are especially worried about their portfolio losing value at a bad time are also attracted to the “guaranteed” nature of annuity income protections.
Let’s also be clear that I’m NOT talking about annuities that are pitched as a way to accumulate assets prior to retirement. That’s a whole different type of dessert in my opinion. We’re talking ice cream here, not cake, cookies, or brownies.
How do annuities work?
The vanilla annuity is where you pay a sum to the insurance company and they promise to pay a sum back over time via payments. The reason annuities exist is because insurance companies have an opportunity to collect money from lots of different customers (i.e. “risk-pooling”), and some of those customers are going to die before getting more back than they paid in, allowing those who remain alive to benefit from the sums paid by those who died (i.e. “mortality credits”).
Depending on the kind of annuity you buy, the time period for which you get paid back could be just your lifetime or that of you and your spouse (or someone else). If you want to cover more than one life, your payout will be lower, because the joint life expectancy of two people is longer than one.
If you chose to receive payouts for only a specific time period (i.e. “a period-certain” annuity), that will affect the payout offered. If you want the annuity to start paying you way into the future, like age 85 (i.e. “longevity insurance”), your payout will be different than if you want to start getting paid today (i.e. “immediate annuity”). If you want to get some money back for your heirs if you die early (i.e. “return of premium”), that will lower your payout. There are a seemingly infinite number of combinations of annuity features that can be sold.
And as you can see, every bell and whistle you want to add can affect the payout. That’s why annuities can get really complicated, really quickly. That also makes them hard to compare. Insurance companies know this, and in my opinion make these contracts filled with language that is darn near impossible to understand. Add to that a salesperson who is putting pressure on you to make a decision, and using fear-based sales tactics, it’s easy to understand how annuities have gotten a bad reputation.
How do annuities fit into your retirement income plan?
Knowing they get a bad rap, is there a place for these kinds of products in your retirement plan? There could be. Math and research indicates that it could be possible to increase your expected retirement income by purchasing an annuity product. The kinds of annuities that most often provide these results are a single-premium immediate annuity (SPIA) or a deferred income annuity (DIA). The SPIA provides an income stream that starts within a year, and the DIA provides an income stream that starts at some point in the future. In both cases, the premium for the annuity is paid now-ish.
The reasons this type of product can benefit retirement spending is due to a couple of reasons. The risk-pooling and mortality credits mentioned earlier can provide higher income than a comparable individual bond portfolio. Then there’s the ability that having guaranteed income gives you to allocate your remaining assets in a more aggressive manner, which correlates with higher expected return over time on that portion of assets. You may also want to protect yourself from making behavioral mistakes with investing or protect less financially savvy family members. There can also be tax benefits to using an annuity. We’ll discuss those more later in another blog post.
Let’s wrap up the ice cream analogy by saying that in addition to annuity flavors, there are containers that act like having your ice cream in a cup or cone (or even type of cone). There are add-ons (“riders”) that act like toppings that make the taste better, but have higher calories (i.e. higher fees). There are economic scenarios that can make annuities more attractive like when you want ice cream on a hot summer day. Do you want two scoops or one - how much of your assets should you use to purchase an annuity? I could go on. But do you really need three scoops of rocky road ice cream in a chocolate dipped waffle cone with hot fudge and sprinkle toppings? Maybe not.
The bottom line is that the annuity picture isn’t black and white. As with any financial planning question, it can help to have a second set of impartial eyes to help you make a decision and evaluate the pros and cons. The decision to purchase an annuity is also not solely a numbers decision. Lots of non-numeric factors come into the picture. A full analysis will include both quantitative and qualitative considerations.
Stay tune, because next up is a discussion of Social Security - sometimes called “the best annuity money can buy”. We’ll talk about why that is.
