should I buy an annuity when I retire?

Should I Buy an Annuity When I Retire?

The Purpose of an Annuity When I Retire

Should I buy an annuity when I retire? It depends on the purpose of the annuity!

Before you do anything with your money, before you invest or buy an insurance product, make sure you understand the purpose of that money. What is the money intended to do for you? Before you buy an annuity when you retire, make sure you understand the purpose!

I think annuities are good tools if you know what you are doing. Make sure you know the purpose of the money then you can decide if you should buy an annuity when you reitre.

 

Are Annuities a Good Investment for Retirees?

No! Annuities are not investments! Whenever you purchase an insurance product, you are trading money in order to access a risk pool. That is, you are pooling your risk with others in order to mitigate that risk! You don’t invest in annuities, you buy insurance!

Certainly there are good annuities such as SPIAs, DIAs, and QLACs.

It can also be smart to consider longevity insurance.

And there are expensive, inefficient, and frankly bad annuities that are sold to you.

You buy a good annuity. You are sold a bad annuity. Annuities are not good investments. You buy them when you understand the purpose of the annuity.

What is the Purpose of That Annuity?

Annuities can do quite a lot. Quite too much most of the time! My new favorite saying is: you need to know the purpose of the money before you go out and buy an annuity.

I actually like annuities and what they can do for you. People live longer and spend more money when they have an annuity. Maybe it is because they want to beat the actuarial assumptions of life span, or maybe it is the never-ending stream of income that comes in every month. There is a lot to be said for annuities. And against.

But investments can’t do what annuities do. Let’s talk about what that means and try to understand the purpose of your money you put in an annuity.

Investments Can’t Do What Annuities Do

Remember, you have different pots of money set aside to do different things. This is mental accounting but it is how we think about money. Investments can’t do what annuities do because they are not supposed to! And in fact, most of the time, annuities are actually bond-replacements rather than stock-replacements.

Investments have their place in your portfolio. They are to grow, outpace inflation, and provide you with total returns (which is your income when retired). Bond are there to stabilize the portfolio and provide funds when stocks are down. And annuities? What do they do?

Well, as I mentioned above, annuities do too much! They are, often, too complicated.

Keeping things simple, though, let’s break down and review some features of annuities when you retire. First, let’s look at the aspects that are stock-like and those that are bond-like.

 

Investments Vs An Annuity When I Retire

When I retire, I’m going to have investment and annuities. I understand the purpose of stocks and of bonds. So, if I’m going to replace some of my stocks and/or bonds with annuities, why?

What are the features of annuities when I retire that make me interested?

Stock-Replacement Features of Annuities

Remember, the price of admission for stocks is volatility. Market volatility is a feature of stocks rather than a bug. It is expected, and it is the reason stocks have a premium!

Some folks think that volatility is a risk. It is not, for the most part, if you plan to own stocks for 10-15 years. They will almost always out perform most other instruments over that time span. The risk is in NOT owning stocks and having your money lose purchasing power.

If folks cannot tolerate volatility because they actually think it is risky, then perhaps there is a role for an annuity. Here, you can consider a variable annuity (VA) which actually invests in actual stocks within an annuity wrapper. This is not an efficient way to gain exposure to the equity market, but if someone cannot tolerate volatility at all, perhaps the long surrender period (illiquidity) of a VA might help behavior. There are less expensive IOVAs (Investment-Only Variable Annuities) available.

Or, consider a Fixed Indexed Annuity (FIA), as they are principle protected and don’t suffer from any stock market risk. And now, more often than not, you are being sold a RILA rather than a FA.

Again, these are not good reason to own an annuity, but annuities are for the most part not intended to be stock-replacements. Accumulation is not where annuities shine. They are bond-replacements.

Bond-Replacement Features of Annuities

As bond-replacements, annuities can shine!

A Fixed Indexed Annuity might return 1-2% more than bonds over time. If you use a FIA instead of bonds and increase your equity exposure as a result, chances are you will come out ahead. This is a use case of annuities during accumulation. If you must have bonds, especially if you are thinking about “income” rather than total return, an annuity might do you well.

I would much rather you think of total return investing, as investing for income is riskier. As you reach for yield in fixed income products, by definition you increase your risk. Annuities actually decrease risk and can provide stable and/or more income during accumulation.

But during de-accumulation, it is when annuities as bond-replacements shine.

 

When I Retire and an Annuity as a Bond-Replacement

Why do you have bonds when you retire?

Some folks think about bond ladders as providing liability matching assets. You need money in 2, 3, 4, and 5 years, so you set up bonds that mature in those durations. In today’s interest rate environment, bond ladders are dead.

