Today: A controversial subject: Annuities. Regardless of strong opinions on all sides, I’ll make an effort to address the question of “What Role Should Annuities Play In Retirement?” (or at least provide a general overview of the topic).
For those of you who are new readers (btw, lots of you lately, much appreciated!), you’ll learn that I often weave in “harder” financial/investment articles along with the “softer” articles about retirement planning (Purpose, anyone?).
Make no mistake. today’s is a “harder” article, about a specific retirement planning investment tool. If you hate the “Hard Finance Stuff”, feel free to pass (I promise I won’t be offended). Have Faith, more “softer” stuff is on the way in the very near future (Hint Hint: Watch out for a “Weekend Edition” in the next few days).
BTW, I sometimes struggle with the right balance between the two styles…but I digress.
What Role Should Annuities Play In Retirement?
I’ve had this article in “Draft” for months. It’s an important topic, and one worthy of discussion here on The Retirement Manifesto. However, it’s also a very controversial subject, with valid reason. I’ve struggled with how to address the topic, and finally decided it’s time to finish this post, build up the courage to hit “Publish”, and provide my first “Annuity” post for you, my reader. It will live forever in my archives, along with other “investment specific” articles I’ve written in the past. I hope I give the topic a fair report.
First: I am not, and do not pretend to be, a financial professional. I’m simply a 54 year old guy who’s working toward early retirement, who’s enjoyed personal finance as a semi-serious hobby for 32 years, and has learned some stuff along the way. I’m merely offering you readers a “no cost journey” down my path as I work through The Retirement Red Zone.Today, Annuities. From a guy who's merely offering a No Cost Journey on his road to FIRE. Click To Tweet
To be clear, I am FAR from an expert on annuities. I’ve studied them a bit, considered buying some a year ago (even talked to Vanguard’s Annuity experts), did some analysis, and decided to wait. I think I’ll buy something (likely a deferred longevity annuity, but I get ahead of myself) in the next ~10 years or so.
I haven’t decided yet whether I’m going to buy an annuity.
That’s Me. My situation. My decision.
I don’t know anything about your situation, and do not pretend to be making any recommendations. I’m attempting to provide an objective description of the various annuity types, explain what situations they may be useful for, and some risks to consider with the product. This is not intended to be a comprehensive summary, and there are important details which you will need to study for your situation.Use this as a diving board into the world of annuities, but realize you still can't swim. Click To Tweet
DO NOT get into annuities without FULLY understanding what you’re committing to.
I wouldn’t want you to drown.
Annuities are a hot topic for controversy. I won’t attempt to fully explain the arguments that either side has, but a general summary is in order.
The “Annuities Are Bad” view: Let’s start with the “Annuities Are Bad” camp. In my humble opinion (with apologies in advance to anyone I may offend), the controversy stems around potential Conflict Of Interest in the financial advice industry. Due to complicated pricing structure, commissions, and high fees involved in many annuities, some cite the risk that a “financial expert” may be enticed into selling you a “high fee” (and, high commission) product that isn’t necessarily in your best interest. Learn enough about this stuff yourself to have an intelligent conversation with an adviser. Then trust, but verify.
The “Bad” view also makes the argument that you can generate a higher lifetime income stream, at a lower expense, by using an appropriate Withdrawal Strategy, and investing your money into a diversified portfolio instead of into an annuity.
The “Annuities Are Good” view: On the other hand, there’s no doubt that there is some merit to the various annuity products, and there are places where they are exactly the right tool for the job. As mentioned, I’m considering them as a potential addition into our retirement cash flow plan (see deferred longevity annuity below), and have done some general studying on annuities. There’s no doubt that they work extremely well in meeting the retiree’s cash flow needs in specific situations. They also may provide useful as a tax optimization strategy, as well as reducing/deferring your Required Minimum Distribution after age 70 1/2 (outside the scope of this article).
Annuities – The Basics
The Primary Concept
Annuities, as a gross generalization, are an insurance product. You’re essentially paying for the assurance that you’ll have a future cash flow. The annuity is a product in which the investor provides a lump sum of money to a counter-party (often, an Insurance Company). In return, the Insurance Company provides a steady and potentially lifelong flow of cash back to you for your retirement spending. Guaranteed income for a number of years, or for the remainder of life, depending on the annuity structure.
Dana Anspach, a financial writer I respect, (and author of Control Your Retirement Destiny, the best book on retirement planning I’ve read) uses the analogy of cookies and a cookie jar to explain annuities. In essence, you give the insurance company your cookie jar, and they hand you back a cookie each year. It’s a good analogy.
