Not All Annuities Are Bad!
Annuities have been getting some bad press in the financial planning community. Financial planners tend to denigrate them due to their cost – “They have way too many fees, many of them hidden” – or due to the fact that they are not hedged against inflation, effectively reducing their usefulness at exactly the time (later in life) when they’re designed to provide the most value. FINRA, the brokerage industry self-regulator, even has an investor alert about some annuity products on its website: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndInsurance/P005976. What’s important to recognize is that not all annuities are the same, and that allocating a portion of your retirement portfolio to certain types can in fact provide better longevity protection than investing solely in stocks & bonds.
As a quick refresher, an annuity is a contract between you and an insurance company. You pay them a certain amount of money either up front or over time, and they guarantee to provide you periodic income starting at some point in the future for as long as you (and possibly your spouse as well) remain alive. You can think of annuities as having two phases: the growth phase and the annuitization phase. During the growth phase, the money you’ve invested in the annuity grows based on prevailing interest rates (fixed annuities) or via a more complex formula involving stock market growth (variable annuities). When you are ready to begin collecting income from the annuity, you annuitize it. From that point on, you receive a fixed monthly or annual lifetime payment from the insurance company that does not change.
A more detailed explanation and comparison of the different types of annuities as well as how they compare to alternative fixed income investments such as bonds is beyond the scope of this blog. But it is useful to understand the two big disadvantages of most annuities: (1) there are many fees, caps, and surrender charges imposed during the growth phase that can significantly impact the expected growth, and (2) you cannot know how much income you will actually get from the annuity until you annuitize it. The exceptions to both of these limitations are single-premium immediate annuities (SPIAs) and deferred-income annuities (DIAs). What’s different about them is that there is no growth phase. You pay your premium up front and immediately annuitize. The income stream begins right away for SPIAs, and at a defined point in the future for DIAs. The longer the deferral period, the greater the DIA payout. In either case the income amounts are specified up front in the contract.
Wade D. Pfau, professor of retirement income at the American College in Bryn Mawr, Pennsylvania found that by allocating a portion of their retirement portfolios to SPIAs and DIAs, retirees can achieve more liquidity and better longevity protection at a lower cost than investing only in stocks and bonds. He determined that putting about 40% (based on current interest rates) of your assets into a DIA with a 10-year deferral period provides the most downside protection for spending shortfalls. A shorter deferral period leaves more time for inflation to erode the value of the annuity, and a longer deferral period risks having your financial assets depleted before receiving your DIA income.
Of course, money put into an annuity is lost to your heirs, unlike money invested in the capital markets or in real estate. So if your estate plan calls for leaving a legacy to your children or to others, you will likely want to reduce the amount used for the annuity. If you extend the deferral period to close to 25 years, Pfau calculates that you can put just 10% of your assets into a DIA and still get better longevity protection than not using one at all.
It’s important to keep in mind that no investment is 100% safe. If the insurance company issuing the annuity goes bankrupt, your state’s Life & Health Insurance Guarantee Association will cover some (but not all) of the payments. Even U.S. government bond returns and social security payments have been tinkered with at various times. In the hierarchy of common retirement income sources, from safest to least safe, annuities fall right in the middle:
- U.S. government bonds
- Social Security
- ERISA-regulated company pensions
- Non-U.S. government bonds
- Real estate
Despite the many drawbacks with annuities, SPIAs and DIAs in particular can be very useful in diversifying the income streams from a retirement portfolio and help improve the likelihood that you don’t run out of money.