An annuity is more efficient than a bond ladders. Here, compared to a long bond ladder (you have ongoing liabilities you want to meet with an income stream), a SPIA is most efficient. A Single Premium Immediate Annuity removes a lump sum out of your portfolio and provides a long-term ongoing stream of income. Bonds do not come close to a SPIA due to mortality credits. They just don’t.

For a shorter term bond ladder, a period certain annuity might be indicated. With any sort of return of premium guarantee or feature, you are losing out on mortality credits, but you might still be better off than bonds. Or, consider MYGAs. Rates are better with MYGAs than with bonds or CDs. And they are tax deferred. If your plan is to have an income stream anyway (via withdrawal or annuitization), MYGAs can make sense as a short term bond replacement.

I’m not a big fan of bond ladders because, again, they idea is that bond ladders provide income. They don’t in todays world, and we must thing about the purpose of bonds in a total return world, not an income portfolio world.

When I retire, the purpose of an annuity is to provide income as part of a total return approach.

When I Retire: Total Return and Annuities as Bond-Replacements

So, in a total return world, what is the purpose of bonds? Bonds provide stability and a source of income if stocks just happen to be down when you need income.

Stability. When a 90/10 portfolio goes down by 40%, a 60/40 portfolio may only be down 25%. Remember, you have to gain back much more than 40% to recover from a 40% decline. It is easier to claw back from smaller declines. Plus, you can re-balance a bond-rich portfolio when it is down in order to “buy low” and then “sell high” when you need the income.

Do annuities provide stability? Yes, but in a different way.

You may actually suffer a larger loss if you use annuities as bond-replacements and increase your equity exposure as a result of having an annuity. But when you retire, remember, annuities are for income. If you have a lower income need each month, you won’t have to sell equities when they are down, because you don’t need the income. So, you lose out on the re-balancing with an annuity, but your portfolio is under less stress to provide an income as well.

There it is. As a bond-replacement, annuities provide higher income than you can get from bonds. When the market is up, you have less need for withdrawals. When the market is crashing, you still have income needs. Part of those needs are filled by the annuity income, and part is still from the smaller amount of bonds you have in your portfolio.

As a bond-replacement, annuities don’t replace all bonds, just some.

 

Do you understand why you might want to have an annuity when you retire? What is the purpose of the money?

Purpose of Annuities When I Retire

Too often I come across folks who have annuities and they don’t understand why. What was the purpose of the money you put in the annuity?

That is unfortunate, and it is driven by the fact that the annuity was sold and not purchased. It is the fault of the “advisor” who wanted the commission rather than to help. That is harsh, but please understand, annuities need to be purchased, not sold. You need to want an annuity, and in order to want one, you need to understand the purpose of the annuity.

So, during accumulation, you might want tax-deferral and growth with the possibility of a future income source. Tax-deferral implies you are already optimizing your other tax-deferred options. Be very careful about buying an annuity in an IRA or a 403b. Very careful.

What is the purpose of a tax-deferred vehicle in an already tax-deferred account? Growth: sure, you can use annuities as bond-replacements during accumulation. Income: sure, you can annuitize the money where you get an income in exchange for the money. Also, there are riders (that cost money) that allow you to get an income without annuitization and giving up the lump sum. And there are other withdrawal features, return of premium, death benefit, long-term care…. And the list goes on and on into complexity. Complexity is the opposite of purpose, though. What is the purpose of the annuity during accumulation?

And, when I retire, what is the purpose of the annuity? Income is a good purpose. We all need income. After all, the function of retirement planning is to turn assets you have accumulated into income to live on after the pay check stops.

For now, I’m going to stop there. Just remember, you need to understand the purpose of an annuity in your overall plan. There are many reasons to own an annuity. Complexity is not one of them.

should I buy an annuity when I retire?

PROs and CONs of An Annuity When I Retire

I do not sell annuities. I don’t often even suggest them. But I strongly believe you need to buy one, not have one sold to you. Thus you need to understand the pros and cons of them in order to know when you might consider buying one.

 

Pros of an annuity when I retire 

Let’s look at the top reasons to have an annuity:

Fees are worth the cost

Not all annuities are chock full of fees. Advisor-sold Variable Annuities tend almost never to be worth the cost. But Investment-Only Variable Annuities can be used to 1035 exchange prior bad decision annuities or life insurance into lower cost alternatives to make up your basis before finally selling them.