Hey Dana, one thing I’d propose adding to your analogy, if I may be so bold, is this:
- “The rationing of cookies by the cookie jar holder also insures you don’t eat too many cookies at once, to control your diet.” (hereby declared, by me, as “The Retirement Manifesto Addendum”). I hope you like it. Smiles.
While the primary concept is fairly easy to understand, annuities can get complicated when you start looking at the varieties and structures of different annuity products. The general principle is the same (but please check into the details of any annuity you’re considering):
The Investor puts in up-front money, and receives a future flow of retirement cash.
The Risks Of Annuities
There are some “snakes in the grass” in the world of annuities, and it’s important that you understand the risks before you commit any retirement funds to the purchase of an annuity. Below are some general risks associated with the annuity concept. Rather than address risks associated with each specific type of annuity, I’ll be providing a more generalized summary of risks. (Notice I said “risks” 4 times in the above paragraph, it was intentional. Pay attention, class!).
- Early Death = Lose Your Money: If you were to die shortly after placing your lump sum, your heirs could lose access to the money. In the case where the annuity income stream ends at death, the payback on your initial sum is higher if you live a long time. Die young, you lose. There are options to eliminate this risk (your heirs can get your lump sum back when you die), but they come at added fees, see the next bullet:
- High Fees: Various annuity structures have high fees, with variable annuities averaging 2.35% in fees. The more complex the structure, the higher the fees (add in that living benefit rider from bullet #1, and your fee jumps to 3.4%!!). Avoid complexity, and buy the simplest hammer you need to drive your nail. The fees are a major drawback on variable annuities, in particular.
- Loss of Liquidity: Once the lump sum has been used for the purchase of the annuity, it is no longer accessible for you to spend in the event of an emergency (you gave up the cookie jar, remember? And, based on “The Retirement Manifesto Addendum” you’re only getting 1 at a time to control your diet, remember?). Make sure you only invest $ into an annuity that you won’t need for short-mid term living expenses. Early withdrawal penalties can be steep.
- Counter Party Risk: Since the future flow of income is guaranteed by the financial institution which sold the annuity, there is some risk should that institution become insolvent. Stick with only the highest rated companies, your future income depends on them staying afloat.
- Inflation: If you annuity generates a fixed income stream, it will lose purchasing power over time to inflation. While there are inflation riders available, they result in a significantly lower payout than a fixed annuity in the early years (another “fee”, in effect). There’s no free lunch.
Interest Rate Impact
In addition to the risks mentioned above, There are various things that affect the economics of annuities. Beyond fees, the interest environment has a tremendous impact on the cost/benefit of buying an annuity. In a low interest rate environment, the investor gets less cash flow in return for the same investment than she would receive if she were to invest the same amount in a high interest rate environment.Annuity 101: The Higher The Interest Rate, The More Attractive The Return. Click To Tweet
An investor needs to be aware of the interest rate environment, and the impact of increasing/decreasing rates on annuity returns, when deciding on making an investment into annuities. (For the record, I suspect that interest rates are starting a slow, bumpy upward grind for decades to come. Then again, I really don’t know anything).
In my case, I’ve decided to delay my purchase of an annuity, primarily due to: 1) my need for short term liquidity (did I tell you I’m retiring early?), and 2) my view on interest rate trends. I’ve decided to wait until I’m 60 to revisit the potential purchase of an annuity, but continue to monitor the annuity market in the interim. One purchasing strategy is to buy annuities over a period of years, to minimize “interest rate risk”, but that’s beyond the scope of this overview.
A Fixed Annuity provides a fixed rate of return to the investor from the financial institution. There is no stock market risk, and the interest rate and payout rate is fixed for a period of time (~5-10 years) and known at the time of the annuity purchase. These are a “safe, low risk” investment, but that comes along with lower rates of return. Think of them a bit like a Certificate Of Deposit. These are typically the least complicated, and lower cost, of the annuity choices.
Indexed Annuities are a variant of a fixed annuity, but the interest rate is tied to a specific index (e.g., S&P 500). These are sometimes referred to as Fixed Index Annuities, or FIA’s. (I don’t know about you, but I find all of the nomenclature surrounding annuities to be a bit confusing. If you’re thinking of investing, take the time to learn the language of annuities).
A Variable Annuity offers investors the potential of earning a higher rate of return than a fixed annuity, while also assuming some return risk. Unlike fixed annuities, a variable annuity does typically have stock market exposure, and various other investment classes may be customized within the portfolio.