In addition, no-load variable annuities with income riders might be considered if you want to use them as a sequence of return risk hedge. The strategy here: aggressively invest a low-cost VA for retirement. If the market does great, you do fine. If the market doesn’t do well, you still have the guaranteed return you get from the income rider. Win-Win. Some suggest putting up to 30% of your nest egg in the VA Sequence Risk strategy. I don’t think I’d ever bite on this, but it is in fact a use case for a VA. Blame Moshe Milvesky for the idea, not me!

Some annuities are “Free”

You will often hear that Fixed Indexed Annuities have no fees. While that is strictly true (100% of your money is put into the account—sometimes with a bonus!), the advisor is being paid from the spread on your illiquid money. That is, the insurance company earns more than they pay out, and there is a surrender penalty to get out of the annuity before the lock up period. They use that spread to pay the salesman if you leave early. Let’s be honest, though, nothing in life is free.

As a Bond-Alternative

Indexed Annuities pay more than bonds. That’s right, there is a use case for annuities as a bond-alternative. If you take some money out of your bonds and put it in an annuity, you might earn 1-2% more than if you leave it in bonds. Remember, bonds have a purpose in your portfolio, and make sure you understand what that is. I’ll just say it now—bonds are no longer for income. Total return trumps income anyway, as I explained in the last blog.

Principal Protection

Index Annuities are deferred annuities and protect against loss of principle. If you want return of your money more than return on your money, a MYGA or Fixed Indexed Annuity might be worth considering.

Tax-deferral

Enough said. If you are a high-income earner and you are maxing out your other tax-deferred space, this is at least worth considering. Tax-deferral is an indication for Life Insurance as well. Careful as there is a 10% penalty if you take out income before 59 and a half.

Income You Cannot Outlive

People who have annuity income are happier than people who don’t. Spend your account down to zero and magically more money appears next month. That is a nice feeling! Of course, maximize social security before you consider this use of an annuity. Social Security is the best annuity around.

You Cannot Tolerate Market Volatility

If you understand that volatility is not risk and you don’t lose out unless you sell, then this is not a problem. But people sell low all the time. They would be better off if they didn’t invest in the first place! For these troubled people, an annuity might help. If you cannot help yourself and you are going to sell low, don’t invest in the stock market, look to a VA or FIA.

Mortality Credits

I’m going to say that again: Mortality Credits. Understand these if you are going to buy an annuity.

If you are worried about outliving your savings, then an annuity is right for you. Your bond portfolio will not provide you as good of an income floor as an annuity because of mortality credits. Mortality credits mean that the annuity company can pay your more from day one because they know some people will die and stop being a liability on their balance sheet. This “risk pooling” allows them to pay you more. Many complex features of annuities (such as period certain and return of premium) destroy mortality credits and much of the reason behind getting an annuity in the first place.

Income

You cannot beat the fixed-income returns of an insurance company. They are big and get better prices on bonds, and hold them for the duration. If you want income, think no further than a SPIA

Insurance Companies—They Play Both Sides of Life

If you die early- they win because they stop paying out your annuity. And if you die late- they win because they can wait to pay out on your life insurance. If an insurance company has too much liability from life insurance, they can sell annuities, and visa-versa. Die early or die late, they are covered. Insurance companies, for the most part, are highly rated and secure companies that will not go out of business. If they do, there are funds in your State to cover some of your losses.

You Blow All Your Money Every Month

If you cannot save, you might want to think about an annuity. After all, once you turn on the income stream, you can spend everything you get and next month there will be more. But then again, if you blow all your money, how did you save up enough for an annuity in the first place?

Creditor Protection

This might be oversold, but not infrequently annuities have better creditor protection than your brokerage account. This is state specific, so see here.

You have under-saved for retirement

Honestly, if you take your cash out and buy a SPIA, you will be better off if you plan to live a normal or prolonged life span. Mortality credits will pay you better than your bonds do.

You think you need an income producing portfolio so you are taking too much risk

Risk can sneak up on you all sorts of ways if you are reaching for yield. If you are reaching for yield, annuitize some of your reach and you will reduce risk significantly. Total return investing beats the pants off of income production for this generation. If you think you need income producing assets to retire on, think again, and think about a SPIA instead.

You have longevity

Longevity insurance is what some annuities are all about.

You are already old but desperately need to do Roth conversions

Yes you can still do partial Roth conversions when you are older than 72. A QLAC or two might help out in this situation. If you take longevity out of the equation by using a QLAC or two, you might be able to save your heirs a ton of money, especially if they are in a high-income tax bracket or you must put your legacy assets in a trust. This is a new idea I just had. I’m not sure how well it would work out, but it is a consideration if you want longevity insurance and the ability to aggressively Roth convert after RMD age.