Income payouts fluctuate based on actual returns. In addition, investments into the annuity can be made over a number of years instead of a single “lump sum” payment. With a death benefit rider, a variable annuity can provide a payout to the owner’s beneficiaries of no less than the original lump sum investment. Further riders can be purchased which guarantee a minimum return. As you can see, the variable annuity can get complex (and expensive), and should only be pursued after all of the implications (and costs) are clearly understood. For the record, I’m not a big fan of variable annuities.
Immediate Vs. Deferred Payouts
For both Fixed and Variable annuities, the investor has the choice between an immediate or deferred payout period.
- Immediate: Sometimes called a Single Premium Annuity, or Income Annuity, in which payments back to the investor begin shortly after the lump sum is deposited (typically within 30 days). Payments can last for a fixed number of years (a “term-certain” annuity), or guaranteed to pay until death.
- Deferred: Sometimes called a “Longevity Annuity”, these are typically used to build up a future payout on a tax-deferred basis. Payouts are delayed in a deferred annuity for a period of time (~10 years) after the initial investment, allowing payout values to increase (the longer the deferral, the larger the growth of the payout). These annuities can be useful in protecting against longevity risk, given that a relatively small upfront investment can grow into a helpful lifelong income stream starting later in life.
In our retirement planning, I’m considering a deferred annuity as a hedge against longevity risk. We’ll likely get serious around Age 60, with a 15-20 year deferral (allowing payments to start at Age 75-80, and set it up to last as long as we live).
Annuities As A Retirement Tool
To determine whether an annuity is the right tool for your retirement planning, you first have to understand what cash flow objective you’re attempting to solve. Then, you need to consider the risks. Some situational examples are below:
- No Pension: In the event where you have a base spending level of “required spending” with no guaranteed income, the use of an annuity can provide some comfort in knowing you’ve got a guaranteed income stream for life. Establishing an annuity income stream to cover your essential living expenses is a valid situation for potential use of an annuity. This could also be used as a “top off” between your expected Social Security income and the minimum income level required to cover your basic needs.
- Longevity Risk: If you’re worried about outliving your money, a deferred annuity may make sense for you as “longevity insurance”. This is the area I’m considering for our retirement strategy. In our case, we’ll consider buying a deferred fixed annuity sometime during our 60’s, with a start date in our late 70’s. Payments (retirement income) would continue until death, providing us some insurance against a very long life.
- Income Diversification: Just like there’s value in having a diversified asset allocation, there’s value in having diversified income streams in retirement. If you’re overly dependent on one source of income (e.g., your stock portfolio), diversifying into annuities may be a reasonable step to reduce your overall risk.
- Tax Strategy: If you’re in need of additional tools to make tax deferred investments, annuities do allow a means of investing in a variety of fund types with tax deferred dollars. They are also a tool to help reduce/defer your Required Minimum Distribution (RMD) after Age 70. I wouldn’t suggest you “go solo” on this one, best to hire a financial adviser, or talk to Vanguard, to discuss the specifics of your situation.
According to this survey from Retirement Journeys, 11% of Baby Boomers plan on using annuities as a component of their retirement income plan. As I said, they are a valuable tool in the right situation, and you should familiarize yourself with the product and decide for yourself if there’s a place for them in your retirement portfolio.
I’ve taught myself the basics about annuities, but I’m no expert. Following are some of the articles “from the experts” which I found particularly useful as I researched this post:
- Investopedia: Annuities; How To Find The Right One For You
- MarketWatch: An Income Menu That Could Help Retirees Make Their Savings Last
- The Retirement Cafe: My Appreciation Of Annuities Has Grown
- Investopedia: Should You Buy An Annuity?
- The Balance: Beginners Guide To Understanding Annuities
- Vanguard’s Annuity experts: Very helpful folks, give them a call to discuss details.
Anyone working on their retirement financial plan should be aware of annuities. They are a “tool in the toolbox”, and you should be aware of the potential benefits that annuities can provide. As more people are impacted by the “extinction” of the defined pension plan, I suspect annuities will get more attention in coming years. In my view, it’s only a matter of time before 401(k) plans start offering annuities as a way of converting your nest egg into an income stream for life. Take the time to understand annuities, and talk to an expert if you think there may be a fit with your situation.
Just beware the risks, and understand all of the fees, before you give away your cookie jar.
PS: To assist you in finding my “investment specific” articles, I’m considering a “compilation post” in the future. Perhaps, a “Table Of Contents” type of post, with links to the various investment-specific articles I written over the past two years. Let me know in the Comments if you’d be interested (and I just may pull it together for you!).