You desperately want Long-Term Care Insurance but cannot get it with traditional or hybrid policies

Annuities with Long-Term Care riders tend to be based on your mortality risk rather than your morbidity risk, whereas the opposite is true with hybrid Life Insurance/LTCI policies. We are getting far into the weeds here, but if you have a pot of money laying around and you desperately want LTCI and cannot get it through other means, talk to a salesman about an annuity with an LTC rider.

You must have guaranteed income for life

The safety-first vs investment-only spectrum is just that—a spectrum. I suppose there are some people who cannot take any risk at all and cannot have any stock market risk.

Cons of an Annuity When I Retire

  1. Because you got sold one.
  2. You don’t know the purpose of the money.
  3. You don’t understand every feature and bell and whistle attached to the product
  4. The money is already tax-deferred. Don’t get snookered into investing your pre-tax money into an annuity. This is called a qualified annuity. One of the nice features of annuities are tax-deferral. If you are investing in an already tax-deferred account, please be careful!
  5. You know how to invest your money and are comfortable with volatility. If so, a total return approach will beat out an annuity. Only if you use an annuity as a bond-replacement might you win. If you are thinking about an old-fashioned bond ladder just stop it—and get an SPIA instead
  6. Your Gut Tells You No. Just Walk Away if your gut tells you no. There is almost no reason why you cannot buy an annuity tomorrow instead of today. If considering a deferred product, the longer you wait the less you might make. Eventually, you will lose out to inflation, but not in just one day. Remember, you buy annuities, you are not sold them.

Summary: Should I buy an annuity when I retire?

Honestly, if you can think of any bad possible feature of an annuity, the industry can come up with a comeback for you. A lot of the complexity baked into annuities are “answers” to the problem people had. Here are some of the problems:

They are Illiquid—so, FIAs and VAs have withdrawal features which allow you to take out 10% or so a year

Loss of Legacy—they make return of premium riders and death benefit riders for these. I’m not sure these will ever make sense because if you plan to die early, an annuity is almost never right for you. If you plan on living a long time, then you will be happy if you die early and the kids can have whatever is left over.

Loss of Money—there are period certain annuities that pay you or your heir for a certain period of time. These mostly don’t make sense unless you are using them to cover expenses until some other income source kicks in. Again, this takes away mortality credits which is what makes simple annuities so special

I like to keep it simple. If you want income, if you understand mortality credits, and if you want a safety-first retirement, then consider an annuity.

Remember, in times of low interest rates, mortality credits actually pay out proportionally more than during times of high interest rates. So, bonds won’t do what annuities can do when rates are low.

When I retire, I am going to have an annuity. It makes a lot of sense to have some income coming in every month. Should you have an annuity when you retire? If you don’t have a pension, and you want to live longer and spend more, then answer is yes!

Posted in Retirement Income Planning and tagged .

8 Comments

  1. The biggest problem I have with annuities is that, in my opinion, they do not adequately provide what they claim to provide, a stable source of income in an inflationary economy. They provide a declining income stream that may lose 75% of its buying power over a 35 year retirement. A fixed income that doesn’t escalate cannot provide true longevity protection because, should you win the genetic lottery and live to 110 then the generous income that the annuity paid initially will probably not pay your Netflix subscription. I can see someone with excess retirement resources buying it for peace of mind, the feeling of having a paycheck come in monthly. But I get that now with monthly direct deposits from Vanguard and Personal Capital and I get to adjust them for inflation as often as I want. Buying insurance when you are already adequately self insured is not the optimum economic choice. Its kind of like the term life insurance policy my wife has on me in my sixties when we already have more than we will ever spend. It makes her feel better so, why not?

    • All true. But folks with annuities in retirement are more confident and spend more money. And if you use it as a bond substitute, most of the time you have more money left over at the end. Perhaps that is the true inflation component is that they let you take more risk with the rest of your portfolio?

  2. my apologies but you had a couple spelling errors/typos that always makes me think this is Nigerian spam…???

    • but the thought process is better than anywhere else on the web… and the price is right! So I never learned how to spell… at least I learned how to think!

  3. but really appreciated the vote of confidence in annuities as an income source just for reassurance in my specific situation with certain restrictions

    • Of course, to point out the obvious, I don’t know anything about your specific situation! I’m glad the shoe fits, though.

  4. So I’m curious how you plan to invest in annuities when you retire in six months. Which kind of annuity will you replace your bonds? Will you have more than one annuity type?

    • Remember I’m retiring to stay at home dad, so there will still be income coming in. I plan an immediate income annuity for income as a bond replacement when she retires!

Comments are closed.